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Non-Listed BDC 101

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A business development company, or BDC, is a closed-end fund that is subject to certain sections of and rules under the Investment Company Act of 1940 but file annual and quarterly reports under the Securities Exchange Act of 1934. BDCs typically invest in debt or equity of private or thinly traded public companies, with objectives of generating current income or capital appreciation. Generally, a BDC must invest at least 70% of its assets in U.S. private companies or public companies with a market cap of less than $250 million.

Many BDCs are listed on securities exchanges, but non-traded BDCs are not. Non-traded BDCs are less liquid than their traded counterparts, typically offering shareholders limited liquidity through periodic repurchase offers. One rationale for investing in a non-traded BDC rather than a traded BDC is that the value of a non-traded BDC more closely tracks the net asset value, or NAV, of the debt or equity investments it owns, while the value of a traded BDC is also influenced by general stock market conditions and volatility.

The earlier generation of non-traded BDCs are “lifecycle” funds, which have a limited lifespan, often seven to 10 years, after which they intend to liquidate their portfolios and distribute the proceeds to shareholders or list their shares on an exchange. The liquidity strategy and horizon for lifecycle BDCs is not binding, and their boards may delay a liquidity event or change the liquidity strategy based upon market conditions.

Most non-traded BDCs currently offered are “perpetual-life” BDCs, which offer shareholders limited liquidity through repurchase offers at designated intervals, such as monthly or quarterly, generally at higher levels than were offered by predecessor lifecycle BDCs. These repurchase offers are discretionary, not mandatory, and may be suspended by the board at any time. Repurchases are made at or based upon NAV and are subject to limits, such as a maximum of 5.0% of the BDC’s total NAV per quarter. If shareholders request an amount greater than the limit for a particular period, repurchases are pro-rated, meaning shareholders will only have a portion of their requests honored and will have to wait until future periods to have the remainder of their shares repurchased. Perpetual-life BDCs regularly value their shares, often with the assistance of third-party valuation experts. They have become much more common and widely accepted than lifecycle BDCs in recent years.

BDCs are subject to limits on borrowing. The standard limit is a 200% asset coverage ratio, or $1 of borrowing for every $1 of investor equity. If certain conditions are met, the limitation can be increased to an asset coverage ratio of 150%, or $2 of borrowing for every $1 of investor equity.

Most perpetual-life BDCs currently being offered primarily focus on a debt investment strategy in order to generate income to pay regular distributions to investors. Most debt investments and borrowers are either rated below investment grade by investment rating agencies or are not rated. Debt investing strategies can vary based upon factors that will affect the fund’s risk/return profile, including: (i) the size of the borrower and the loans; (ii) where the loans fit in the borrower’s “capital stack,” such as senior secured loans or unsecured subordinated loans; (iii) whether the loans bear interest at a floating or fixed rate; and (iv) whether the loans are “originated” by the asset manager or purchased in the syndicated loan market.

Factors to consider in evaluating a non-traded BDC include the following:

  • Liquidity: Is a lifecycle or perpetual-life liquidity strategy more in line with an investor’s objectives? If the BDC is perpetual-life, has it honored all repurchase requests to date or has there been pro-rating? If it is a lifecycle BDC, what is the exit or liquidation strategy for the fund?

  • Investment Strategy and Portfolio: Different equity and debt assets have different investment characteristics; for example, senior secured loans of large borrowers are generally viewed as having lower risk than subordinated loans or loans to smaller borrowers. Also, loans with floating interest rates benefit from rising interest rates, while fixed rate loans lose value in a rising interest rate environment.

  • Performance: How has the BDC performed to date? Performance is generally measured based upon distributions paid and changes in NAV.

  • Distribution Coverage: Have distributions been fully paid from earnings, or has the BDC supported distributions with offering or borrowing proceeds? It is also important to consider the sources of the BDC’s earnings. Does it rely primarily upon interest income or does it also depend upon fee income from originating loans or realized gains from an active trading strategy?

  • Leverage: Borrowing at low interest rates can improve a BDC’s overall returns, but debt increases risk, particularly during a market downturn or in an increasing interest rate environment.

  • Fees and Expenses: How do the BDC’s fees and expenses compare with those of its peer group? If they are higher, are they justified, for example, due to a more complex, management-intensive strategy?

  • Manager Quality: Does the manager have the staff and infrastructure to effectively execute the BDC’s investment strategy? Does it have a successful track record investing in the types of assets the BDC is investing in? Does the manager have a team equipped with relevant work-out experience, who can step in if the outlook of the BDC’s investment or the underlying portfolio company begins to deteriorate?

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