Investors lose out as interests conflict

When Goldman Sachs floated a Business Development Corporation in March, it was motivated by two compelling trends.

The first reflects the reluctance of some banks to make unsecured loans to small and medium sized business, and the second involves the willingness of investors to give asset managers so-called permanent capital.

Goldman's move also shines a spotlight on a sector where differences in the way such companies are managed are stark and attracting scrutiny. Namely, how the boards of some BDCs are allowing managers to place their own interests ahead of shareholders.

"The more we've thought about it and spoken to managements, the more we've realised the conflicts of interest that can exist with this structure,'' says Stephen Zurilla, senior research analyst for Advisors Capital Management, which invests in BDCs. ''There has been some movement, but there is still tremendous room for improvement if the sector is to develop as a true asset class."

A BDC is effectively a form of US closed-end fund set up to provide finance to small companies. Created by Congress in the 1980s, they raise money through an initial public offering, and use the cash to make loans, typically to private companies too small to issue corporate bonds. Investors can buy or sell shares in the BDCs, overseen by independent boards which set the investment objectives.

As with other US investment structures, such as real estate investment trusts, there can be tax advantages to paying out most of a BDC's income as distributions. Several BDCs are set up as a sort of hybrid private equity vehicle, where an external management company oversees everything, in return for fees.

Such fees are a familiar faultline in asset management. Their size is both a signal for supposed excellence - private equity must be good to charge so much, say some investors- but also an object of scorn.

What stands out for BDCs, however, is the transparent way fees and incentives are reflected in market valuations.

For instance, the managers of Mainstreet Capital are in-house and incentive fees are among the lowest for the BDC sector. The company is valued at almost 1.5 times book value.

By comparison, Fifth Street Finance is run by an external management company, and last year fees were three times that of Mainstreet when judged as a proportion of the assets managed. The BDC trades at 0.8 times book value, according to Keefe, Bruyette & Woods.

Robert Lee, KBC analyst, has assessed valuations: "Some of the higher growth BDCs experienced higher asset growth, but the key was a meaningfully lower expense ratio that allowed the asset growth to translate into earnings growth and higher distributions to BDC shareholders."

Fees are not the only factor, as BDCs still have to make decent loans and avoid defaulting borrowers. Valuations also reflect expectations for earnings growth, but when a typical interest rate is about 10 per cent, how much of that is paid out in management fees, makes a substantial difference to what is left.

Consider also the opportunity presented when a BDC trades at a substantial discount to book value. If a manager is confident in the quality of the loan book that underpins the valuation, it makes sense to buy back stock rather than make new loans - the old investment adage about buying dollar bills for 80 cents.

The point, say critics of the BDC model, is the alignment of interests.

Share repurchases shrink a BDC's assets under management, thus reducing fees paid to an external manager, calculated as a percentage of those assets. Although, as with mutual funds, independent boards are supposed to represent the interests of shareholders, rather than the management company paid to choose and oversee the investments.

Some BDCs have established programmes to buy back stock automatically if the opportunity arises.

"If we're trading below our net asset value, we think the right thing to do is repurchase our shares. We go to our board every quarter and renew a repurchase programme", says David Golub, head of the externally managed Golub Capital BDC.

Repurchases only make sense when the BDC trades at a discount, however, and while at least nine BDCs trade below book value, use of buyback facilities has been minimal.

Companies will have the opportunity to address the question when they start to report first-quarter results in coming weeks.

Asked why he had not bought back stock on a February call with analysts, Todd Owens, Fifth Street chief executive, told them: "We have had debates with the board and we continue to evaluate whether that makes sense for our business and we look forward to reporting back to you in the future."

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