Warning: Business Development Companies Just Got Doubly Risky

At this point of the credit cycle, a lot of securities look cheap. But the question is whether they really are cheap or whether they are cheap for a good reason.

One class of investment is looking exceptionally cheap right now – trading at 82.7% of their net asset value and kicking off very high income of 10% to 17% at the same time. But in fact, the whole class is in trouble.

It’s a group of companies known as Business Development Companies (BDCs). A BDC is a closed-end investment company that lends money to small and mid-sized companies. Due to their structure as closed-end funds that pay high dividends, BDCs are designed to appeal to retail investors. The problem is that investors often forget that high dividends come with a price – and that price is usually that the loans made by these companies are illiquid and high risk. And that means that when the economy weakens and the credit cycles turns for the worse, these companies tend to get into trouble. It happened in 2008-2009 and it is happening again now, as I’ll show you in a moment.

But Congress just made the risk much worse…

To add insult to injury, the industry has lobbied Congress to enable them to take more risk while paying themselves higher fees. In November, Congress voted on legislation to raise the limit on how much money BDCs can borrow to enhance their returns. Further, BDCs will be allowed to charge management fees (which are already higher than most closed-end funds) on levered rather than unlevered assets. Finally, BDCs will be allowed to lend money to financial companies, which tend to be opaque and higher-risk than the more mundane nonfinancial businesses they were originally intended to serve. This legislation is reminiscent of the decision to allow investment banks to increase their leverage in 2004; within five years, half of them had borrowed themselves to smithereens!

Coming at the late stages of an epic credit cycle, this is classic pro-cyclical legislation that can only lead to trouble.