IT IS a common gripe among businessmen that although central banks in the rich world have done their damnedest to bring down interest rates, many firms still struggle to borrow, as battered banks curb lending in an effort to shore up their capital. In America, one beneficiary of this unfortunate squeeze on credit is a form of mutual fund that lends to businesses, known as a business-development company (BDC). BDCs have been around since the 1980s but have recently multiplied. More than 50 of them are now listed, with a combined market capitalisation in excess of billion (see chart).
BDCs are allowed to borrow as much money as they raise from shareholders, usually through fixed-rate bonds, so the total amount at their disposal is approximately billion. That is not much. The industryБs total valuation is only a quarter of CitigroupБs, and were they to lend out this entire sum, it would equal just 4% of AmericaБs commercial and industrial loans. In reality, some of their money is invested in shares and some goes into property, so their impact is even smaller.
Still, BDCs are big enough to be receiving attention from businesses hungry for capital and willing to pay interest of 10% or more to get it, as well as from investors hungry for dividends, which can also exceed 10%. That is more than four times the dividend on the average stock and more than double the yield of even a junk bond. The high payout comes with a caveat, however. Because BDCs are classified as a fund, they pay no corporate tax, unlike a bank.
To preserve this status, they must distribute 90% or more of their income each year. As a result, building up their capital base is a slog. So too is finding good customers for loans, since they do not offer the prosaic products like current and payroll accounts through which banks typically acquire their customers. Many BDCs specialise in financing the acquisitions of private-equity firms.
That helps to keep down costs, as they make big loans to just a few customers. But it can also suppress returns, as there is lots of competition to back private-equity deals. Although BDCБs limited borrowing makes them safer than banks, they also suffer from higher defaults. As a result, when the financial markets become volatile, and in particular when the market for high-yield debt wobbles, their shares slump and they struggle to raise capital.
Another quirk is that all but a handful of BDCs do not have internal managers; instead, they farm out their management to notionally independent firms. The managersБ compensation under such deals is often opaque but lavish. Indeed, charges akin to the Б2 and 20Б that hedge-fund managers once typically extracted (a management fee of 2% of assets and a performance fee of 20% of profits beyond a certain threshold) remain common. Triangle Capital, based in Raleigh, North Carolina, is an exception.
Last year it returned 18% on equity by backing private companies in the region, with both debt and equity. It is managed in-house, and provides transparent accounts, complete with details on managersБ pay. TriangleБs market capitalisation is far greater than the value of its assets; BDCs with external managers typically trade at a discount. For the industry to continue growing, reckons Christopher Nolan of MLV Co, an investment bank that focuses on it, BDCs must make two changes.
First, they should align the interests of owners and managers better. Second, they should ally with banks, which have lots of loan-hungry clients but less appetite for risk. A bit of financial engineering might spur such partnerships: loans could be sliced up to create a high-yielding but riskier portion for BDCs while leaving the safer and less lucrative bit with banks. Regulators are keen on the idea of transferring risk from outfits with flighty, government-insured funding, such as deposits at banks, to ones with more stable, loss-absorbing backers, such as the shareholders of BDCs.
Building arrangements of that sort on any scale will take time, but a foundation is starting to emerge.