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Sunny Days in the Shadows for Nonbank Lenders

Business development companies are thriving at middle-market lending. Should regulators be worried?

Banks want to lend to them, institutional investors want to invest in their funds and businesses want to borrow from them, at least when banks turn them down: Business development companies (BDCs) are doing a much larger slice of the lending to middle market U.S. companies these days — about 25 percent, according to the Financial Times. Their assets grew to $43 billion as of the third quarter of 2013, up from $28 billion in early 2008.

As Alex Frank, CFO of Fifth Street Management LLC told CFO a couple of weeks ago, “We’re filling a void in the marketplace and providing capital to an underserved portion of the economy that has been largely abandoned by the banking sector” — businesses flagged as too risky by credit committees or whose borrowing needs aren’t large enough to make lending to them profitable.

Analysis_Bug3“When you factor in the amount of regulatory capital banks have to hold against [a middle-market or small business] loan, and factor in that we are talking about smaller companies and smaller loans, and that it’s just as much work to underwrite a loan of $40 million as it is one of $400 million, banks have struggled with the expense structures,” Frank says. “It’s not a very efficient model.”

Business borrowers often like private debt also. As CFO wrote last October, loans from BDCs, while more expensive, have fewer covenants, and the lender often does not require personal guarantees from ownership.

But regulators certainly need to keep watch over the rise of business development companies and the asset class they represent. Relative to commercial and community banks, BDCs are loosely regulated; indeed, they are considered part of the nation’s “shadow banking system.”

BDCs were created by an act of Congress in 1980 and were envisioned to be publicly traded, closed-end funds that would make investments in private companies in the form of long-term debt or equity. BDCs don’t have bank examiners looking over their shoulders at the quality of loans they originate and for the most part are not subject to rules on their balance sheet makeup, except one: a BDC must meet a debt-to-equity ratio of one to one.

But now even that is being challenged: bills pending in Congress would increase the amount of leverage with which BDCs are allowed to operate. In the estimation of at one law firm, the legislation is likely to go nowhere. In part that’s because last year Securities and Exchange Commission Chair Mary Jo White came out against any BDC reforms.

Indeed, it doesn’t appear like BDCs are at all impeded by the leverage requirement. Lending to noninvestment-grade companies, BDCs can charge higher interest rates, which means they earn high risk-adjusted rates of return for yield-starved investors. For example, Fifth Street Finance, one of the BDCs owned by Fifth Street Management, had a weighted average yield on its debt investments of 10.9 percent as of December 31, 2013.

On the debt side, CFO Frank says it’s more efficient for banks to lend money to BDCs than to individual middle-market companies. Fifteen of the biggest banks lend to Fifth Street Finance, for example, which has investment-grade ratings from Fitch and Standard & Poor’s. And BDCs have another source of capital: the Small Business Investment Company program from the Small Business Administration. Once a BDC qualifies to be part of the SBIC program, it can borrow from the U.S. government to augment the funds of private investors. Fifth Street, for example, has access to $225 million over 10 years with no covenants.

Fifth Street has always operated with a substantial equity buffer — it finished the third quarter with a ratio of .61 debt to equity, says Frank. “Historically, we have operated at low leverage; we have been very conservative to maintain our dry powder,” he says.

As more asset managers enter what seems to be an extremely attractive business (Goldman Sachs is planning a BDC listing and TPG Capital is prepping an IPO of its specialty lending arm, according to the FT), regulators will have to keep close watch on this part of the financial system. BDCs may very well not need more regulation at this size, but if their share of middle-market lending grows larger, more investor and borrower protections might be in order.

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