If new capital is going to be tough to come by, a BDC may be tempted to stretch for higher debt and equity returns on new investments as a way to improve earnings, which may mean sacrificing credit quality. Alternatively, a BDC can look to reduce overhead to maintain or improve earnings.   But yet another idea would be for a BDC to look at complementary asset classes that can generate solid returns.

Near-Term BDC Interest in Commercial Finance

Despite the aforementioned equity market challenges facing the BDC sector, we continue to see a significant level of interest from BDCs in our asset-based lending, accounts receivable factoring, equipment lending, and SBA lending clients. To be sure, these companies are not a fit for all BDCs. But several BDCs have seen the merits in the commercial asset classes.

A BDC’s interest in the commercial finance sector can be far-ranging, including a simple desire for solid returns, or a desire to bring another ancillary debt product to the table for the BDC’s existing borrowers. Other BDCs or their affiliates are going one step further by creating discrete pools of capital to invest exclusively in the commercial finance space, seeking to exploit the uncertainty and regulatory quagmire of the banking sector.  

Given the highly competitive market for new loan originations today, more sellers are showing an interest in aligning with other partners who can help them find some competitive advantage with which to grow or expand.   Banks are always interesting buyers for a commercial finance company because of the obvious cost of funds and leverage synergies, and private equity buyers tend to leave a management team alone to operate a business as long as things are going well. Many BDCs, however, will bring capital like a private equity buyer but will also bring a ready-made customer base of borrowers that private equity buyers cannot always provide. And while a BDC’s cost of funds is not as attractive as a bank’s, their overall equity return targets often are not too different from those of a bank’s.  Today, a good bank generates a 10% after-tax return on equity.   A well performing BDC generates a 10% pre-tax return on equity.

Conclusion

While the BDC peer group is trading lower today than it was a year ago, we believe the broader specialty finance sector will provide an attractive debt and equity investment opportunity for the BDC lender and buyer universe due to the steady cash flows that many finance companies have generated, which provides dividend income or debt service capacity for the BDC. BDCs with stock prices trading below book value could do well to boost dividends by investing in a high risk-adjusted returning commercial finance company.   And many management teams would enjoy the freedom that can come from affiliating with a BDC that doesn’t have the regulatory burden of a depository.

Note: Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.