Investing Through Business Development Companies

June 20, 2019

Grant M. McGregor, Portfolio Manager McKinley Capital Management, LLC

Robert A. Gillam, CFA Chief Executive Officer McKinley Capital Management, LLC

McKinley Capital Investing Through Business Development Companies (PDF)

For nearly three decades McKinley Capital Management, LLC (“McKinley Capital”) has sought to improve risk-adjusted returns for its clients and to be a leader in innovation in the asset management space. With this mindset, and in partnership with a large RIA, McKinley Capital developed a way to offer its income-oriented client’s access to private debt through Business Development Companies (“BDC’s”). These unique instruments are investment companies who focus on small and middle market enterprises through debt and equity investments. Given stricter banking regulations and regulatory requirements bank lenders have avoided the small to middle market loan segments BDC’s serve. This market segment represents approximately 200,000 businesses that employ over 47 million people and represents more than $87 billion in investment capital. Because of this lack of funding, BDC’s have the ability to lend at a considerably higher rate, often times between LIBOR plus 300bps and LIBOR plus 1000bps. These higher lending rates can lead to higher net interest income that lands in investors pockets as most BDC’s are registered investment companies, making them pass-through entities. As pass-through entities BDC’s are required to payout at least 90% of their taxable income to investors which equates out to an average yield of over 9% for most BDC’s. Exhibit 1 below shows the McKinley Capital BDC Representative Portfolio dividend yield compared to several other high yielding spaces such as Master Limited Partnerships (MLP’s), Corporate Bond’s, Real Estate Investment Trusts (REIT’s), and Utilities.

Exhibit 1: McKinley Capital Business Development Company Representative Portfolio – 12 Month Yield Analysis

Portfolio/Index12 Month Yield
McKinley Capital BDC Representative Portfolio (Median)9.61%
Alerian MLP Index7.76%
High Yield Corporate Bond ETF5.27%
Dow Jones REIT Index3.84%
Dow Jones Utility Index3.14%
S&P 500 Index 1.94%

Source: McKinley Capital Management, LLC; Bloomberg retrieved on 06/20/2019. Past performance is not indicative of future results.

BDC’s have not only provided investors with industry leading yields but they have also delivered performance as well. The Wells Fargo BDC Index, which consists of the most liquid BDC’s in the space, has outperformed the S&P 500 Index by 168bps annualized over the past ten years. Exhibit 2 below demonstrates this outperformance.

Exhibit 2: Growth of a Dollar Comparison – For the period March 31, 2009 through March 31, 2019

McKinley Capital has grown increasingly optimistic on the BDC space given the legislation changes that have occurred in the last 12 months and industry changes that are on the horizon. In 2018, the Small Business Credit Availability Act (SBCAA) was passed allowing BDC’s to increase their leverage from a 1:1 ratio to a 2:1 ratio. This gives BDC’s the ability to double the amount of investment currently on their books following board and shareholder approval. Keefe, Bruyette and Woods estimate it could increase investment capital by $8-25 billion. Though the SBCAA became effective in 2018, it will take time to implement as BDC’s have to decide how much additional leverage to take, how to secure funding, and how to invest the capital.

Index inclusion has also become a foremost topic for BDC’s and could unlock an incredible amount of investment. In 2014 BDC’s were removed from the Russell and S&P indices due to the Acquired Fund Fees and Expenses rule (AFFE). This led to considerably less institutional and retail ownership due to their exclusion. Several of the leading BDC’s have now developed an entity known as the Coalition for Business Development with the mission to petition the SEC to exclude BDC’s from the AFFE rule, and if successful, will allow them back into Russell and S&P indices. If the coalition is successful we could see flows back in to the space similar to the outflows we saw at the end of June 2014, which was north of $2.8 billion and approximately 23 times the average daily trading volume in the Wells Fargo BDC Index for the day of the reconstitution alone. With possible index inclusion and the increased leverage potential from the SBCAA, BDC’s are set up for more investment potential than they have seen in over a decade.

McKinley Capital is excited about the prospects for our BDC product. We believe investors can benefit from exposure to an asset class that offers a unique diversification opportunity within an investors existing allocation mix. The portfolio is designed to capture appreciation while providing investors an attractive yield via exposure to BDC’s that satisfy McKinley Capital’s rigorous screening criteria. Please feel free to direct any inquiries to IR@mckinleycapital.com.

Exhibit 3: McKinley Capital Business Development Company Representative Portfolio – Holdings Characteristics

Characteristics 
Number of Holdings22
Avg. Wtd Capitalization (in MM’s)2,136
Dividend Yield9.61
FY1 P/E Ratio9.58
Price to Book0.96


Source: FactSet, 04/26/2019
All characteristics median except market capitalization


Exhibit 4: McKinley Capital Business Development Company Representative Portfolio – Top 5 Holdings

Security Name% Weight
Ares Capital Corp11.99
FS KKR Capital Corp10.88
Prospect Capital Corp7.08
Main Street Capital Corp5.68
TPG Specialty Lending Inc.5.42
TOTAL40.37


Source: Advent APX, 04/26/2019. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. It should not be assumed that recommendations on this list have been profitable or may be profitable in the future. All securities may lose value. Positions may change without notice, are part of a larger program and should not be considered for individual investment. A complete list of all securities held for the most recent 12-month period is available upon request.

Sources

Coalition for Business Development. Retrieved April 5, 2019, from Coalition for Business Development: https://coalitionforbusinessdevelopment.com/.

Dodd, Robert and Leslie Vandegrift. “Unveiling Business Development Companies.” Raymond James & Associates 2019.

Lynch, Ryan, and Paul Johnson. “2019 Outlook: 2018 Was Highlighted by Regulatory Change; 2019 Could Be an Encore.” Keefe, Bruyette & Woods 2018.

Lynch, Ryan, and Paul Johnson. “Deep Dive into the BDC Leverage Bill.” Keefe, Bruyette & Woods 2018.

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