In the latest sign of a relatively obscure investment strategy finding its way out of the shadows, business development companies are getting their own index, which will likely lead to an investible product soon.
Wilshire Associates Inc. announced the launch of the Wilshire BDC Index on Wednesday to measure the performance of the $30 billion category of publicly-traded, debt-focused BDCs.
Until the index is licensed and investible versions are created, it will mainly act as a benchmark for the approximately six dozen individual BDCs that make up the universe.
BDCs typically are closed-end investment companies that
invest primarily in the debt and equity of small public and private companies. Yields can be attractive because of the BDCs' exposure to high credit risks. But the debt is typically senior secured and set to float with interest rate benchmarks.
The timing of such an index should add momentum to a strategy that is in some respects well positioned in the current market environment.
“BDCs take credit risk, not interest rate risk, so they benefit from rising interest rates,” said Zachary Klehr, executive vice president of Franklin Square Capital Partners, which runs four BDCs and has $13.4 billion in total assets under management.
According to Wilshire's research, BDCs are currently averaging yields of more than 10%, which compares with utility stocks and real estate investment trusts at around 3.8%, and a 2% dividend yield for the S&P 500 Index.
On a back-tested total return basis, the new Wilshire benchmark has a three-year annualized return of 17.1%, and a five-year annualized return of 14.4%.
“Investors have been chasing yields in bonds and bank loans, as well as tax-advantaged equities, and the Wilshire BDC Index measure performance for investment instruments that seek to combine the best of both asset classes,” said Robert Waid, managing director at Wilshire Analytics.
He added that over the past five years, the number of BDCs has grown by 13%, while the total market value has increased by 38%.
A driving force behind the growth, Mr. Waid explained, is the attractive income component of a registered investment vehicle that is required to
pay out 90% of its income in the form of dividends.
The index is designed to include approximately 30 capitalization-weighted publicly-traded securities. Among the requirements for inclusion in the index is a minimum market cap of $100 million, more than 75% of the assets invested in debt, and the company must be a registered investment company.
While BDCs have been around since the 1980s when Congress passed a law that essentially expanded the scope of the private-equity industry,
they have grown largely as a niche category.
One rub against them has been the internal fee structure that typically includes a 2% management fee and 20% performance fee.
Mr. Klehr of Franklin Square acknowledges the initial sticker shock of such high fees, but he added that the fees should be considered in the context of investment performance.
“These are alternative investments,” he said. “I would justify the fees based on performance, and the manager should be beating the best available other option.”
As the law allowing the BDC structure was originally written, the BDC is responsible for taking an interest in ensuring the success of the underlying companies in which the BDC is invested.
“We focus in on BDCs that use debt to help companies grow,” Mr. Waid explained. “It's an alternative to bank loan debt.”
Meanwhile, Mr. Klehr described the income generated as an “alternative to high-yield debt.”
While the category is clearly growing and gaining appeal among certain investors, it still hasn't gathered mass appeal among the broader financial advice industry, as indicated by Paul Schatz, president of Heritage Capital.
“High potential yield and total return doesn't outweigh the risk, in my opinion,” he said. “There's poor understanding of how BDCs operate from advisers, and no understanding from clients. I'm not a fan.”
