How BDCs can help in changing equity markets

Shep Perkins, CFA

Chief Investment Officer, Equities

Michael C. Petro, CFA

Portfolio Manager, Putnam Small Cap Value Fund

Returns for small-cap value stocks have been nothing short of breathtaking over the past year. These stocks have reaped stellar gains, boosting returns for our small-cap value portfolio. Recently, this was due to an environment of declining unemployment, Covid-19 vaccine developments, and expectations for the reopening of the U.S. economy.

However, it is now important to consider how an investment portfolio might weather a retracement — or temporary reversal — of this trend. In the case of an equity market downturn or increasing market volatility, a stream of current income can provide a base level of return and add some ballast to portfolio performance. We believe one way to achieve this is through an emerging asset class known as Business Development Companies (BDCs).

An emerging asset class for equity investors

Organized under the Investment Act of 1940, BDCs invest in the debt, and occasionally the equity, of U.S. middle-market businesses. In other words, BDCs provide financing capital to small- and midsize private companies.

  • BDCs typically originate and hold a portfolio of loans, most often in the senior secured position of the capital structure.
  • Net interest income, after management fees and expenses, is passed on to BDC equity investors via regular dividends.
  • BDC holdings are generally diversified across industries.
  • BDCs may take on leverage, but it is limited and is well below that of bank leverage.
  • Similar to the REIT model, BDCs avoid tax at the corporate level as long as they distribute the bulk of their income to investors.
  • BDCs can profit, and potentially increase their dividends, when short-term interest rates eventually rise because they typically hold floating-rate assets.

Like many REITs, BDCs are often managed by external firms. BDC managers include some of the best known and most experienced hands in debt capital management. While relatively small right now, the public BDC market is growing and includes many liquid names such as Ares Capital (ARCC), Owl Rock Capital (ORCC), and Hercules Capital (HTGC). It currently has a market capitalization of about $50 billion, which we expect to grow in the next year via both IPOs and equity follow-on offerings.

Attractive yield potential, but security selection is critical

Most BDCs strive to deliver returns on equity in the 8% to 10% range, which today generates commensurate dividend yields. They are able to achieve this through a combination of high-yielding loan assets, favorable corporate tax status, modest leverage, and strong underwriting.

BDC managers differ in their approaches to credit and interest-rate risk, portfolio construction, fee structures, and raising additional capital. Credit quality is the biggest swing factor in individual BDC performance over time, with the best managers historically achieving long-term annualized returns that are several percentage points higher than the median BDC. A few BDCs have been hampered by less robust underwriting, resulting in weak credit selection. In these instances, total return — dividend yield plus capital appreciation — is softer. As a result, stock selection is critical when investing in BDCs, as is properly evaluating a BDC’s liability structure, dividend policy, fee structure, and underwriting philosophy.

A potential counterweight to market volatility

The S&P BDC Index delivered a solid 5-year average annual return of 9.8% as of 4/30/21. Cushioned by BDCs’ high current yield, the index has a 5-year realized beta of 0.93x versus the Russell 2000 Value Index. It has generally exhibited lower volatility in non-recessionary periods when compared to both the Russell 2000 Value Index and REITs. These characteristics, combined with their high cash dividends, make BDCs a good counterweight to market volatility in the current environment.

BDCs have been less volatile in non-recessionary periods

Rebounding economy should favor BDC performance

Because they are vehicles for accessing the private credit markets, BDC equities are not immune to recessions, as we saw most recently in 2020. This is because investors quickly price in expected losses to BDC book values from negative credit developments. However, with the recession firmly in the rear-view mirror, we expect the rapidly rebounding economy to continue to improve credit metrics and asset valuations broadly. This should support rising BDC book values and dividends, independent of short-term gyrations in the stock markets, and contribute to lower volatility of BDC equities compared to most other small-cap value stocks.

The past year has been a great one for small-cap value equity returns. However, high investor expectations can lead to periods of flat performance, declines, and volatility, even within a longer-term bull market. In this context, active portfolio management is essential. Portfolio construction strategies — such as investments in BDCs with attractive yields and volatility-dampening characteristics — should prove beneficial.

Explore Putnam Small Cap Value fund

As of 4/30/21, BDCs represented 2.70% of Putnam Small Cap Value Fund assets, and the portfolio yield was 1.35%. As of 3/31/21, Ares Capital (ARCC), Owl Rock Capital (ORCC), and Hercules Capital (HTGC) were not held in Putnam Small Cap Value Fund.

The S&P BDC Index is designed to track leading business development companies that trade on major U.S. exchanges. The Russell 2000 Value Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their value orientation. You cannot invest directly in an index.

Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company.

Business Development Company (BDC) strategies entail numerous risks and may not be suitable for all investors. Such risks include, but are not limited to portfolio company credit and investment risk, leverage risk, market and valuation risk, price volatility risk, liquidity risk, capital markets risk, interest rate risk, dependence on key personnel, and structural and regulatory risk. BDCs invest in private companies and thinly traded securities of public companies, including debt instruments of such companies. Less mature and smaller private companies involve greater risk than well-established and larger publicly traded companies. Debt investments in which a BDC may invest will not be rated by a credit rating agency and will be below investment grade quality. These investments have speculative characteristics with respect to an issuer's capacity to make payments of interest and principal. BDCs may not generate income at all times. The market price of securities issued by a BDC may fluctuate significantly. Also, there can be no assurance that the securities issued by a BDC will have an established trading market or otherwise have sufficient liquidity. Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio.