Liquidity, Leverage, and the Structure of BDCs
A few years ago, I was on a bus headed to dinner with a group of investors. It was one of those industry gatherings where conversations naturally drift toward markets and portfolios. Nearly everyone was discussing private credit, including the yields, the perceived stability, the diversification benefits, and their own allocations to the sector.
As someone who spends his days evaluating the relative risk and reward of fixed income investments, I found myself asking a simple question. Where is the catch?
When an asset class becomes widely embraced, particularly one offering yields meaningfully above traditional bonds, it warrants careful examination. This is not skepticism for its own sake, but an effort to understand the structure beneath the return.
Two years later, when Blue Owl announced that one of its non-traded BDCs would modify its redemption program and instead return capital through structured asset sales and distributions, that question resurfaced. Private credit had not failed. Rather, the episode demonstrated that structure eventually reveals itself, especially in credit markets.
This paper examines what a Business Development Company is, how it is funded, where risk resides for retail investors, and what recent developments reveal about the mechanics of private credit.
A Business Development Company is a regulated investment vehicle created by Congress in 1980 to facilitate capital formation for small and mid sized United States businesses.
At its core, while the name is somewhat ambiguous, the model is straightforward.
To maintain favorable tax treatment, BDCs must distribute at least 90 percent of taxable income. As a result, they often feature relatively high dividend yields.
BDCs generally fall into two categories. In both cases, the underlying strategy is middle market direct lending.
The defining structural feature of a BDC is leverage. BDCs borrow additional funds to expand their lending portfolios. For example, 100 dollars of equity capital combined with 100 dollars of borrowed capital allows 200 dollars to be deployed into loans. If loan yields exceed borrowing costs, the spread enhances returns to equity holders.
BDC leverage typically comes from secured bank credit facilities, institutional bond issuance, insurance company private placements, pension fund capital, and in some cases Small Business Investment Company debentures. Debt providers are generally large, sophisticated institutions. Retail investors largely participate through the equity layer.
Leverage, of course, improves returns when credit performs well. It also magnifies equity losses when asset values decline.
Private credit portfolios are not inherently unstable. However, structural features create distinct risks.
Credit Risk: Borrowers may experience earnings pressure or default during economic slowdowns.
Leverage Risk: Declines in asset values disproportionately affect equity holders.
Liquidity Risk: Public BDCs offer market liquidity. Non traded BDCs offer limited periodic liquidity. Repurchase programs may be capped, prorated, modified, or suspended.
Equity Versus Fixed Income: Perhaps most importantly, it may seem intuitive to some but many investors never connect the dots that, when they purchase shares of a BDC, he or she is not buying bonds. The investor is purchasing equity in a leveraged lending vehicle. Equity holders sit below institutional lenders in the capital structure and absorb first losses. They participate in the residual income of the portfolio only after borrowing costs are paid. The underlying assets may be debt instruments but the investment itself is an equity. Understanding that distinction is essential when evaluating risk, volatility, and liquidity expectations.
Blue Owl announced that one of its non traded BDC vehicles would transition away from traditional quarterly tender offers and instead return capital through structured distributions funded by asset sales. This change reflected the interaction between investor liquidity demand and leverage constraints.
In a non-traded BDC, redemptions reduce equity and increase leverage ratios. Regulatory asset coverage limits must be maintained. Managers may sell assets or modify redemption programs to remain compliant.
Institutional lenders sit senior in the capital structure, while equity investors bear first losses and liquidity constraints. This dynamic is inherent in leveraged private credit vehicles.
Business Development Companies play an important role in financing middle market businesses and can provide attractive income within diversified portfolios.
However, they are leveraged credit structures in which institutional capital typically funds the debt layer and retail investors largely occupy the equity position. Liquidity, particularly in non traded formats, is periodic and conditional.
In credit markets, structure is not a footnote. It is the story.
With gratitude,
David and Mike
Disclaimer
Roosevelt Capital Management LLC is a registered investment adviser. The information presented is for educational purposes only and is not intended to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. No guarantees or assurances that the target returns will be achieved, or objectives will be met are implied. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal.
While all the values used in this report were obtained from sources believed to be reliable, all calculations that underly numbers shown in this report believed to be accurate, and all assumptions made in this report believed to be reasonable, Roosevelt Capital Management LLC neither represents nor warrants the values, calculations or assumptions and encourages each prospective investor to conduct their own review of the audits, values, calculations and assumptions.