BDC sales tank in 2020 after product performs poorly

Sales of nontraded business development companies — a popular, high-commission product sold by many independent broker-dealers for the past decade — hit new lows in 2020, while at the same time, the product had poor performance as COVID-19 had a negative effect on returns.

Broker-dealers sold just $362.3 million in nontraded BDCs last year, the least since 2010, which was the year after the first product was launched, according to Robert A. Stanger & Co. Inc. That amount is one-third less than 2019 and a mere fraction of its peak in 2014 when brokers sold almost $5.5 billion, according to the company.

Broker-dealers have sold more than $22.6 billion of nontraded BDCs since 2009, and one product sponsor and manager, FS Investments, accounts for roughly half that total. The individual rep usually charges a 7% commission and the firm 1%, which translates into a total of $1.8 billion in commissions over that time.

Meanwhile, both nontraded and traded BDCs performed poorly last year, in large part, due to conditions created by the pandemic. Nontraded BDCs often work with the goal to become listed or traded products and thus giving advisers and clients an opportunity to see liquidity.

BDCs work like banks and raise capital from investors to lend to small and mid-sized private companies, and sectors for those loans, including energy and restaurants, have been particularly hard hit during the pandemic.

The closed-end companies invest primarily in debt and equity of private firms. Yields can be attractive because of the BDCs’ exposure to high credit risks amplified by leverage.

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When the economic shutdown began last March, Fitch Ratings warned that BDCs would feel increased stress due to levels of debt and loan covenants.

According to Stanger research, its proprietary Non-Listed BDC Total Return Index had a negative return of 14.3% last year, compared to a negative return of 8.8% for S&P BDC Total Return Index.

“Many BDCs employ leverage, which amplifies broader market movements,” wrote A. Joseph Warburton, Professor of Law and Finance, respectively, at Syracuse University College of Law and Martin J. Whitman School of Management, in a new paper about BDCs. “In addition, BDCs invest in small and mid-size businesses that were hit hard by the pandemic-induced shutdowns.”

That translated into poor performance last year. A $10,000 investment in an index of traded BDCs was worth $9,115 at the end of 2020, versus $10,711 if invested in indices for high-yield bonds and $10,312 if invested in leveraged loans, according to Warburton. 

BDCs were also more volatile over the year than the benchmarks, which themselves are among the riskiest parts of the fixed income market, Warburton added. "While their high dividend yields are attractive, BDCs are risky investment vehicles that can significantly underperform once you adjust for their greater risk-taking," he noted.

But the run for nontraded BDCs is not over, said Kevin Gannon, CEO at Stanger. "A bunch of these BDC deals deployed capital into wrong assets, like energy, and got killed," Gannon said. "But big league managers are coming into the space."