Business development company managers are seeking creative ways to increase their portfolio yields in the best risk-adjusted manner. The BDC leverage limitation of one-to-one as outlined in the Investment Company Act of 1940 (the 40 Act) prevents them from increasing their direct leverage.
However, managers have invested in unitranche, second lien and mezzanine loans, as well as CLO equity and the equity of joint venture
loan funds. All the above investments can provide enhanced yields (of 10-20%) but also involve increased leverage in one form or other. While many BDCs have CLO equity investments, there has been a growing feeling within the BDC investment community that a 10-times levered CLO equity investment might not be appropriate for a BDC.
As CLO equity investments appear to be falling out of favour, investments in JV loan funds have experienced tremendous growth over the last year or so. Since 2015, eight BDCs have established seven JV loan funds with a current investment capacity of $6.3 billion.
A JV loan fund is a standalone, unregistered investment vehicle created by a BDC and an unrelated third party that has established leveraged loan credit capabilities (the counterparty). The purpose of the JV loan fund is to invest in first-lien middle market loans that fit with the BDCs overall investment strategy. The counterparty and the BDC must unanimously approve each investment by the fund.
The first JV loan fund was established by Allied Capital (later purchased by Ares Capital Corporation) and GE in December 2007. Allied/Ares provided 87.5% of the first loss capital in the Senior Secured Loan Program (SSLP) and GE provided the remaining 12.5%. GE also provided leverage of 400%.
Historically, BDCs have followed SSLP in having an 87.5%/12.75% equity split. However, more recently, new funds have changed the percentage ownership with the counterparty contributing a greater percentage of the equity. In the newly formed $2.2 billion Middle Market Credit Fund, Carlyle GMS Finance and LBC Credit Partners have agreed to coinvest equally in the equity of the fund.
Generally, the JV loan fund will lever its equity investment by obtaining a revolving credit facility with a term of three to five years. While these credit facilities are private and individually negotiated, they are generally structured as borrowing base loans and advances are only made against conforming investments. The facility may or may not have a market value trigger. These facilities are similar to the revolving loan facilities that many BDCs themselves have and generally cost Libor plus 2.0% to 2.5%.
FASB accounting rule ASC 810 and the newly enacted ASC 20152
outline the rules for whether a BDC must consolidate the assets and liabilities of its JV loan fund.
Without getting too much into the accounting minutiae, a BDC that owns 87.5% of the first loss tranche of an investment fund would normally have sufficient control over the entity that it would be required to consolidate it. However, under ASC 946810101510(1)(iv), the fact that the minority equity investor – the counterparty – must approve each investment prevents the majority holder – the BDC – from having operational control over the JV loan fund. This means that the BDC is not required to consolidate the JV loan fund on its balance sheet. The SEC requires that the counterparty’s right to approve each investment be real and therefore requires it to have credit capabilities.
Theoretically, there is no limit to the leverage JVs can use. However, BDC managers have consistently limited the leverage to a maximum of 400% or lower (see table). BDCs can always increase or decrease their borrowing capabilities given current market conditions and investment opportunities. But, as with all of these borrowing base credit facilities, it is quite difficult to fully utilise the facility. Currently, the average utilisation of JV loan fund credit facilities is only 53% (excluding SSLP).
Some BDCs have argued that the assets in the JV loan funds are eligible assets as defined by the 40 Act. However, the SEC has not blessed this position so market participants treat their investment in the JV loan fund as part of their 30% noneligible investment portfolio.
Obviously, the biggest benefit of an investment in a JV loan fund is the enhanced returns, which are very attractive on a risk-adjusted basis. While CLO equity also provides attractive yields, it is levered 10 times and does not directly add to a BDC’s investment capabilities. According to Prospect Capital’s most recent investor presentation, it expects to earn an IRR of between 15% and 20% on its CLO equity portfolio. The average BDC’s current yield on its JV loan funds (excluding SSLP) is approximately 12%. Ares reported that its overall investment yield for the third quarter of 2016 was 8.7% (on an amortised cost basis), while it earned over 13% on its SDLP investment.
In addition to their strong risk-adjusted returns, JV loan funds provide BDC origination platforms with a competitive advantage by allowing them to invest in larger portions of loan facilities and potentially invest throughout a borrower’s capital structure. With the growth in one-stop shopping and unitranche loans, a BDC’s competitive position in the origination market place is greatly enhanced if it has the ability to take large positions in the entire capital structure of a Thursday, December 01, 2016 borrower’s loan facility. As an example, the Fifth Street Asset Management platform was able to take a $60 million position in Valet Merger Sub and place the senior and subordinated tranches of the loan facility within its two BDCs and their respective JV loan funds.
Over the past few years, BDCs have increased their investment in JV loan funds and have introduced various changes to their capital structures to better suit their needs and the needs of the counterparty. JV loan funds still predominately invest in first lien middle market loans but several JVs have started to invest in second lien loans, while others invest in broadly syndicated loans. Also, two BDCs have joined forces and created a JV loan fund, with Capital Southwest and Main Street Capital jointly creating the $245 million I24 SLF fund.
With their enhanced yields, the ability they afford managers to take larger positions in loan facilities and their ever more flexible structures, JV loan funds will continue to grow, I believe, and this growth may well accelerate. Absent a congressional change in BDC leverage limitations, I believe most BDCs will have at least one JV loan fund.
The only question is whether managers can source enough quality investments to keep their JV loan funds fully invested. Therefore I would not be surprised if managers start including different types of investments in their funds in the future. Small BDCs may join with CLO managers to create JV loan funds that invest in a mixture of broadly syndicated and middle market first lien loans.
About the author
Sean Dougherty has over 15 years of experience in the CLO industry, including structuring, legal, operations, valuations and risk