Considering Private Equity? Think Twice Before Investing in Business Development Companies – Morningstar

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BDCs offer investors a way into private equity, and they’re hard to recommend.
Since the global financial crisis of 2007-09, the size of the private credit market has grown dramatically and now exceeds $1 trillion. Antti Suhonen, author of the study “Direct Lending Returns,” published in the Financial Analysts Journal, examined the returns, risk exposures, and performance persistence of business development companies. BDCs, created by congressional legislation, are closed-end investment vehicles organized under the Investment Company Act of 1940. They have the following characteristics:
Suhonen’s database consisted of 47 BDCs (with about $112 billion of assets at the end of 2021) and covered the period of December 2009 through June 2022. The following chart shows the market-capitalization-weighted asset allocation of the 47 BDCs in the sample.
Following is a summary of Suhonen’s key findings:
Once traded in the listed market, BDCs adopt the volatility of common stocks and may deviate from their fundamental value because of changes in investor risk aversion and market liquidity. The result is that they are riskier than the assets they hold, a problem compounded by their use of high amounts of leverage. Add to that their extremely high fees relative to net investor assets (in excess of 5%), and it is hard to make a case for investing in public BDCs, especially when there are less risky and less expensive alternatives, such as Cliffwater Corporate Lending Fund CCLFX and Cliffwater Enhanced Lending Fund CELFX. The high expense ratio is particularly egregious when it is applied to gross assets (as opposed to net assets). The reason is that gross assets include those that are financed with leverage that has had an average cost of about 3.6% above Libor. The result is that the investor is paying full fees on the leveraged assets when they are not earning the full yield paid by the borrower. In contrast, Cliffwater’s fees are applied to net assets.
*When I discussed this finding with Cliffwater’s CEO, Stephen Nesbitt, he informed me that, while the finding was correct for a buy-and-hold strategy, his research found that a periodic rebalancing strategy from high price/book to low price/book produced higher returns than a buy-and-hold strategy.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For educational and informational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Mentions of specific securities are for educational purposes only and are not recommendations of implementing them into a portfolio. Individuals should speak with a qualified financial professional based on their circumstances. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. The opinions expressed here are their own and may not accurately reflect those of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. LSR-24-627
Larry Swedroe is a freelance writer. The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
Larry Swedroe is head of financial and economic research with Buckingham Strategic Wealth. He has written and cowritten 16 books about investing. His latest work, “Your Complete Guide to a Successful & Secure Retirement,” was cowritten with Kevin Grogan and published in January 2019. He holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.
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