The Cost of Accessing Middle Market Debt through Business Development Companies (BDCs)
By nature, private capital market investment management is simply not as cheap as the public side. Private market investments usually require additional time to be spent on diligence due to less publicly available information in the form of financial statements. The added time spent on investment management is a cost that can add up to be significant in the long run. When taking a position in a BDC, understanding the fees associated with the management of the company’s investments is essential.
The two major BDC fees are management and incentive fees. Base management fees are typically a portion of gross assets in the range of 1.25-2%. Incentive fees are broken up into two parts. The income portion of the incentive fee is paid as a percentage of net investment income after some hurdle rate is surpassed. The capital gains portion of the incentive fee is a simple percentage of capital gains, often around 20%.
There are notable variations in fee structures across the different BDCs. The sharpest difference can be seen between the “legacy” BDCs and the “new” BDCs that were created after the 2008 financial crisis. The “new” BDCs typically have fee structures that require better performance before the managers can be paid, such as requiring that returns be generated over a longer period before rewarding management. While variations exist between how BDCs’ incentive fees work, there is little difference between the base management fees. The base management fee effectively incentivizes BDC managers to raise as much capital as possible, even if that’s not what’s best for current shareholders.
These fees, coupled with general and administrative expenses, can draw down the returns of even BDCs with high performing loans. CrowdOut Capital provides investors with an alternative means of getting exposure to the private markets with lower fees than BDCs. CrowdOut Capital’s fee structure is 1-3% of the loan amount and 10% of interest received by the investor. To put that into perspective, the BDC with the lowest fees, non-interest expenses as a percentage of investment income less interest is 19.1%. The average for the industry is 39.7%.