BDCs are required to maintain a 200% asset coverage ratio. This means that a BDC’s assets must be two times its liabilities, if not larger. In other words, BDCs must maintain a debt-to-equity ratio of less than 1:1. Liabilities resulting from SBICs are generally excluded from this regulatory requirement. Credit rating agencies generally require BDCs to maintain an asset coverage ratio of 2.18 (debt-to-equity of less than 0.85 to 1) to qualify for an investment-grade rating.
Bonds that are sold by BDCs to retail investors, and typically trade on a stock exchange. Unlike institutional bonds, which have a par value of $1,000, baby bonds frequently have a par value of $25. Some people refer to baby bonds as “exchange-traded debt,” or the acronym ETD. See the alternative, institutional bonds.
The amount of a BDC’s original investment. If a BDC invests $10 million in a company, it would report that the investment had a cost of $10 million.
An accounting term that refers to a business’s earnings before interest, taxes, depreciation, and amortization. Businesses are generally bought and sold at multiples of EBITDA, with slower-growing businesses generally selling for single-digit multiples, while faster-growing businesses can sell at double-digit multiples. A business that generates $10 million in EBITDA might sell for five to ten times EBITDA, or $50 million to $100 million.
BDCs pay an excise tax on investment company taxable income that is not promptly distributed to investors. The excise tax is 4% of amounts that were not paid out to shareholders.
Externally-managed BDCs are managed by the employees of an asset management company. Rather than pay compensation directly, externally-managed companies pay fees, typically assessed as a percentage of the BDC’s assets and earnings. See the alternative, internal management.
The current value of a BDC’s investments, frequently based on an opinion by a third-party valuation service. As a requirement, a BDC’s Board of Directors is required by law to approve fair values for a BDC’s investment portfolio. Because BDCs tend to invest in illiquid assets that are not traded on markets, the fair value of investments is subject to great interpretation and, at times, manipulation.
A form of senior debt, a first-lien loan has a first priority claim to repayment and collateral in the event a company is liquidated. A first-lien loan sits above second-lien loans and mezzanine loans, and earn a lower rate of interest because of the lower risk.
Bonds that are issued by BDCs and sold to institutional investors are referred to as institutional bonds. Institutional bonds typically have lower interest rates, and may be more liquid, but are generally only issued by BDCs that have an investment-grade rating. BDCs that cannot issued institutional bonds typically issue baby bonds to retail investors.
BDCs that pay their employees directly from the fund’s earnings and assets. Internally-managed BDCs employ analysts and portfolio managers directly, rather than paying fees to an external management company. See the alternative, external management.
Lower middle market businesses generally earn between $3 million and $10 million in earnings before interest, taxes, depreciation, and amortization (EBITDA). These businesses tend to have less access to financing, and may be more frequently owned and managed by families rather than professional management. Loans and investments in lower middle market companies are expected to generate higher returns.
Mezzanine loans typically blend the risk profile of debt and equity investments. A mezzanine loan will sit just ahead of the equity, and below the first-lien and second-lien loans. Mezzanine lenders typically receive warrants as part of the loan consideration, which gives the lender an opportunity to cash in on a company’s upside potential.
Middle market businesses generally earn about $10 million to $50 million in earnings before interest, taxes, depreciation, and amortization (EBITDA). There is variation in the size and scope of companies that BDCs classify as being middle market companies. These businesses tend to have more access to financing, and may be more frequently owned by private equity firms and managed by professional management. Loans and investments in middle market companies are expected to generate lower returns than investments in lower middle market companies, due to a lower risk profile.
Also known as book value, net asset value is calculated by subtracting all of a BDC’s liabilities from its assets. This is frequently expressed as net asset value per share, or net asset value divided by shares outstanding.
Also known as operating income, net investment income is a GAAP earnings measure that calculates earnings before capital gains or losses. Investors use net investment income as a measure of a BDC’s earnings power before the impact of capital gains or losses.
Also known as “Net Increase In Net Assets Resulting from Operations,” or, more simply, “Earnings,” net income is equal to a BDC’s net investment income, plus net capital gains or losses from changes in the value of a BDC’s portfolio. Net income is a volatile measure of earnings, as portfolio investments can be written up and down from quarter to quarter and year to year.
An asset that is underperforming, and thus a BDC does not recognize income from it. BDCs also report non-accrual rates, or the percentage of investments on non-accrual divided by the BDC’s total portfolio. BDCs put investments on non-accrual when it is unlikely that the BDC will receive regular payments as originally promised, although non-accrual policies may differ from BDC to BDC. Non-accrual rates are typically disclosed as a percentage of cost and fair value.
A special entity BDCs form to borrow money that is guaranteed by the Small Business Administration. SBICs are common in the BDC industry, because they allow BDCs to borrow at very low interest rates and the leverage is generally excluded for regulatory limits that relate to a BDC’s asset-coverage ratio.
A second-lien loan has second claim to a company’s collateral in the event of a liquidation. In exchange for taking a subordinate collateral position, second-lien lenders receive higher rates of interest than first-lien lenders. Second-lien loans frequently sit below first-lien loans, but above mezzanine loans. In personal finance, this is the equivalent to a second mortgage.
A unitranche loan is a loan which is underwritten as a one-stop shop for buyout financing. Rather than seek a combination of first-lien, second-lien, and mezzanine loans, a company might choose a unitranche loan that finances the entirety of its debt needs. A unitranche loan will have an interest rate that is higher than a true first-lien loan, but lower than a mezzanine loan, as a unitranche loan is really a blend of these types of loans. Some BDCs deceptively label unitranche loans as first-lien loans.
Warrants are a derivative that allow a BDC to buy an equity stake in a company at a certain price in the future. Warrants are similar to stock options, and can become very valuable if a business’s value grows. Lenders who take on the riskiest tranches of a debt deal (mezzanine loans) might receive warrants that give them the ability to profit from the growth of the company.