One reader wrote in to ask “What’s an internally managed BDC, and is there a difference between those and externally managed BDC?”
Great question. Here’s what we hope will be a great answer.
How to spot an internally-managed BDC
There are two types of business development company management structures. Internally-managed BDCs work like…uh, a bank. They hire a CEO, CFO, CCO (Chief Credit Officer), and potentially hundreds of front-office staff like originators, portfolio managers, and credit analysts. All these people work for the BDC, and the cost of employing these workers shows up on the BDC’s income statement.
There are many internally-managed BDCs, the biggest of which is Main Street Capital Corporation (MAIN). If you look at the expense section of its income statement, you will see this clearly.
Main Street Capital lists cash compensation and share-based compensation as expenses on its annual report. This is a clear sign that it is internally-managed (of course, this fact is also stated in its quarterly and annual reports, and on its website.)
List of internally-managed BDCs
These five business development companies are internally managed, making them a minority of publicly-traded BDCs.
|Main Street Capital||MAIN||LMM/MM|
|Hercules Capital||HTGC||Venture Debt|
|Newtek Business Services||NEWT||SBA lender|
How to spot an externally-managed BDC
By contrast, externally-managed BDCs do not have employees. Instead, they operate more like mutual funds. An asset manager manages the BDC and earns a fee for doing so. Ares Capital (ARCC) is currently the single-largest externally-managed BDC. Here’s what the expense section of its income statement looks like.
Notice that there are not any compensation items. Instead, Ares Capital pays its external manager a fee of 1.5% of assets, plus 20% of returns in excess of a hurdle rate of return. The 1.5% fee is the “base management fee,” which is the second expense item in the list. The “income based fees” and “capital gains incentive fees” are collectively the “incentive fees” or the fees it takes for earning a return in excess of the hurdle rate — fees for good performance.
Ares Management (the company that manages ARCC), uses these fees to pay staff who work for Ares Capital (the BDC).
Internal vs. External management: Which is better?
Main Street Capital’s relative success has left many investors to conclude that their is some special sauce that comes with internally-managed BDCs. However, it isn’t internal management that makes Main Street Capital special. It’s that its overhead costs are inexpensive. Externally-managed BDCs could theoretically charge low fees that match Main Street Capital’s low overhead costs and have a similar advantage.
There have been many bad internally-managed BDCs including one of the largest BDCs, American Capital, which overpaid insiders and had disastrous performance history as a result. There have been many good externally-managed BDCs. Ares Capital Corporation has generated double-digit annual returns to its investors over a 13+ year period. Its performance was battle-tested by the financial crisis, something only a minority of BDCs can say about their underwriting.