BDCs Stand To Benefit From Interest Rate Increases

Interest Rates Natural Rate
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Business development companies may not get as much attention as big name stocks, but they have are an important way for investors to gain exposure to middle-market companies. While technically an investment in the finance sector, BDCs are best evaluated by looking at what sectors they are invested in and what types of debt they own. They also stand to gain a lot from rising interest rates, and could see regulations loosened in the next year.

Market environment for BDCs has improved

“We believe the market environment for BDCs has improved over the past few years, given stabilizing credit quality, increased M&A and financing activity, high levels of portfolio company exits at reasonable valuations, and improved investor appetite for high-yielding stocks in this low-rate environment,” writes BMO Capital Markets David J. Chiaverini.

Chiaverini is particularly interested in Prospect Capital, which he rates as Outperform with a $12 target price, because of the company’s strong management team and the diverse set of lending transactions they’re engaged in, including private equity sponsored transactions, direct lending, investing in structured credit, syndicated debt, and real estate investments. Investing to middle-market companies is competitive: banks, public and private funds, PE, and insurance companies are all competing with BDCs, but companies like Prospect that have lots of floating rate assets and fixed rate liabilities are poised for growth when interest rates start to rise.

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“We expect Prospect and the other BDCs to always remain well capitalized, given regulators mandate a 1:1 debt-to-equity limitation. Several BDCs did breach the limit during the great recession as asset values were written down, but were cured by a combination of asset sales to pay down debt, equity raises, and asset appreciation,” writes Chiaverini. But money invested in BDCs is indirectly leveraged because “BDCs are lending to and investing in companies with highly leveraged capital structures.”

Congress will ease restrictions on BDCs next year

There’s also a chance that Congress will ease restrictions on BDCs in the next year. A series of bills calling for relaxed regulation have been proposed, and one of them made it out of committee earlier this month. Even if none of the current bills makes it through, getting credit to under-served mid-market companies is an easy cause to argue for.