An Analysis of a BDC Reveals a Shocking Picture

An Analysis of a BDC Reveals a Shocking Picture

An Analysis of a BDC Reveals a Shocking Picture


After reading Jason Zweig’s good piece, “Should You Bottle Up Your Money in ‘Baby Bonds’?” I said to myself, “But what does the prospectus look like?”  So I went to EDGAR, and pulled up the prospectus for Fifth Street Finance Corp’s 5.875% Senior Notes due 2024.

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Please understand — I get squeamish with the unsecured bonds of exotic financial companies.  Losses on the bonds of financial companies when they fail tend to be far worse than those of industrials or utilities.  That is a major reason why financial bonds typically yield more than similarly rated non-financial bonds.  They are more risky.

So, looking through the deal summary terms, we learn:

  • At $75 million, the deal is small.
  • It’s a 12-year deal — that’s done to confuse buyers, because it gets priced off the 10-year Treasury, giving the illusion of more spread.
  • Quarterly pay of interest which raises the effective yield a touch.
  • Senior subordinated, but…
  • effectively subordinated to all our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, the $206.3 million of borrowings under our credit facilities outstanding as of October 10, 2012; and
  • structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Fifth Street Funding, LLC, Fifth Street Funding II, LLC and our SBIC subsidiaries.
  • The bonds are callable at par after 5 years.

The structural protections here are weak.  You are lending to a financial holding company where many of the assets are pledged to other creditors.  More on that in a moment.

The risk factors for a business development company like Fifth Street Finance Corp. (NASDAQ:FSC) are significant, and can be found here, all eighteen-plus pages of them.  But the risk factors of the debt are more significant, and can be found here.  Here are the main headings:

  • The Notes will be unsecured and therefore will be effectively subordinated to any secured indebtedness we have currently incurred or may incur in the future.
  • The Notes will be structurally subordinated to the indebtedness and other liabilities of our subsidiaries.
  • The indenture under which the Notes will be issued will contain limited protection for holders of the Notes.
  • There is no existing trading market for the Notes and, even if the NYSE approves the listing of the Notes, an active trading market for the Notes may not develop, which could limit your ability to sell the Notes or the market price of the Notes. 
  • If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the Notes.

Unsecured holding company debt can be weak, because with some subsidiaries there may be regulatory limits or private limits to upstreaming capital to the holding companies.  That puts financial holding companies in a weak position, because when financial conditions get bad liquidity can get very tight.

And with business development companies [BDCs], which own and finance small-to-medium sized businesses, there is a lot of idiosyncratic risk including:

  • Your downside is 100%, but your upside is capped.
  • BDCs tend to be speculative investors.
  • Many of the assets held are subject to third-party security interests, which lessens the rights of unsecured lenders to the holding company.
  • BDCs, life REITs, have to pay out 90%+ of taxable income in order not to face corporate taxation.  That forces BDCs to continually go to the credit markets for financing.  But what if the market is no longer favorable for a year or two?
  • BDCs are placid weather vehicles, and more so the bonds.  One might be better off holding 30% Treasuries and 70% BDC stock.  At least you have more downside protection, and more upside.

So put me in the camp of those that have no interest in BDC debt.  It is a weak instrument, and regardless of what the rating agencies say, they are not investment grade risks.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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