Business development companies are in many ways like banks. The business model hinges on raising money at one rate and lending at another, higher rate. In fact, the industry's "core" business of lending to private equity buyouts was a big profit center for banks until regulators cracked down.
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There are differences, of course. Banks lend against assets, whereas BDCs lend against a company's future profitability. And banks can take in low-cost deposits; BDCs raise debt funding via the capital markets -- Wall Street.
The biggest difference isn't in the model, or in what drives profitability (underwriting quality and efficiency). The biggest difference is in the accounting, and I think it's important for every investor to understand this.
The role of accounting
Banks know that they will write bad loans. It's unavoidable. As such, banks are required to make provisions for loan losses each time they make a loan. On the balance sheet, this appears as an "allowance for loan losses."
Basically, using historical models and its expectations for the future, banks have to set aside capital to cover loan losses that will come from loans made today. In fact, virtually every financial company, from bank to consumer finance company, to insurer, operates this way.
BDCs, however, do not operate this way. They don't, and largely cannot, set aside capital to cover future losses. Instead, BDCs are required to appropriately mark the assets from quarter to quarter at "fair value."
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This is vastly different from the accounting at a banking institution, where loans are automatically reduced by the allowance for loan losses. If loans tally $100 billion, and the allowance totals $5 billion, the loans have a balance sheet value of only $95 billion.
A BDC, so long as its loans are performing well, can mark its loans at full value, with no built-in adjustment for potential losses in the future.
Why it matters
The fact that BDCs don't and cannot provision for loan losses results in a few important implications for those who invest in them.
First, any losses have a seemingly larger impact at a BDC. If a loan goes bad, and is sold or written off at a loss, it results in an immediate and large reduction in book value. They don't have an allowance account to take the blow.
Secondly, the lack of provisions obscures risks in the short run. Banks, should they take higher risks for higher returns, should show it by posting higher loan yields, but the immediate benefit would be tempered with higher provisions for losses. BDCs can step up the risk curve and pretend that higher yields are a "free lunch" that won't be paid for with bigger losses in a downturn.
It also lowers the bar for the management team. Investors love financial companies that have a record of conservative accounting. Whether its banks that provision for more losses than occur, or insurers who consistently report prior-year favorable developments, investors take notice. Seeing as BDCs don't provision for loan losses, they lack a barometer on which their managers' assumptions can be measured years down the line.
Finally, and most importantly, without provisions, BDCs must eliminate losses (impossible) or generate more gains than losses (hard to do) in order to offset book value erosion over time. For most BDCs, maintaining the same level of income will require that shareholders reinvest a percentage of their dividends back into the stock. Otherwise, losses will eventually put a drag on book value per share, and inevitably on dividends per share.
The article Why These High-Yield Stocks Are Always Worse Off Than They Appear originally appeared on Fool.com.
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