Understanding Shareholder Dilution in BDCs

Share dilution is the bogeyman that haunts many investors' nightmares. Most companies can issue shares (almost) at will, but business development companies are special. A BDC must ask its shareholders whether or not it can issue shares below net asset value. Bewilderingly, shareholders frequently green-light it.

Tune in to this segment of Industry Focus to learn more on the BDCs' special twist on shareholder dilution.

A full transcript follows the video.

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This podcast was recorded on Nov. 16, 2016.

Kristine Harjes: So then, what sorts of issues do you run into if they decide they want to issue even more shares?

Gaby Lapera: This is really interesting, and this gets into how the value of BDCs are calculated. If you've invested in a mutual fund, or have heard of mutual funds, you might have heard the term "net asset value," which is super easy to calculate with mutual funds, because it's just the value of all the assets minus the liabilities that are on the balance sheets. Now, the problem with BDCs is, they get to decide how valuable their assets are.

Harjes: And that's because they're these tiny pizza/mattress/etc. companies, right? You can't just go look online to say, "How much is this mattress shop worth?"

Lapera: Exactly. They don't issue 10-Qs, they don't have any of that. Unless you happen to be wherever that mattress company is, and you can walk in and look at it and maybe talk to somebody there, it's really hard for investors to do their due diligence on what the BDCs actually own, so you have to just trust them. There are accounting principles that they follow for this, but I like to call it emotional accounting, because it's really just how the BDC feels about this business. There is math involved, but it's a little bit more ... I wish listeners could see me, my hands are making vague motions in the air.

Harjes: Her face looks highly skeptical.

Lapera: I'm so skeptical.

Harjes: The point is, it's a little bit shady, how you determine that asset value. But that's a really important metric for BDCs.

Lapera: Absolutely. The easiest way to explain BDCs is in contrast to mutual funds, which is why I keep bringing them up. If you want to buy into a mutual fund, you know exactly how much each bit of the mutual fund is, because the net asset value is calculated once a day at the end of the day, which is why you only come in and out of mutual funds once a day. But BDCs, their share price is not 100% dependent on their net asset value. You can buy BDCs at a discount, or a premium. Typically, people want to buy at a discount.

Harjes: In that way, it's kind of like a stock.

Lapera: Exactly, it's exactly like a stock. And people do take net asset value into account when buying shares. But it's an interesting thing, because where is the point where you're saying, "You're trading it too much of a discount to your actual net asset value, and it makes me really nervous"?

Harjes: Right. At that point, is the market missing something, or is the company misleading you? I can see how that's a shaky gray area. Bringing that back around to this whole shareholder dilution thing, where exactly does that come into play here? What are the steps involved, the considerations?

Lapera: OK, let's throw in one more complicated thing. This requires a lot of definitions to even get to the point here, so bear with us -- thank you, listeners! BDCs are technically not allowed to issue shares below their net asset value. So if their net asset value is $10, they can't issue shares for $8.

Harjes: Which is kind of fascinating. If you think about it, go back to the example of Puma Biotechnology, I'm pretty sure they were trading at $52 the day that it was announced that they were going to offer more shares. They're not going to offer more shares at a higher price than that, because who's going to buy them? You can buy them on the market for $52. So you naturally have this ceiling for stocks, where if you're going to issue more shares, it has to be below know that current share price.

Lapera: Right. Companies can just decide to do that. BDCs cannot. If they would like to do that, they need to ask their shareholders to let them dilute their stock. So they have proxies every year. It's interesting, because if BDCs are struggling, they can't just automatically lean on share issuance to prop themselves up. But there's this caveat -- BDCs frequently ask their shareholders, every year pretty routinely, "Hey, can we issue stocks below net asset value?"

Harjes: "Like, hypothetically, in the future, if we want to, will you let us?"

Lapera: Yes.

Harjes: That's a pretty long leash.

Lapera: Exactly. And Investors will frequently say yes, which I hate.

Harjes: Why is that?

Lapera: Why say yes?

Harjes: Can you see the rationale there at all?

Lapera: No. I really can't. I can't justify it. If you're one of these people who vote yes, please write in to me at industryfocus@fool.com and let me know why you say yes. I really want to know. Because I would never say yes in a million years.

Harjes: Even if you totally trusted this BDC, it had been great to you in the past, you thought the net asset value was very trustworthy, all that?

Lapera: Yeah, I would never say yes. Partially because BDCs are a really complicated beast, which is really something that I say every time we talk about BDCs, and there's a lot of room for mismanagement to occur in BDCs, not just with share dilution but with the way that management occurs, external vs. internal management, fee structures, the accounting processes we talked about earlier, there's just a lot of ways for people to mess up in BDCs, so it's one of those things -- why give you the temptation when it's not necessary?

Gaby Lapera has no position in any stocks mentioned. Kristine Harjes has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.