My last three columns have concerned various aspects of business development companies (BDCs). In this column I'm going to provide some positive counter considerations to the cautionary comments I made in yesterday's column, How BDCs Can Backfire. I'm also going to expand the subject to include private equity (PE) and alternative lenders (AL).
BDCs, PEs and ALs have very similar businesses, something I'll come back to.
But first, the principal differences are 1) the size of the companies, 2) the size of the investments made and 3) the tax treatment of them.
In general, the BDCs are smaller and make investments in smaller developing companies while the PE and AL firms are larger and make investments in typically more established companies.
The largest of the PE and AL companies that are publicly traded, listed in descending order by market capitalization are, The Blackstone Group (BX), KKR & Co. (KKR) and Apollo Global Management (APO).
All of the BDCs discussed in earlier columns and the much smaller focused ones I've not yet written about have more in common with the larger PE and AL firms than they do with any other sector in finance.
They all supply financing to companies that does not conform to the established packaged financing that banks and investment banks mostly focus on today.
The business of supplying or arranging for capital investment has become increasingly bifurcated. The banks and investment banks underwrite debt and loans with the intention of packaging them into products that may be pooled and sold in a secondary market.
The BDCs, PEs and ALs make investments of equity or debt that do not conform to those packaged standards, are illiquid as a result and are retained and serviced by them.
The importance of this with respect to the cyclical vs. linear views of economic activity is that the banks and investment banks are captive to the existing dominance of cyclical theories, whereas the BDCs, PEs and ALs have the ability to adjust their strategies for providing financing very quickly and as the market and economy evolves.
These differences may be considered static vs. dynamic with the banks and investment banks captive to the economy, the interest rate environment and monetary policy, while the BDCs, PEs and ALs can adjust to economic and market action, even though it does not conform to what's been anticipated.
This also means that the BDCs, PEs and ALs are more closely aligned with real economic and market action, as well as the real environment being faced by their corporate clients.
The banks and investment banks, on the other hand, are now essentially one derivative removed from the real environment faced by their clients and aligned almost exclusively with the needs of the secondary market for securities and all of the regulation that entails.
As a result, the banks and investment banks have become financial product intermediaries and pushers rather than problem solvers and solution creators.
When a client is need of financing the banks goal is to try to figure out how to accomplish that financing so that it meets the pre-stated requirements of the buyers they will resell the loans to. And that means that the industry has evolved into one where there is now an institutional conflict of interest built into their businesses.
The BDCs, PEs and ALs don't have that issue. Their principal relationship and responsibility is with and to the client. Although the structure of any financing will be affected by the economic environment, interest rates and issues specific to the client's business and sector, those issues will not dictate the structure of the financing.
If the lack of the expected economic response to monetary and fiscal measures persists, one of the logical outcomes of it will be a decrease in conventional-bank-financed deals and a corresponding increase in business flowing to the BDCs, PEs and ALs.
Because the financial size of that space in total is a tiny fraction of the conventional bank sector, even a minor shift away from the banks will have an enormous positive impact on all of them.
