Episode 281: How Can BDCs Be Used to Optimize Direct Lending?

 

Stewart: My name's Stewart Foley, I'll be your host. Hey, welcome back. It's nice to see you. We always have a lot of fun doing these podcasts and very happy to be bringing you a really interesting topic today. A couple of housekeeping items on the front end. You may have noticed on our website we have a new subheading that says Home of the World's Smartest Money. We trademarked that, by the way. It's because insurance investors have, by far, the most complicated Rubik's Cube to solve for and we thought it was fitting, and so just to take note of that.

We also have an ABF real estate and infrastructure event that's coming up in Philadelphia on May 7 and 8. If you are a buy-side LP insurance company person who's responsible for those asset classes, please shoot us a note at events@insuranceaum.com and we'll be happy to get a registration packet headed over your way.

Today's topic is how do you use BDC's public disclosure to optimize direct lending? And we're joined today by Michael Occi, who is the president of Morgan Stanley Private Credits BDC platform. Michael, welcome. Thanks for taking the time. I can't wait to get into this topic. It's a good one.

Michael: Hi, Stewart. Thanks for having me on. Honored to be here.

Stewart: It's a privilege. We're happy to have you. Let me start the way we always do and I want to get into your background a little bit. So where did you grow up, first of all? And what was your first job? Not the fancy one. And then let's talk about how you got into your seat today.

Michael: Yeah, good questions. So I grew up in North Central New Jersey. Father was a chemist, mother was a designer commuting into Manhattan, which had some lore and probably, ultimately, led me to the city. But first job was working at a golf course where I like to spend my time and sometimes where my heart still is.

The journey to Morgan Stanley where I've actually worked ever since I graduated undergrad at Georgetown about 19 years ago, was a little bit all over the place. I was actually a banker for 16 years all the while in the building here in Times Square, advising financial services companies from various different angles, so in corporate finance, M&A, debt, capital markets.

And then prior to my departure to private credit here in investment management, I was running the financial services equity capital markets business. And so the move for me, Stewart, if that's where you're going, was effectively move from advising financial institutions to working within a financial institution and having the opportunity to do that within the same firm here at Morgan Stanley.

Stewart: It sounds like you're a very avid golfer. Is that still the case today and are you going to throw a handicap out here for this audience? If we're going to talk about it, let's talk about it.

Michael: I'd like to play a lot more golf than I do, which is probably a common answer to that question. And the only thing I'd say about a handicap is that the system is essentially rigged to not accurately reflect the handicap or true ability of someone who does not play enough. And so my handicap would overestimate my game, said differently.

Stewart: That's a good reminder. One of the people I met in this business years and years ago was Randy Johnson at Texas Mutual, and he has a story about golf handicaps that he'd be happy to share with you, and I believe that he shares your view, to say it nicely. Let's get into it here. And I appreciate the pre-call that we did and your focus on education here. So let's just start with the very basics. Can you please explain what a business development company, otherwise known as a BDC, is and why it's so relevant in today's market?

Michael: Happy to start there, Stewart. So a BDC is something that evolved out of the Investment Company Act of 1940. I believe there was a legislation in the 1980s, which essentially was amended to create this fund structure, the business development company, with a goal of accelerating investment into small, medium-sized businesses. So in effect, the BDC, as we know it, and as a disclaimer, we have several in our platform, is a fund that houses certain types of investments.

And so the most typical use case for a business development company is essentially a portfolio of corporate loans to middle market companies. So underlying borrowers with EBITDA profiles somewhere between 10 and upwards of $200 million. And we can talk a little bit more about the asset class, although I know the audience is fairly familiar with it. But what you don't or tend not to find in a BDC are venture-oriented equity investments, other asset classes that either don't throw off a yield, BDC investors have been drawn to these structures because there's an income profile associated with it, and loans do a pretty good job of generating income that is attractive.

There's also structurally a cap on what we call bad assets or non-qualifying assets that equity investments in larger companies would work against. And so you found they're akin to REITs in that regard where they're producing income that is healthy for the end investor, they're exempt from entity-level taxation if they qualify as a regulated investment company like a REIT, so long as they satisfy certain income thresholds and distribute at least 90% of that net investment income to investors.

But that's the high level. There's a governor on leverage, so how much leverage the fund itself can take on, that's a cap of two to one debt-to-equity or NAV. Governance-wise, the BDCs are required to have a board that is majority independent. They are 34 Act reporting entities. And so they've got to produce quarterly financial statements and subject to SOX. And they mark the portfolio using fair value accounting, at least a quarterly type frequency.

And the last point I would make is generally, BDCs are what we call externally managed. They can be internally managed too. But all that means is the portfolio, the fund itself is separate from the manager that is actually making those investments and managing it. And so the BDC will pay a fee or a series of fees to the manager in exchange for those services. And the fee structure does vary from BDC to BDC.

Stewart: Super helpful. So the two to one ratio of debt to NAV, if you have a decline in the NAV, can that ratio get out of whack? And is there a mechanism by which you can repair it?

Michael: It absolutely can. So going into your question, the denominator is essentially shrinking, ratio is increasing. So in practice, the industry tends not to manage towards the upper end of that cap. And so in practice, you'll find most BDCs operating at just above one times with obviously some variance around it so as to, in part, allow for some buffer if you do see a more significant move in the valuation of the book and have a corresponding hit to NAV.

Stewart: Super helpful. And I just don't know this market well enough. How significant is the BDC sector within the broader landscape of direct lending? And can you provide some context regarding the size and relative importance?

Michael: It's a great question. So I'd start by saying that investors really across the spectrum, maybe starting with retail, but including institutional investors too, have used BDCs as a means to get access to the asset class. Sophisticated investors generally have the ability to partner with managers through private funds, but BDCs have been a popular tool for broad range of investors. But to answer your question, they do constitute a pretty meaningful piece of the direct lending AUM base.

And I would break it down as follows, if you look at all private credit strategies globally, including direct lending, obviously relevant for this discussion, mezzanine, distressed, even asset-based finance, you have about $3.1 trillion of levered assets under management. So equity and debt combined. Direct lending is about half of that, a little more than half of that at $1.65 trillion. Of that number, BDCs are about 25%. So 75% said differently are in non-BDC pools of capital, be it in other forms of private funds, but BDCs constitute a pretty meaningful portion of that direct lending base.

Stewart: In my next question, let me just take a piece of that and wrap it in here. So you've had extensive experience with structuring IPOs and equity offerings for BDCs. How have these structures... And I'll preface this like this, we were talking about the other day we had an EMD podcast, and I'd be the first to tell you that my version in my aged brain, my version of what I think EMD is isn't what it is today.

And I suspect that it's the same for BDCs. If you knew what a BDC was five years ago, you may not know what one is today, right? So can you talk a little bit about how this structure has evolved over the last couple of years, and in particular, in response to changes in market or investor demands that are out there? And to glom onto the last question you had, you said it's about 25% today. What was it a few years ago? Has that 25% changed significantly in the last few years?

Michael: Yeah. To answer the second question first, I don't have the statistic looking back in time, but I would have to imagine the share of BDC capital relative to the broader direct lending base has grown. I can talk a little bit about the mix. And Stewart, you nailed it, I think driving the evolution in the technology of the BDC product has been investor demand, and I'll come back to that.

But there are essentially three flavors of BDCs, and the way I would put it is two existed five years ago, one was emerging, and the three are essentially you have a public BDC, they've been around for about 20 years, so listed on a national securities exchange. These used to come to form through blind pools, which is a term for you do the IPO, the business didn't really exist other than in legal form. You raise your first dollar of capital effectively in that IPO itself and you go and deploy it and grow it over time.

Then evolution-wise, you built it private first, typically through a capital call structure where you raise the money, you draw it over time, invest it, and then list it later. But you got public BDCs, there are about 50 of them in existence today. Then you have private BDCs, which can be finite-life or evergreen, and they can be levered or unlevered. And those are typical capital call structures popular within the institutional and the retail investor base.

But what has really dominated the fundraising engine for BDCs over the last handful of years has been what's branded the non-traded BDC. And those are structured to continuously raise money. Most are taking in what we call subscriptions on a monthly basis. And the benefit to investors is rather than you raise the capital, call it gradually over time, the BDC takes in the money and we put it to work immediately. 

But it's an opportunity for investors to get access to the asset class, avoid the J-curve associated with gradually taking in the money and deploying it over time. Often they're monthly distributions, whereas the first two flavors are typically quarterly. So it's frequent income. And one of the things that certain investors don't like about the public BDC space, although many vehicles do trade pretty well from evaluation point of view, is the beta risk of owning a public security. And so these non-traded BDCs, by definition, don't intend to list.

And so it's a nice marriage of the public and the private structure. And the only other thing, structurally, I would mention is often there's an opportunity for some liquidity. It's not as on demand as if you owned a public BDC. But typically, there's some opportunity for quarterly liquidity with a cap that is akin to what you see in the non-traded REIT space. And so if you look at that 25%, more than half of that AUM base today in BDCs is in this non-traded category.

Stewart: That's great insight. And you mentioned this, BDCs are often considered a window into the direct lending market. Could you just elaborate a little bit about how investors can leverage BDCs to better understand trends in direct lending, specifically regarding asset quality, credit conditions and portfolio performance?

Michael: Yeah. I think they can be useful as a lens into those things, Stewart, even if structurally they're different than for tax or fee reasons than let's say a direct lending fund that an insurance company is evaluating for a potential investment. They can be valuable in ascertaining asset quality trends or other trends or to diligence the performance of that manager who actually may have a BDC or BDCs.

And by virtue of these BDCs being SEC filers and the requirements associated with that, there's a lot of information out there in the public domain. And so the 40 Act requires that BDCs produce a schedule of investments, investment by investment in the Ks and the Qs. So that's a quarterly obligation. There's additional portfolio level information for these monthly non-traded funds that is produced in 8-Ks, again, monthly. So even more frequently.

As it relates to asset quality, there's the accounting framework where you've got this definition on non-accrual that is transparent and publicly disclosed, a measure of weakness in a portfolio. There's risk ratings that BDC managers put out there that's qualitative. You can look at income statements to see the quality of the earnings profile, what is cash flow paying versus what is payment in kind.

You can look at, of course, the underlying mark of each of the portfolio companies. And to that end, each BDC has a regimented valuation policy, typically, with board oversight and often engaging a third party to assist in that process. So multiple lenses into the asset quality.

There's additional information in the MD&A on quantitative and qualitative risks and other disclosures. And the other thing I would mention is for the public BDCs, there's typically a public research following, and so analysis that has been published on the underlying company. And in the case of many BDCs, they're rated by rating agencies because they access the market to source some of that leverage we talked about earlier in the unsecured market.

And so there's third-party transparency and validation that comes with it too that is obviously absent for the private BDCs. I think even if the underlying portfolio or even the manager itself isn't perfectly applicable or representative of what is being diligent, a lot can be learned about that manager or the market by looking at a group of BDCs.

Stewart: That's interesting. Transparency is key for insurance companies looking to assess risk and performance. You've talked about a number of the disclosures that are required. How do those disclosures compare if I own direct lending outside of a BDC structure? It seems to me by listening to you that I'm going to get better transparency and I'm going to know more about what I own in this structure, but I don't want to put words in your mouth either.

Michael: Yeah, I think it can probably go both ways. If you're an active investor in a private fund, it might be the case that you've got an NDA with that manager where they have the ability to share information that is much more detailed, Stewart, than you're going to find in public disclosure for a public or private or non-traded BDC just to be fully balanced here.

But it might be the case if you're not an active investor or not actively diligencing a specific opportunity where there's a good opportunity for you to analyze a BDC or a series of BDCs as a proxy for that to get some detailed information about the industry or a certain subset within the direct lending ecosystem.

Stewart: And is there a size that's too big or too small? Where I'm headed with this is insurance companies, they come in a variety of sizes, and some of them do everything themselves and some of them have more limited resources. Let's just say it like that. Is there a sweet spot in terms of the size of an insurance company that you find is particularly well-suited for BDCs, or is that not a very good question?

Michael: Yeah, it's a good question. I think for smaller insurance companies, it might be the case that an actual investment in a BDC is the most efficient versus relying on, in many cases, third party consultants to do that manager assessment and source a potential bespoke private fund structure in lieu of a BDC.  
I think for larger insurance companies, it might be the case that we go back to where we started here where the BDCs and an analysis of the space could be a real lens into the asset class or another way to approach diligence on a manager. But I think it cuts both ways. We've certainly seen instances where larger insurance companies have been large and active investors in a variety of different BDC structures.

Stewart: I've learned so much today and I really appreciate that. From your perspective, what are two key takeaways that insurance investors should remember from this podcast and when they're thinking about allocations to BDCs?

Michael: Yeah. I think the biggest takeaway is even for a sophisticated insurance company with a meaningful allocation to direct lending and with access to the who's who within the direct lending manager universe, it's very easy to ignore what is a very public sector for BDCs. Public meaning transparent picture into the asset class that is probably worthwhile to consider. And whether the shortcut is to maybe look at an equity research report, look at a rating agency report, a recap of earnings, and then there's an opportunity to dig deeper where it makes sense.

And I think that's the biggest takeaway. For insurance companies that are newer to the asset class, I think an analysis of the BDCs is it could very well be a useful place to start getting smarter about the ecosystem, the differentiation between the managers and then, ultimately, the underlying performance. Because even if there's a de novo fund that manager XYZ is starting, it would be prudent to understand how that manager may have executed vis-a-vis the BDC or BDCs that they have managed over time.

Stewart: Very helpful. So I have a couple of fun ones for you on the way out the door, if you're willing. And so the first one is when you're hiring and adding people to your team at Morgan Stanley, and you mentioned being there a long time, so you've been through this a few times, what characteristics are you looking for in new team members? And I don't mean they can use Python. I mean what characteristics do you think are helpful in somebody joining an asset management firm, a world-class asset management firm, to be successful?

Michael: Yeah, it's a good question. I think we've done a very good job at this. I certainly won't take all the credit personally, but our platform has grown pretty dramatically over the years. We've been in the private credit business for more than 15 years, but the direct lending side has grown at a pretty impressive clip. And it was done on the shoulders of exactly what you're getting at, which is talent management and intentional effort around that. Hiring the right individuals who don't just have the expertise but would fit in culturally.

And culture, I understand is a bit of a hackneyed term, but we do take it very seriously. I think the underlying attributes beyond knowing the content or if you look at the investment side of the house, individuals that have decades of experience covering private equity firms, and to have the deep relationships to give them the ability to not just say yes, but also to say no, where those private equity firms keep coming back because they value that relationship.

Even on the non-investing side of the business, it's the same thing. We look for people who have credibility, but also humility across the board. I think that's one thing that is true on the sell side of this firm as well, is that talented, smart people, it's a meritocratist place, but at the end of the day, they're fun to work with. And so I think we built on the shoulders of the broader Morgan Stanley brand something that is very consistent with that culturally.

Stewart: That's super helpful. I think that my head is always with the person who's 24 and looking out at the world and trying to figure it out. I've had a zillion students come to my office and be all wigged out, "I don't know what I want to do." And I'm like, "You're 19, it's okay. You'll figure it out." But the advice I always gave the students was look for the confluence of something you like and something you're good at.

And I do believe that there are certain investment professionals that are really highly motivated and are really interested in this space. And I've been fortunate enough in my job as a podcast host to talk to several including yourself. So I'm thrilled to have you on.

The last one is purely fun. And that one is you can have lunch or dinner with up to three guests, alive or dead. You don't have to choose three, you can be one, two, or three. Who would you most like to have lunch or dinner with, alive or dead?

Michael: I guess we'll have to go back to golf.

Stewart: Oh, okay. All right.

Michael: If they don't have to be alive, I'd pick Arnold Palmer and if they do, it'd probably be Jack Nicklaus. And it would be a bonus, Stewart, if you could arrange it to be hosted at Augusta.

Stewart: There you go. So just the two of them, Jack and Arnold. Wow, that would be quite a lunch.

Michael: And maybe Randy. You mentioned earlier.

Stewart: Yeah, Randy. I'll promise you this, he would want to play for money, anybody who'd be willing. He's super competitive. So I really appreciate you being on. It's been a great education on BDCs today and it's been a lot of fun too. So thanks for taking the time, Michael, and you're welcome back anytime.

Michael: Enjoyed it. Thanks again for having me on, Stewart.

Stewart: Our pleasure. We've been joined today by Michael Occi, who's the president of Morgan Stanley Private Capital's BDC platform. Thanks for listening. If you have ideas for a podcast, please shoot me a note. It's stewart@insuranceaum.com.

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