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Staci Warden
Executive Director, Center for Financial Markets
Africa and Banking and Capital Access and Capital Markets and Emerging and Frontier Markets and Europe and Finance and Financial Innovations and FinTech and Global Economy and Impact Investing and Public Policy and U.S. Economy
Staci Warden is executive director of the Center for Financial Markets at the Milken Institute, where she leads initiatives on strengthening capital markets, access to capital, financial education, and financial-markets solutions. Warden is also chair of the Rwandan Capital Markets Authority.
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Enhancing business development with BDCs
By: Staci Warden
November 05, 2013
   
   

Small to mid-sized companies (SMEs) are important generators of jobs and economic growth. In the United States, most jobs are created by companies with fewer than 500 employees; in fact, one-third of all jobs are created by companies with fewer than 50 employees. But because retained earnings come in large part from achieving economies of scale, smaller companies are particularly dependent on external financing for operations and growth. As such, they need stable, diverse sources of capital throughout the business cycle. Yet the global financial crisis aEUR" though not the first event to do so aEUR" has shown the particular vulnerability of small businesses to the vagaries of bank lending. During the worst years of the crisis, lending to small business was dramatically and disproportionately curtailed. This lack of capital has been a big driver of unemployment and the slow economic growth since the crisis.

Smaller companies suffer disproportionately during an economic downturn for three reasons:

  • They are typically less diversified than larger enterprises and have smaller financial cushions to weather storms.
  • They represent to investors a riskier, less liquid asset class, so banks tend to pull back lending to them when they face balance sheet pressure.
  • The increased regulation that often follows financial crises can overwhelm smaller businesses that lack the resources to ensure compliance.

For these reasons, policymakers on both sides of the aisle have tried to find effective, reliable ways to facilitate necessary capital flows to small businesses.

Business Development Companies (BDCs) are an important part of the solution. BDCs are closed-end investment funds that exclusively invest in startups and small businesses. They were created by Congress in 1980 (in a modification to the 1940 Investment Company Act) in response to a sharp decline in bank lending to middle-market businesses, an environment similar to the post-crisis period. Today, new legislation before Congress will increase the impact of BDCs in facilitating capital formation for small businesses in several important ways. I believe this deserves support from both Democrats and Republicans.

Most importantly, proposed legislation would double the potential debt-to-equity ratio of BDCs. BDCs can now fund half of their assets through borrowing. Under the new legislative regime, they will be able to fund two-thirds of their assets through borrowing. This will enable BDCs to expand their balance sheets and increase lending to small businesses. In addition, they will have more headroom to invest in less risky assets (i.e., fill a more senior slot in the capital structure and offer a lower cost of funding to SME borrowers) without sacrificing return to their equity investors.

One could argue that a higher leverage limit will expose BDCs or their investors to greater potential losses. However, under normal market conditions, lenders to BDCs have chosen not to leverage higher risk assets beyond a 0.6:1 debt/equity ratio, and it is reasonable to assume that BDCs will maintain the same relative leverage cushion if given more headroom. Still, in periods of market aEURoefrothaEUR? it is possible that unsophisticated lenders to BDCs could enable subpar BDC managers to leverage low-quality collateral up to the 2:1 debt/equity threshold.

It is important to keep in mind, though, that even if BDCs are able to increase borrowing levels to the new proposed leverage limits, leverage ratios of BDCs will still remain well below that of their peers. Bank leverage, for example, remains at an average of 8:1 and Real Estate Investment Trust (REIT) leverage at an average of 7:1. Under Dodd-Frank, permissible bank leverage is 15:1.

A second provision of the legislation creates financial flexibility by allowing BDCs to treat preferred shares as equity. This affords BDCs the same accounting treatment as other funds, such as REITs.These measures, together with the proposed measures to ease reporting requirements, will place BDCs better on par with other companies. By allowing BDCs to increase the supply of capital to small business, by potentially lowering borrowing costs for issuers and raising investment returns for investors, and by harmonizing the treatment of BDCs vis-A -vis similar peer-group entities, proposed legislation before Congress will be supportive of the intent of the original legislation as well as that of the JOBS Act.

The fact that BDCs are permanent capital vehicles with a mandate to invest in startups and SMEs results in a more stable funding source for SMEs relative to other investment vehicles, such as banks and mutual funds. But beyond this, BDCs have additional benefits.

First, because ordinary (non-accredited) investors can buy shares in publically traded BDCs, they provide one of the only liquid vehicles through which retail investors can get diversified investment exposure to startups and small companies. In this way, Main Street lends to Main Street.

Second, BDCs are smaller in size, far less leveraged, and often more geographically diverse than their banking and community banking peers. The demise of a BDC would pose little or no systemic danger to the financial system or to a regional economy.

Third, BDCs offer no recourse back to the American taxpayer. More specifically, BDCs cannot take deposits and do not offer an explicit or implicit government guarantee to investors. For example, BDCs did not receive TARP funds.

For all of these reasons, Congress should support legislation that will increase the impact of BDCs in facilitating capital formation for small businesses - measures that will likely be a part of a broader package in a JOBS Act 2.0.