Business development companies have become an integral part of most credit managers' capital war chest, giving investors a choice between liquid and illiquid investments.
Almost all private credit managers have BDCs these days, said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners.
BDCs are public companies that provide financing, typically for small and midsize companies, giving investors — who buy shares in the BDC — a more liquid access to private credit than the traditional private equity-style funds, separately managed accounts and hedge funds.
“Most BDCs are credit oriented; they provide senior debt, mezzanine debt and possibly equity, and sometimes they invest in all three layers of a company's capital structure,” Mr. Fann said.
For institutions, investing in a BDC generally costs more in management fees and performance fees than separately managed accounts, he said. In some cases, BDC fees are more than 50% higher than separate account fees, he noted.
So while the BDC and separate account investors would earn the same gross return, separate account investors are more likely to earn a higher net return because they pay lower fees, Mr. Fann said.
At Ares Management, as well as at many other managers, the BDC capital and capital from institutional investor allocations to credit funds are invested together.
Ares direct lending team invests for all clients, including the BDC, said Kipp deVeer, New York-based partner and co-head of Ares Management's credit business and CEO of Ares Capital Corp., the firm's BDC.
“Some pension funds and insurance companies come to our BDC for the benefits of being a public vehicle, while some institutions invest in private funds and separately managed accounts to help meet their customized needs,” Mr. deVeer said.
Some invest in both but they are all investing in Ares' direct lending business, he said.
BDC shares held by public pension funds increased nearly 150% to 4,825,818 total shares, according to Bloomberg and S&P Global Market Intelligence data.
Conflicts can arise when a BDC finances a transaction of the affiliated private equity firm, Mr. Fann said. “To resolve the perception problem, usually a third party establishes the pricing and terms of the financing” and outside board members may review and approve the transactions, he said.
On the private equity side of a firm's business, transactions are reviewed and approved by the limited partners' advisory committees as well.
Ares has set up systems to guard against potential conflicts of interest that could arise from temptations to make more investments with the pools of capital that earn the most fees, Mr. deVeer said.
Ares' BDC does not finance investments made by Ares' private equity arm, which can lead to conflicts of interest issues, he said. The BDC sticks to financing leveraged buyouts of other managers.
Ares executives allocate capital between the BDC and its institutional investor separate accounts based on the investment objectives, diversification requirements and capital availability of each vehicle, Mr. deVeer said. When an investment meets the standards of more than one pool of capital, each investor gets a slice.