Why CEOs Should Know About BDCs

Ditto for a nationwide distributor of office equipment with $11 million in annual revenues looking for $5.4 million to recapitalize the company. And when an industrial-controls corporation needed $9.5 million to roll several sales-representative firms up into a larger company, it found the financing at a BDC.

Banks, under tougher regulations than ever, either would not or could not meet the financing needs for these representative, middle-market businesses.

Congress enacted legislation creating BDCs in 1980 as an amendment to the Investment Company Act of 1940. The idea was to create a regulated entity to focus on the capital needs of smaller, middle-market companies.

Few investors or CEOs have known what BDCs are and why they are advantageous to growing businesses, but that situation is changing. Since January 2007, BDCs have grown from 16 to 41 companies. They serve an estimated 65,000 businesses in the U.S. with revenues in the range of $20 million to $200 million; the overwhelming majority of these businesses are privately held and family owned. Such companies have significant capital needs; but, because they work in a fragmented marketplace, they are underserved by banks.

Here, then, are six reasons why BDCs are thriving and will continue to grow as a source of capital for smaller, middle-market companies and why CEOs should understand how valuable they are as a source of financing.

1. Evaluation as a growing concern, not just a credit risk. A BDC looks at the entire business and its prospects for growth rather than just its credit history. Banks under tighter scrutiny as a result of recent law and regulation, such as the Dodd-Frank Act, now have less freedom in accepting risk. A BDC working with a bank can structure deals that otherwise might not be acceptable.

2. Focus on relationships, not just transactions. A BDC typically takes on an investment that is higher risk than most bank portfolios can tolerate. This opportunity means the BDC needs to truly understand a company’s business and to form an ongoing relationship with it, so it can help the company to expand. BDCs grow by doing their homework and maintaining investment discipline.

3. Certainty of closing. Once a BDC approves a company, there is a high certainty of closing a deal without wasting time. Often those who arrange a deal are on the investment committee approving it, unlike other financial institutions, where there are multiple levels of approval and fewer people who fully understand a company and its marketplace.

4. Shrinking capital market. There are fewer banks with lower market shares and their capital structures have become more conservative. This contraction has narrowed the capital window for many smaller, middle-market companies, even stable and conservative ones.

5. Customized financial engineering. BDCs take on more financial engineering than just term loans. It is common for a BDC to fund a shareholder buyout or a dividend recap, allowing owners to take money from a business. BDCs with extensive experience in the lower, middle market create customized, financing solutions for clients. As solutions-oriented lenders, they partner with business owners, equity sponsors, fundless sponsors, family-owned businesses and management teams to craft capital structures that enable them to pursue their business plans.

6. Experienced professionals. BDCs are staffed by professionals with deep experience, both in the private-equity side and the mezzanine and senior lending side of businesses. They have closely examined thousands of companies and can understand more extensively and quickly how to customize a financing solution for a client.

BDCs are beginning to emerge as a significant force in lending to smaller, middle-market businesses, but there still is limited understanding of what they are and how they work. CEOs who haven’t encountered them will find them not only to be alternative sources of capital, but easier to work with than traditional lenders, and conclude that they should be a regular part of their financing tools.

Christian L. Oberbeck is chairman of the board and CEO of Saratoga Investment, a business development company traded on the NYSE (SAR).