BDCs versus Mutual Funds and ETFs

I have been looking at the Business Development Companies (BDCs) being offered by Franklin Square and CNL.  Both of these funds are investing in loans made to private companies, primarily floating rate tied to LIBOR.  Each has an affiliation with the lending desk of a major private equity firm.  Each expects to employ leverage.  Each will invest selectively in fixed rate debt.

The structure of each is about the same as well:  10% load and a 2% management fee plus 20% profit participation in excess of some benchmark.

Everything is sounding fine.  Except that there are already funds that invest in these floating rate loans available to investors.  I wrote about bank loan funds back in January.  Except for the leverage and fixed rate debt, the fund portfolios will be invested the same as the BDC portfolios.  The major difference is the structure: No-load with an expense ratio typically around 1%.

Now PowerShares has a floating rate loan ETF, the Senior Loan Portfolio (NYSE:BKLN).  It is designed to track the S&P/LSTA U.S. Leveraged Loan 100 Index.  Since its March 31, 2011 inception, it has tended to trade at a premium of 50 to 100 basis points.  BKLN has an expense ratio of 0.93% which is is currently being subsidized by ten basis points.

There is the choice:  invest in a traditional mutual fund or and ETF at virtually no load and with a 1% expense ratio.  Or invest with a 10% load and a 2/20 management fee.  PLUS direct expenses.

The promoters of the BDCs point to the leverage and illiquidity as investor benefits.  By borrowing at rates lower than is being earned on the portfolio, leverage is expected to enhance the returns.  The illiquidity of the investment will force an investor to hold during times of uncertainty, relieving selling pressure in a weak market.

In fact, leverage and illiquidity are risk factors, not investor benefits.  Indeed, an investment which exhibits these characteristics should be expected to provide incremental returns relative to similar investment which does not have the characteristics.  It seems rather dubious to rely on these additional risk factors to just overcome the BDCs' structural weaknesses and achieve performance parity with traditional funds and ETFs.