Middle market lending: me and my shadow Premium

If the financial crisis is forcing American banking out into the sunshine, it is also forcing pockets of American lending towards the shadows. In 2013, lenders other than traditional banks made more than a quarter of loans to companies with less than $500m in revenue, according to Thomson Reuters, up from 19 per cent in 2012. The trend away from bank lending in the so-called middle market began more than a decade ago, but was interrupted by the financial crisis. Pre-crisis, collateralised loan obligations (which pool loans and sell securities) made up the bulk of nonbank lenders. CLOs have returned post-crisis, but other structures, such as business development companies, are increasingly joining them, as regulators nudge banks away from certain leveraged deals.

BDCs, like real estate investment trusts, pay 90 per cent of income in dividends. That has made them attractive in an era of low rates; dividend yields average about 9 per cent. In all, BDCs have raised almost $35bn of equity, Wells Fargo reckons. It is a concentrated industry, though. The 10 biggest BDCs, such as Ares Capital, represent nearly three quarters of it.

Most BDC portfolios are made up of floating rate loans, and BDCs are funding themselves mostly with fixed-rate debt, so cash flow will improve as rates rise. Many BDCs trade around book value, but the yields remain relatively high. Junk bonds, by contrast, pay 6 per cent. The difference exists as the loans that BDCs own are illiquid and money has flooded the junk bond market in recent years. The main concerns for BDC investors are economic downturns and defaults. The bigger risk now, perhaps, is that BDCs attract so much capital that over time they lower their lending standards to compete for assets. Then the industry could cast a long shadow indeed.

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