BDC Bond Masterclass with Radcliffe Capital Management's Steve Katznelson

Stewart: Welcome to another edition of the InsuranceAUM.com Podcast. This is the Ice Bowl edition. We've just gotten our power back on after an ice storm last night in Chicago, and we are joined today by Steve Katznelson, the founder and CIO of Radcliffe Capital Management. Steve, thanks for being on.

Steve: My pleasure. Thanks for having me.

Stewart: I want you to know that we've rescheduled this thing once already. I was like, "I am not rescheduling this again." So, I'm up at Harbor Freight 25 minutes before they open. I'm first in line in front of 30 other people all trying to buy generators. I've put a 100-pound generator in the front seat of my car, get here, had my neighbor help me get it out. As I walked in my garage, I realized the lights were on. So, this is a good-luck podcast from my perspective. So, thanks for being here. Before we get going too far, I want to start you off the way we start them all, which is, I'd love to know where you grew up, your first job, and a fun fact.

Steve: Sure. I grew up in Montreal, Canada, which was a chilly, but fun place to grow up. I then went to business school in the US and have been living in Philadelphia for over 30 years. First job, when I was 9 and 10 years old, I delivered local Montreal newspapers for a penny a paper. I asked for two routes so I could get over 100 papers, but it was heavy. The papers were dropped off at the bottom of my driveway at 4:00 AM or something, and there were far too many for me to carry it at any one time. So, I had to keep returning to home base and refill the bag. It was challenging for a scrawny kid, especially through Montreal winters. But, I saved up over a dollar a week and with my parents' help, opened my first bank account.

Stewart: There you go. All right, so that's cool. So, how about the fun fact?

Steve: Fun fact, when I was 17, I was working at a Burger King in London, England with a friend. We had a work visa to do that, and we managed to scrape up enough money to buy tickets to see Pink Floyd in their first tour performing The Wall in London. It was an amazing experience, one that I'd never expect to repeat. The fun fact for me is that when my son was 17, the same age I saw the concert, Roger Waters with Pink Floyd came to Philadelphia to perform The Wall, and I got to bring him to see that concert, just me and him, and got to relive that experience through his eyes.

Stewart: Man, that's really cool. I'm an old school rock and roll guy, and I like Pink Floyd. I think that's super cool. So, what a great experience. I pride myself on being a fixed income geek, and we're going to talk about BDCs today, which I've got a lot to learn. But, before we do, can you give us just a little bit of background on Radcliffe Capital Management and when you founded it and who your clientele is and asset classes and so forth?

Steve: Sure. I founded it. I founded Radcliffe back in 1996. Prior to that, I was director of convertibles research at Drexel Burnham Lambert. That's going back a bit. Then, after Drexel went bankrupt in February of 1990, I ended up joining Susquehanna Investment Group, which is how I came to Philadelphia. They hired me to build and run their convert arb desk. I became president of two of the five broker-dealers there and resigned on good terms back in 1996 to start Radcliffe. Radcliffe Has always pursued niche strategies that have demonstrable mispricing, where we have edge in capitalizing on that mispricing, and where we want to invest heavily ourselves. We're not on any major platforms. We've never been a marketing machine, but we are managing over $4 billion for clients. Those clients include some of the largest institutional investors in the US. We've seen growing interest from insurance companies. In fact, our most recent large SMA is focused on BDC bonds for an insurance company that was looking for excess returns in the investment grade bond market.

Stewart: That's really cool and leads us right into our topic, and I need you. I need an education here. I often say that I'm the one who learns the most on these podcasts, and it's true. I always get a good education, because I'm talking to smart guys like you. What is a BDC? And, why should insurance companies care?

Steve: Sure. A BDC or business development company is, or they are closed-end investment funds governed under the 40 Act. Congress created the BDC concept with the idea that BDCs would raise equity and debt capital for the sole purpose of investing in middle-market American companies and stimulate economic growth. Most BDCs are RICs or registered investment companies, similar to a REIT, whereby if they're in compliance with all the rules, they pay out 90% of their investment income as dividends. That's the boring part of what BDCs are. In our view, what makes BDCs really interesting is how their balance sheets are constructed. The balance sheet construction is so attractive for BDC bond buyers and in different ways. The left side of their balance sheet or their assets, which is their investment portfolio, are very similar to CLOs. Their investment portfolios are highly diversified. They're mostly or entirely comprised of secured loans to these middle-market American companies. Those companies are cash flowing companies. They're lending based off of EBITDA, not speculative VC type of lending.

The right side of the balance sheet is where BDCs are really differentiated, their liabilities in equity. What makes BDCs unique is that under the 40 act, there's a regulatory limit on the amount of leverage they can employ. Specifically, there's something called the asset coverage ratio, which is 150%. In practice, they keep it at about 200%. What that means is that for every, for instance, billion dollars of their diversified investment portfolio to cash flowing companies at the top of the capital structure with secured loans, for every billion dollars of that, they have typically about half a billion dollars of total debt. The implications of that small amount of debt is profound, because it provides so much downside protection. That underlying portfolio, for instance, can go down by 50%, and the bonds are still whole. That's something that the market just is not properly pricing in.

Stewart: I'm glad you clarified the difference between BDC and VC because I was going to ask you that, but what does a typical BDC portfolio look like?

Steve: Yeah, well, in addition to the portfolios being diversified, comprised of secured loans, floating rates, secured loans to cash line companies that typically have EBITDAs of $50 to $100 million, that ranges, but that's typical. There are other key features to their portfolios, including the fact that these are very quickly amortizing loans that they're making. In fact, most BDCs typically have about a quarter of their investment portfolio being repaid in cash every year. That's just an enormous amount of incoming cash. In that example of a billion dollars of investment portfolio and half a billion dollars of debt, they've got, in addition to income, they've got $250 million coming off as principle payments every year. That's why even in times of extreme stress like 2008 or 2020, all they need to do is stop reinvesting the cash, and they quickly de-lever with no threat of not being able to repay their bonds, in our view. I guess one thing that's topical as we might be heading into a recession with regard to BDC portfolios, it's absolutely true that many, including us, expect an increase of default rates by companies.

That's companies that underlie CLOs and companies who borrow from BDCs. That's why we actually think the vast majority of fixed income is riskier than what's priced in both the IG and high yield. But, for BDCs, the downside protection is so huge that it just isn't a practical risk even under depression, nevermind a recession. I think it's worth pointing out that through 2008 when BDCs were much riskier propositions investing in their bonds, not a single BDC bond was not repaid in full. Every BDC bond in history has been repaid in full. Back in 2008, they were a lot riskier. For instance, only 40% of their investment portfolio were secured loans. Today, it's well over 80%. That's just part of the reasons we believe every one of our BDC bonds will be repaid in full, regardless of market conditions. We can't say that about even the vast majority of investment grade bonds, never mind high yield, of course.

Stewart: And, so there's differences between the BDC portfolios, right? So, can you give me an idea about the range in terms of the most risky profile to the least risky profile? Is there a big span there? Or, how does that work out?

Steve: Yeah, all the BDCs have that regulated downside equity cushion, but you're absolutely right, Stewart. There's really big differences between the least risky and the most risky of the BDCs. What we look for in the best BDCs, for instance, are several broad things. One is large platforms where they're directly originating their loan. That allows them to control terms, documentation, covenants, et cetera. The best BDCs also have low fee structures that align management incentives with investors. We think that's really important. Really good BDCs have investment portfolios that are diversified by count and industry. They're comprised primarily of secured loans, because not all the BDC portfolios are primarily secured loans. They also have minimal realized and unrealized losses and low levels of non-accruals, meaning loans that aren't current in their interest payments. The best BDCs also have really manageable liabilities, which is something we focus on, low leverage, high asset coverage, and a diversified mix of their own liabilities, the maturities of their secured and unsecured debt.

We're also looking for BDCs that have strong track records. How have they done in the past through good times and bad? How have their returns of equity been? And, are they driving positive cash flows with portfolio gains and consistently increasing NAVs per share? So, that's what we look for in a really good BDC. They are several in that bucket. There's also BDCs that are a lot riskier that have small platforms, no direct origination. They tend to have higher fee structures, riskier portfolios, poor quality dividend coverage. Some of them tend to be NAV destroyers consistently. So, there are big differences.

Stewart: Thanks. You mentioned CLOs a moment ago. How would you compare BDCs to CLOs in terms of their relative value and structure? More people are probably familiar with CLOs than they would be with BDC? So, it's a reference point that I think a lot of people will be able to identify with.

Steve: We love the comparison to CLOs, because BDCs are very similar to CLOs in a number of key ways. The investment portfolios of both CLOs and BDCs, they're very diversified. They're mostly or entirely secured loans. And, they're making those loans to cash flowing companies. So, that's similar. They're also similar to CLOs in that under stress conditions, the higher tranches of CLOs have protective provisions at the expense of the lower tranches that essentially get cramped. BDC bonds have very similar provisions that protect the BDC bond holders at the expense of BDC stockholders. That's a longer conversation, but for instance, under distressed conditions, the BDCs have to stop paying dividends and can't buy back stock, can't make new loans. All the incoming cash that I was talking about is going straight to the creditors, the bond holders like us. So, those are some of the things that are similar between CLOs and BDCs.

What's different is that BDC bonds have higher yields than single A tranches of CLOs and way higher yields than AAA tranches of CLOs. What's probably not intuitive is that BDC bonds have vastly more downside protection than even AAA CLOs. In that example I gave you, of half a billion dollars of total debt for every billion dollars of investment portfolio, if that investment portfolio declines by 50%, our bonds are 100 cents on the dollar. But, with CLOs, typically through the AA tranches will be wiped out, 0 cents on the dollar. Even AAA tranches will typically be impaired in that extreme scenario by a third. That's, in our view, a shocking difference and not observed in the market. That's why we believe our bonds that are mostly BBB-minus rated, some BBB, really do have single, AA corporate bond equivalent risk, much less risk than AAA tranches of CLOs. Yet, they're yielding single B, BB type yields. In my history in the financial markets, that is by far the largest mispricing I've ever seen in the investment grade bond world.

Stewart: Earlier in the podcast, you mentioned that Radcliffe focuses on niche strategies, and you talked about mispricing in the BDC market. I guess my question is, why does that mispricing exist in your mind? And, further, do you think it'll persist?

Steve: Yeah, thanks for that question. That's a great one, because we're generally market efficiency believers, and we were shocked when we first found this, and it is persisting. But, our guess is that the reason that mis-pricing exists is for a fortunate combination of what we think are five factors. The first is the space is relatively small and relatively new. Back in 2014, when we started a dedicated strategy on BDC bonds, there were only $8 billion of total market value of bonds issued by BDCs. In 2020, there was $14 billion. Today, there's about $45 billion. So, it's grown a lot, but the market is just catching up. $45 billion is still a tiny sleeve of over $10 trillion of investment grade bonds outstanding. So, I think that's one of the reasons, new and still relatively small.

Another reason is it takes an unusually large amount of work to analyze BDC bonds every quarter, including a granular analysis of their schedule of investments. We know credit analysis. Our flagship strategy is ultra-short duration that we're extremely proud of. So, we do a lot of granular credit work, but BDCs involved even more work. So, I think that's the second reason. The third reason is that up until about September of 2020, there was zero sell-side research on BDC bonds. There was some on the stocks, but none on the bonds. Then, JP Morgan published their view of the understated ratings and mispricing of BDC bonds. They were the first ones in the latter half of 2020. Oppenheimer put out a piece a few months ago where they ultra stressed the portfolio, highlighting the downside protection, whereby they pointed out that 96% of the BDC portfolios of secured loans could default, across the board, 96% with 50% recovery, which is less than your typical recovery of secured loans. Even in that scenario, BDC bonds are 100% unimpaired.

But, I think that's a third reason. Sell-side research was zero and has just recently started publishing on it. A fourth reason is we just think there's a general misunderstanding that, like you alluded to and directed the questioning to, there is a misunderstanding that BDCs really are like CLOs, but with much less leverage and way more downside protection. Unlike CLOs, they are permanent capital vehicles as closed end funds with the ability to work through problematic loans to the extent that they happen, whereas CLOs have virtually no flexibility there since there, since they have to exit on a schedule. So, I think that's a fourth thing. Sorry, I'm almost finished with this, but it's a hot topic for us. Why does mispricing exist? The fifth reason we think is that the rating agencies are broadly giving BDCs essentially the identical ratings, mostly BBB-minus across the board, despite the difference in risk profiles as we discussed and despite the fact the ratings being far too low for the risk, which the sell-side research has only begun to echo. Those are, I think, the reasons.

Stewart: That's really helpful. I guess just to wrap, if I'm a CIO, is there a size of insurance company that's well-suited to get access to this? How can I, as an allocator, invest in a portfolio of BDC bonds?

Steve: Well, I guess fortunate for us, there's no easy way to invest passively in the space. There are a few insurance companies that buy almost every BDC bond new issuance. But, there is a large difference in risk return and return between BDC bonds. We're not aware of any other managers with a dedicated BDC bond strategy. We've been focused on this for 8 years, so I'm happy to be here today, because the amount of BDC bonds has tripled since 2020, and and there's broad mispricing that still persists. But, other than just either throwing darts or indexing yourself, we're not sure of how else to invest in space.

Stewart: That's really helpful. I've learned a bunch. I really appreciate you being on. I have a new closing question for 2023, and I don't know, it's just kind of a fun one. You can take it for what it's worth. Who would you most like to have lunch with, alive or dead? It's kind of an interesting one, right? I've asked the 21-year-old self-

Steve: I have to answer this with no prep, okay.

Stewart: Yeah, no. I've asked the-

Steve: That's fair.

Stewart: What would you tell your 21-year-old self, a million times, and I get people tell me, "Come up with a new question." I thought about it for a long time, and I'm like, "Well, this is an interesting question." Who would you most like to have lunch with, alive or dead? It may be not even most like to have lunch with, but who would you like to have lunch with?

Steve: I think I would like to have lunch with my dad who's alive, but have lunch with him when he was about 30 years old.

Stewart: That's interesting.

Steve: He had just left South Africa to move to Montreal. He didn't even know that it was cold there. He didn't know that he'd have to learn French. He went to McGill Law School, and with virtually no money, came with my mom, his wife. I'd love to talk to that guy.

Stewart: Yeah, I hear stories like that, and you just go, "Man, the courage it took, right?" It just takes a lot of courage to do something like that. In some regards, ignorance is bliss, right? Because, I didn't realize it was going to be this cold. Well, it is, so bundle up. But, no, it's been great having you on, and I just wanted to say thank you for taking the time. Radcliffe is new to our platform, and we're thrilled to have you. Thanks for educating our audience and me on the value in BDC.

Steve: Well, thanks for the insightful questions and that curveball last question. I actually like it.

Stewart: Thanks very much.

Steve: Have a great day.

Stewart: Thank you, Steve Katznelson, founder and CIO of Radcliffe Capital Management. Thanks for being on. Thanks for listening. If you have ideas for podcasts, please shoot me a note at Podcast@InsuranceAUM.com. Please rate us, like us, and review us on Apple Podcasts. We certainly appreciate it. My name's Stewart Foley, and this is the InsuranceAUM.com Podcast.

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