John Cole Scott, President of CEF Advisors, talks about how current conditions have made for nervous times in the business-development company space, and he looks at history to determine whether the risks are systemic rather than situational. The conversation looks at how the BDC space has gotten extensive scrutiny recently from the Financial Times and on sites like Seeking Alpha, with some observers forecasting trouble ahead; Scott, who is also the chairman of the Active Investment Company Alliance, acknowledges the potential for trouble but also highlights the differences between the top tier companies and the weaker players to conclude that there is less danger than the coverage suggests.
CHUCK JAFFE: We’re reaching back into the history books to say what past problems can teach us about large cap business-development companies and whether potential troubles represent systemic risk, welcome to The NAVigator. This is The NAVigator, where we talk about all-weather active investing and plotting a course to financial success with the help of closed-end funds. The NAVigator is brought to you by the Active Investment Company Alliance, which is a unique industry organization representing all facets of the closed-end fund industry from users and investors to fund sponsors and creators. If you’re looking for excellence beyond indexing, The NAVigator will point you in the right direction. And coming back in our direction on The NAVigator today, it’s John Cole Scott, he’s president of CEF Advisors in Richmond, Virginia, which is online at CEFData.com, and beyond CEF Advisors, John is chairman of the Active Investment Company Alliance, which you can learn about at AICAlliance.org. John Cole Scott, welcome back to The NAVigator.
JOHN COLE SCOTT: Great to be here with you, Chuck.
CHUCK JAFFE: John, right now there is a lot of alarming talk around business-development companies, because while BDCs offer a way to generate high income, they do that by being lenders positioned somewhere between traditional banks and private equity companies, and they serve middle market companies that need some more money to grow. So the worry is that rate cuts are going to hurt BDCs, but also that all of the technology disruption created by artificial intelligence is going to create some problems, because while some middle market companies will cash in because of their role in technologies, others will be cashed out as their business models might be made obsolete. There’s a history of BDCs having troubled periods in the past, people can go to places like Seeking Alpha where BDCs are a big topic because the audience loves high income levels like they get on BDCs and you can find plenty of concern right now. So before we can determine if we’re condemned to repeat the past, I figure you’ve got to have some examples of what’s happened to BDCs in the past and why investors might be right to consider if the kinds of events you’re about to tell me about are going to happen again.
JOHN COLE SCOTT: Yeah, so it’s really hard not to be an investor in BDCs if you don’t know the Allied Capital story, this is before our focus as a firm, but this was back in 2008 there were only four or five BDCs with over a half billion dollars of investments, now of course there’s 50. And the challenge, Allied Capital, they were doing great pre-Financial Crisis, they had a reputation of high dividends, growing dividends, really an aggressive business model, but when that crisis hit, the portfolio cracked under the strain, and by the end of it, by 2010 the market price had gone from $30-something to three dollars and something and it got absorbed into ARCC or Ares Capital. However, if you had stuck around, you didn’t do terrible, but that initial bump was horrendous for those investors. And also there’s other funds along the way, American Capital, and then during my career as an investor, Fifth Street and Medley, they had similar issues, too much leverage, bad underwriting, didn’t have the resources to solve problems when basically the water level goes down and you can tell who’s wearing clothes and who’s not.
CHUCK JAFFE: Yeah. Even Ares, which of course as you point out, wound up getting Allied Capital, Ares was off something like 85% during the Financial Crisis at one point. It’s bounced back miraculously, but talk about HODLrs, you know, “holding on for dear life,” yeah, Ares, I remember writing about stuff like that.
JOHN COLE SCOTT: And because they got such a deal on this and worked out the loans, their ROEs actually came out rather well after that period because they got a huge discount on a bucket of assets and some actually turned out fine.
CHUCK JAFFE: Okay, but like a lot of things there were lessons learned during the Great Financial Crisis, and we’d like to believe, it’s why people say, “Oh, we might be inflating a bubble,” but they don’t want to compare it to the Great Financial Crisis or they don’t want to compare it to the internet bubble or what have you, so have we fixed the problems? Like the things that created those issues, could they be creating issues in this much bigger BDC market that we have today?
JOHN COLE SCOTT: Yeah, so like we’ve talked about, leverage magnifies the up and the down, we’ve had a lot more durable leverage with less risk to the portfolio companies and the covenants that get created, the lenders to BDCs are much higher quality than they used to be. And again, we’ve really liked the look of the fee structures, they’re much better now than 16 plus years ago, but you’ve got to make sure when shareholders are feeling these pains, the discount’s wider, the NAVs blow up, the dividends collapse, that’s what you want to avoid. But the market is so much different, as we’ve talked about previously on this podcast, and also there’s now over 50 versus five, you can be diversified and selective.
CHUCK JAFFE: Yes, but if you’re being diversified, you’re getting away from the biggest players, and the biggest players are the names that people are going to be most comfortable with. So if you’re worried about what could happen when rates go down, aren’t you worried that, oh, I got well diversified, did I also just buy a pig in a poke?
JOHN COLE SCOTT: Well, I’d say right now the total universe of BDC assets is almost a half-trillion, you’ve got almost $200 billion in the listed side. The five largest players, these are all very, very large, Ares, Blue Owl, Blackstone, KKR, and Golub, they’re respected credit managers, that’s just the five largest, and you do have much better balance sheets now, you have lower fees, you’ve got more institutional investors, I’d like to see more, hopefully people listen to this and become more active in BDCs, those help create better outcomes. But there is dispersion, like you said, between the largest and to be very selective with the smallest, that’s one reason why recently we launched a large cap BDC index focused just on the larger BDCs.
CHUCK JAFFE: Okay, so you’ve launched a large cap BDC index, which as far as I know there’s not yet been an ETF created against it but I bet there will be, that’s for a future date and time, but anytime I know somebody launches an index, there are lessons to be learned from the numbers.
JOHN COLE SCOTT: We launch these for benchmarking ourselves and others, there’s 18 BDCs that live in that billion dollar plus net assets, they’re currently off about 7.5% quarter to date and 11% from their July highs, however that’s nothing like the pullback we saw when we talked with the BDCs in April of this year, but it’s still very significant. The discounts are trading about 8% wider than their one-year average, there’s an 11 and mid-change dividend yield for these larger funds, they’re down about 5% in the last year, so 95 cents to the dollar as you expected a year ago, but that’s with interest rates coming down two points reflected in that, and probably two more coming. We’re looking at these yields and the leverage levels, people keep thinking the leverage is high, the limits went up in 2018 but the leverage four years ago was like 47% and now it’s 50%, so it is higher but I just always feel people think the leverage is way bigger than it actually is because it’s not as big of an issue. Dividend coverage is still 105%, which is solid, nonaccruals for the large BDCs is just over 1%, just under half as much as the smaller end of the spectrum, and the loans are generally performing better, they’re marked down half as much as cost, about 1.8% versus almost 4%, and again the first-lien loan exposure now is 75% versus under 65% four years ago. The managers have been changing what they buy to adjust for the market I feel that we’re in.
CHUCK JAFFE: In case you’re wondering, CEF Advisors has this new large cap BDC index, if I’m not mistaken, and John, people correct me if I am, there was a rule about 10 years ago that made it that most of the major stock indexes dropped BDCs because of a change in SEC recording rules, that’s AFFE.
JOHN COLE SCOTT: It was spring of 2014, six months before we launched our UTI with SmartTrust, and the sector moved down roughly 15% generally because of the removal and the lack of demand, which again we think one day could come back, especially for this bucket of larger BDCs with the current regulatory environment is what we see and hope for as discussed previously at conferences and this podcast.
CHUCK JAFFE: Yes, the rule is AFFE, the Acquired Fund Fees and Expenses rule, and the only reason I really remember that is AFFE is the only thing ever to rhyme with my last name, so it’s just kind of stuck in my head that way. But speaking of being stuck in the head, I mentioned the stuff I’ve seen on Seeking Alpha, but the Financial Times just had a massive article, about the size of 10 or 12 columns for me, on the big boom in BDCs, that was the headline. They brought out a number of potential concerns about BDCs that suggest that there are problems brewing, right?
JOHN COLE SCOTT: Yes, and I’d say what they really said is that BDCs are ballooning and growing so aggressively, private credit is the favored child of asset managers right now, and they’re requiring leverage to grow the dividends, and really just that these now are such a big amount of capital that there could be systemic risk in a way not even considered five or 10 years ago. They’re worried about the payment-in-kind or PIK income and how it’s masking defaults and where the nonaccruals and PIK income are overlapping. And then the fee structures in theory, every manager wants to make money, and we know that every manager’s not perfect but the fee structures can incentivize more borrowing, more income for their benefit and not necessarily shareholders, which is why we do more work with governance and experienced managers in our work. Where they are correct, I feel personally, is that BDCs are levered lenders, not as much as banks, like I said, 50%’s a lot of leverage, it’s not 200% like banks. PIK reliance and selected defaults can definitely be warning signs, we’ve had a couple of idiosyncratic defaults in this space, Tricolor was a lender to Hispanic people out on the West Coast, and a huge unexpected, well-rated previously, and it’s basically going to zero, essentially in bankruptcy now. These incentive structures really do need scrutiny, you can’t just trust managers to be great because you like them or you know their brand name.
CHUCK JAFFE: What we take away from this, when we started I was reluctant as I put together the beginning to sort of say right up front, “Let’s talk about whether or not there’s systemic risk.” I was reluctant because, one, the word “system risk” might have turned off some people who otherwise listen to us, they go, “Oh, systemic risk, do I even want to hear what they’re talking about?” But the flipside of that is those who do want to hear it, systemic risk is basically saying, “Look, there’s a problem in the system that we need to know about.” So as you look at it right now, is the bigger problem systemic risk and what you could expect in a falling rate environment with what’s going on in the market? Or is it kind of more event risk, where it’s just how good are these guys as underwriters of their loans and what they’re doing?
JOHN COLE SCOTT: Yeah, I don’t personally see it as systemic risk, I think these are larger portfolios, they’re more resourced portfolios, there’s more diversification in all the aspects, and they’ve already been through Covid five years ago, most of the funds on the market, and a few of them through the Great Recession, a double-digit dividend yield can look great until you realize you’re being paid with borrowed time and not stable income. But I feel like these managers are being painted like they’re Lehman Brothers, not just BDCs are lending to companies. Lehman Brothers isn’t the average bank, so ACAS and Allied Capital aren’t the average BDC, especially today with the market, with the regulations and the competition. BDCs are a name brand now, they’re no longer backwater nichey players or just retail investors.
CHUCK JAFFE: But if that’s the case, and we’re worrying about still seeing tariff policies, economic slowdown, whatever we could be throwing out there, if that stuff makes investors say, “I need to run to safe havens,” as much as they love the BDC yields, they’re going to go for something safer. If that happens and you see money moving away, does that again point you in the direction of, if the stuff we’re talking about scares you, stay with the big boys?
JOHN COLE SCOTT: Yes, but remember not every big boy in my opinion is great, just because you’re large doesn’t mean you’re fundamentally good, it just means you’ve collected a lot of assets. Many of the bigger ones are high-quality managers, but we really want to make sure that you’re looking for quality managers, that’s part of our trifecta analysis at CEF Advisors, and the data today shows the sector’s in a moderate downturn, not in a crisis. And again, the yields are higher because you’ve got to opine that we think rates will tick down, dividends will come down some, ROEs will tick down some, but we’re still almost 400 basis points above yields four years ago. We’re in a market where, like we did more tax-loss selling this week for clients in BDCs, I was trying to grab some losses to offset gains, we talked about it [inaudible 0:13:45] in January. I’m still working my job, Chuck, to make this happen. The neat thing about these funds, while they’re private credit, you can trade them during the day, you can pick your spots like any stock, but they’re under the 40 Act, they’re a little bit more transparent than a bank and other yield investments, but you do have to be thoughtful, they’re not boring, I’ve never said they were, so you’ve got to be very comfortable. We say 1-3% is a good allocation.
CHUCK JAFFE: That’s the important thing, because that’s what I was going to ask you. With all of this, given the overarching concerns, even if you think the majority of them are safe, with your customers where you are using closed-end funds and BDCs, which again technically they’re not a closed-end fund but we lump them in with closed-end funds because they function basically the same way, were you changing your allocations at all to BDCs in your portfolios, and the answer is generally no?
JOHN COLE SCOTT: Increasing. No, even Dan Silver on my team is buying more BDCs than usual, that’s more of my focus but he’s asked me for my favorite list this week. We even bought 10 that we like right now, so that we can sell three or four, buy six others, and keep rotating these tax losses and be doing a good job for investors. There’s some good funds out there, Chuck.
CHUCK JAFFE: I know you and I are going to try to make sure we get some of the guys who run BDCs to come back to The NAVigator to talk about it, but thanks so much for taking this up with me today.
JOHN COLE SCOTT: Great to be here.
CHUCK JAFFE: The NAVigator is a joint production of the Active Investment Company Alliance and Money Life with Chuck Jaffe, and I am Chuck Jaffe, you can learn more about me and my show by going to MoneyLifeShow.com or by searching for the show wherever you find your favorite podcasts. Now to learn more about closed-end funds and business-development companies generally, go to AICAlliance.org, that’s the website for the Active Investment Company Alliance, and if you have questions about closed-end funds, send them to TheNAVigator@AICAlliance.org. Thanks to my guest John Cole Scott, he’s the president of CEF Advisors in Richmond, Virginia and the chairman of the Active Investment Company Alliance, the firm is online at CEFData.com and John’s on Twitter or X @JohnColeScott. The NAVigator podcast is available for you every Friday, make sure you don’t miss any of our episodes by following or subscribing along on your favorite podcast app. We’ll be back next week with more closed-end fund talk, until then, happy investing, everybody.
Recorded on September 26th, 2025
