Warning: BDC Risk Is Rising

Combine easy money policies with an appetite for big returns, and you get big, leveraged risks. While most BDCs seem to have taken a lesson from the financial crisis fallout that sent a few big names into the graveyard, financiers are making riskier loans once again.

Measuring riskiness isn't perfect, but one good proxy for general risk levels is debt multiples to earnings before interest, taxes, depreciation, and amortization, or EBITDA for short.

How risk tolerances changes through cycles
New data from Capital IQ demonstrates growing appetite for risk. In 2013, middle-market companies are finding "first-lien" investors to finance debt equal to 5.2 times their annual EBITDA. For comparison, in 2009, first-lien debt stopped at just over 2.5 times EBITDA.

That is to say, first-lien debt issued in 2009 is not at all the same as first-lien debt issued in 2013. Senior debt issues today are much riskier than in 2009 because we've grown more comfortable with how we think the economy will do over the next few years.

I don't want it to seem as though I'm cherry-picking data. First-lien debt is stretching to higher multiples than in 2006 and 2007, when leveraged buyouts last peaked. There's a clear trend toward higher and higher debt multiples being classified as "first-lien" securities.

BDCs require careful study
The takeaway today is that BDCs require true investigative work. The terminology does not change over time, but the definition certainly does. Some first-lien loans are at the same leverage multiple you would have found lowly subordinated debt just a few years ago.

Pay attention to how your business development companies are classifying their debt investments. For instance, Fifth Street Capital recently made moves to write more first-lien, last-out debt. That's debt that's first lien, but paid after other first-lien investors in the event of a default. In all reality, it's not-as-good first-lien debt that is paid second in a worst-case scenario. Fifth Street Capital calls it "first lien" in its quarterly and annual filings, but I'd argue that's a stretch.

Likewise, there should be preference given to BDCs that break out their holdings by leverage multiple. Main Street Capital is very good about doing this. Each quarter, Main Street Capital's presentations show a median credit statistic on its lower middle-market portfolio. Last quarter, it showed that the median credit was financed at total leverage of 2.3 times EBITDA, well under the average. Knowing this can help you compare the riskiness of your BDC investments.

Diving deeper
Now more than ever, it's important to truly understand where your BDC is deploying capital. Is it writing second-lien debt at a time that second-lien loans are in the nosebleed seats? Is it focusing on smaller middle-market companies, which aren't as leveraged as broadly syndicated loans?

The answers to these questions tell us more about riskiness than a BDC's debt to equity ratio or its latest dividend because they get to the heart of the underlying portfolio.

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The article Warning: BDC Risk Is Rising originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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