The following discussion and analysis should be read in conjunction with our financial statements and related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K. Except as otherwise specified, references to “we,” “us,” “our,” or the “Company” refer to Kayne Anderson BDC, LLC, a Delaware limited liability company, for the periods prior to its conversion to a Delaware corporation and to Kayne Anderson BDC, Inc., a Delaware corporation for the periods after its conversion to a Delaware corporation described elsewhere in this Form 10-K. We refer to KA Credit Advisors, LLC, our investment adviser, as our “Advisor.” The Advisor also serves as our administrator (the “Administrator”). We refer generally to Kayne Anderson Capital Advisors, L.P., an affiliate of the Advisor, as “Kayne Anderson.”
Forward Looking Statements
This Annual Report on Form 10-K contains forward-looking statements that involve substantial known and unknown risks, uncertainties and other factors. Undue reliance should not be placed on such statements. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about the company, current and prospective portfolio investments, the industry, beliefs and assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” “continue,” “believes,” “seeks,” “estimates,” “would,” “could,” “should,” “targets,” “projects,” and variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond control of the Company and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements, including:
We have based the forward-looking statements included in this report on information available to us on the date of this report. We assume no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Although we undertake no obligation to revise or update any forward-looking statements, you are advised to consult any additional disclosures that we may make directly to you or through reports that we have filed or in the future may file with the United States Securities and Exchange Commission (the “SEC”), including annual reports on Form 10-K, registration statements on Form 10, quarterly reports on Form 10-Q and current reports on Form 8-K.
Item 1. Business
Overview
Kayne Anderson BDC, Inc. was formed as a Delaware corporation to make investments in middle-market companies and commenced operations on February 5, 2021. We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a BDC under the 1940 Act. In addition, for U.S. federal income tax purposes, we intend to qualify, annually, as a RIC under Subchapter M of the Code.
We are managed by KA Credit Advisors, LLC (the “Advisor”) which is an indirect subsidiary of Kayne Anderson Capital Advisors, L.P. (“KACALP” or “Kayne Anderson”). The Advisor is registered with the Securities and Exchange Commission (“SEC”) as an investment advisor under the Investment Advisory Act of 1940, as amended. Subject to the overall supervision of the Company’s board of directors (the “Board”), the Advisor is responsible for originating prospective investments, conducting research and due diligence investigations on potential investments, analyzing investment opportunities, negotiating and structuring investments, determining the value of the investments and monitoring its investments and portfolio companies on an ongoing basis. The Board consists of seven directors, four of whom are independent.
Investment Objective and Strategy
Our investment objective is to generate current income and, to a lesser extent, capital appreciation primarily through debt investments in middle-market companies. We define “middle-market companies” as U.S.-based companies that, in general, generate between $10 million and $150 million of annual earnings before interest, taxes, depreciation and amortization, or EBITDA. We refer to companies that generate between $10 million and $50 million of annual EBITDA as “core middle-market companies” and companies that generate between $50 million and $150 million of annual EBITDA as “upper middle-market companies.”
We intend to achieve our investment objective by investing primarily in first lien senior secured, unitranche and split-lien loans (collectively, “secured middle market loans”) to privately held middle-market companies. Similar to first lien senior secured loans, unitranche loans typically have a first lien on all assets of the borrower, but provide leverage at levels similar to a combination of first lien and second lien and/or subordinated loans. Split-lien loans are loans that otherwise satisfy the criteria of a first lien loan but which have been structured with a credit facility that is senior in right of payment with respect to working capital assets of the borrower and a term loan that is collateralized by all other assets of the borrower. Depending on market conditions, we expect that at least 90% of our portfolio (including investments purchased with proceeds from borrowings) will be invested in secured middle market loans. It is anticipated that most of these investments will be in core middle market companies, with the remainder in upper middle market companies. The remaining 10% of our portfolio may be invested in higher-returning investments, including, but not limited to, equity securities purchased in conjunction with secured middle market loans and other opportunistic investments (collectively “Opportunistic Investments”), including junior debt, real estate debt and infrastructure credit investments. We expect that the secured middle market loans we invest in will generally have stated maturities of no more than six years.
We intend to execute on our investment objective by (1) accessing the established loan sourcing channels developed by Kayne Anderson’s middle market private credit team, which includes an extensive network of private equity firms, other middle-market lenders, financial advisors and intermediaries, and management teams, (2) selecting investments within our middle-market company focus, (3) implementing Kayne Anderson’s middle market private credit team’s proven underwriting process, and (4) drawing upon the experience and resources of our Advisor’s investment team and the broader Kayne Anderson network.
We believe our Advisor’s disciplined approach to origination, credit analysis, portfolio construction and risk management should allow us to achieve attractive risk-adjusted returns while preserving investor capital. We anticipate the portfolio will be comprised of a broad mix of loans, with diversity among investment size, industry focus and geography. The Advisor’s team of professionals will conduct in-depth due diligence on prospective investments during the underwriting process and will be heavily involved in structuring the credit terms of each investment. Once an investment has been made, our Advisor will closely monitor portfolio investments and take a proactive approach identifying and addressing sector or company specific risks. The Advisor maintains a regular dialogue with portfolio company management teams (as well as their financial sponsors, where applicable), reviews detailed operating and financial results on a regular basis (typically monthly or quarterly) and monitors current and projected liquidity needs, in addition to other portfolio management activities.
Market Opportunity
The universe of middle market companies consists of nearly 200,000 potential borrowers that we believe will continue to require access to debt capital to refinance existing debt, support growth and finance acquisitions. Together, these businesses represent approximately one-third of the U.S. private sector GDP making them equivalent to the size of the third largest economy in the world on a standalone basis and employing approximately 48 million people.
The U.S. middle market includes businesses held under an array of ownership structures including publicly and privately held companies, those held in trusts, sole proprietorships, etc. These businesses are also, broadly speaking, geographically diverse and span almost all industries. Middle market companies outperformed through the financial crisis (i.e., the 2007–2010 period) by adding 2.2 million jobs across major industry sectors and U.S. geographies, demonstrating their importance to the overall health of the U.S. economy. More than three-quarters of middle market companies demonstrated revenue growth in 2021 as compared to the prior year, and while the COVID rebound was not as strong as the rebound exhibited by the S&P 500 Index, the downturn also was not as severe.
Further, there is a large amount of uninvested capital held by private equity funds focused on investing in middle market businesses. We expect these private equity firms will continue to pursue acquisitions and to seek to fund a portion of these transactions with debt.
We expect that a number of factors will continue to drive strong demand for middle market senior credit, both by private equity owned and non-private equity owned companies, for the foreseeable future, including: (i) primary market opportunities driven by a significant amount of unspent middle market private equity capital, (ii) opportunities driven by a large need for the refinancing or restructuring of existing debt of healthy companies and (iii) supplemental and growth capital opportunities. Meanwhile, the supply of capital to middle market borrowers is relatively constrained due to (i) a long-term regulatory trend that has nearly eliminated bank participation in leveraged finance due to stricter federal leveraged lending guidelines, (ii) consolidation of commercial banks over the last two decades, which has caused banks to abandon the middle market as they move up-market to service larger clients, (iii) the continued up-market movement of select competitors that historically participated in middle market financings and which now participate mostly in upper-middle market financings as target hold-sizes have increased and (iv) direct lending increasing share relative to broadly syndicated deals and mezzanine financings.
Further, current economic and geopolitical concerns have created a market dislocation in certain segments of lending markets globally with a lack of available capital to finance transaction activity. We believe this has created a substantial enhancement of the relative risk-reward profile for non-liquid private credit markets as an asset class, particularly for managers with a track record of investing through potentially uncertain economic times.
First, inflationary concerns in the United States have led the U.S. Federal Reserve to substantially increase rates, which have driven an increase in reference rates (e.g., LIBOR or SOFR) underpinning the pricing structure of floating rate securities from under 1.0% at year-end 2021 to over 4.50% (3-month SOFR) as of December 2022. This increase in reference rates inures to the benefit of lenders, increasing returns to investors.
Second, global economic considerations (e.g., the risk of a near-term recessionary environment) driven in part by (i) the aforementioned inflationary environment and the U.S. Federal Reserve’s response thereto, (ii) continued supply chain constraints globally and (iii) uncertainty associated with the Russian / Ukrainian conflict have created an environment in which lending institutions broadly have moderated activity. Most of this pull back has occurred in the upper-middle and large syndicated markets. Regardless, there has been a trickle-down effect of (a) increased opportunities for middle-market lenders to participate in larger transactions at attractive terms and (b) a general shift toward more lender-friendly terms inclusive of more conservative structures, increased economics and tightening of documentation.
While uncertainty associated with each of the above factors exists, we believe that, in the hands of a team with experience managing capital through multiple historical economic cycles, today’s climate represents an opportune time to generate attractive risk-adjusted returns relative to nearly any asset class. In addition to commanding higher pricing, principally due to illiquidity, directly negotiated middle market financings generally provide for more favorable terms to lenders than broadly syndicated loans, including more conservative leverage ratios, stronger covenants and reporting packages, better call protection, and more restrictive change-of-control provisions.
The credit investments that we hold in our portfolio generate what we believe are attractive yields, make quarterly interest payments to holders and typically rank ahead of other debt instruments in the borrower’s capital structure. The vast majority of our credit investments are expected to be floating rate loans, providing a natural hedge against inflation in a higher interest rate environment. As a result of Kayne Anderson’s middle-market private credit team’s focus on lending at more conservative debt multiples than the broader market and to businesses that exhibit limited cyclicality, we believe that operating results for the Company’s portfolio investments will have minimal correlation to price changes in the broader equity markets. This lack of correlation to the broader equity markets, combined with attractive yields on senior debt investments and downside protection as a result of our secured middle-market loans’ seniority in such company’s capital structure, are some of the reasons we find private credit investments to be compelling for our portfolio.
Competition
We compete with a number of BDCs and investment funds (both public and private), commercial and investments banks, commercial financing companies and, to the extent they provide an alternative form of financing, private equity and hedge funds. Many of our competitors are substantially larger and have considerably greater financial and marketing resources than we do. We believe we are able to compete with these entities primarily on the basis of the experience and contacts of our management team, our responsive and efficient investment analysis and decision-making processes, the investment terms we offer, and our model of investing in companies participating in industries which we know well.