Business Development Companies – Excellent Overlooked Investment Strategy

by Darwin on January 14, 2010

A Business Development Company (BDC) is a niche investment category that even many high yield investors don’t have much familiarity with.  While the large banks, energy trusts and real estate investment trusts (REITs) are widely known for their high yields, the Business Development Company opportunity goes widely unnoticed.  Not familiar with BDCs?  Well, think of a Business Development firm as a lender (and sometimes, investor) of last resort to struggling companies starved for cash or even fledgling companies with high potential willing to cede a stake, control or above-market interest rates in exchange for a cash infusion.

BDCs will generally lend to smaller companies and startups at very high interest rates (think corporate payday lenders…but with more class) and often take equity stakes in these companies as well.  In a nutshell, these firms have vast experience in going into a struggling firm, assessing its prospects, making changes if necessary (since they’re holding the cash) and ensuring a favorable return for shareholders and principals in the company.  They are much better at this than individual retail investors.  They have the access and experience that retail investors don’t.  They are also diversified.  While some Business Development firms may focus on a particular sector, like say, Tech firms or energy exploration firms, etc., they hold stakes in several companies at once, smoothing out risk – because defaults do occur, especially in these smaller start-ups.

Business Development Strategy for Investment

Investors seeking to build a high yield portfolio, perhaps in a tax-advantaged self-directed IRA, may want to consider making room for 1-2 BDCs in their mix.  By their very nature, BDCs are optimal income generators.  As mandated by the Investment Act of 1940, BDCs must distribute a minimum of 90% of their taxable earnings quarterly to maintain their one-level tax paying status. In reality, many firms actually pay out virtually all taxable income and short term capital gains, as well as long term capital gains from the sale of equity interests in the companies in which they established positions. There are even some monthly payers as well.  Based on current dividend yields and price levels, many Business Development Companies are currently yielding 8-11%.  Given the crummy low interest rate environment, this is certainly appealing.

More Stable and Predictable Dividend Payouts

During the economic collapse of 2009-2009, while many large Financials were forced to cut their dividends to abide by TARP requirements and smaller Financials acted similarly in order to preserve cash and meet leverage requirements, BDCs hold a bulk of their assets in debt securities of their portfolio companies.  As long as their entire portfolio of companies doesn’t go belly up at the same time, that dividend payout continues in some form.  The difference between a BDC portfolio and say, a high yield corporate bond ETF is that the ETF is passive and based on an index, whereas a BDC has insight into and influence over their portfolio companies.  This, in turn, translates into better performance over time.

BDC Investment Risk

While BDCs are prone to volatility and even collapse like other common stocks (ACAS was a former high flier that tumbled to earth – I had owned it and warned about an exceedingly high dividend ratio and sold myself before it experienced a complete collapse – but I took my lumps on the way down), they are generally less prone to do so than what we just saw on Wall Street.  By law, BDCs cannot leverage up the same way Wall Street firms did since total debt cannot exceed total equity.  Thus, 1:1 leverage is much more manageable risk than the 35:1 we saw with Bear Stearns prior to its demise.

Business Development Company Stocks

In the interest of disclosure, I’ve been long Firth Street Corp (FSC) for some time now in my self-directed high yield IRA.  FSC just announced an 11% Dividend Increase and shares have outperformed of late, including a gain of 3% Thursday in a flat market for Financials. Based on this week’s dividend hike, common shares will now yield over 10% which puts it in the same league as
high yield corporate bonds, but with different risk and performance characteristics.  While municipal bond ETFs can deliver tax free yields in the 4-6% range, which translates into a 6-9% tax-adjusted yield for high-tax bracket investors, they don’t offer the same potential for continued capital appreciation, not to mention, municipalities are actually facing a decent risk of default in many areas (California anyone?).  In addition to the dividend hike announcement, FSC announced that its wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P. (the “SBIC Subsidiary”), has received committee approval for a license from the United States Small Business Administration (“SBA”) to operate as a Small Business Investment Company (“SBIC”).  This is government funding to further their investment ambitions at favorable terms.

There’s also a Preferred Stock ETF yielding over 8% which has high yield alternative investment characteristics as well.

Additional Business Development Company Stocks (with % Yield) include:

  • GLAD – 10.7% – Gladstone Capital Corporation
  • BKCC – 14.6% – BlackRock Kelso Capital Corpora
  • NGPC – 7.7% – NGP Capital Resources Company
  • PSEC – 12.9% – Prospect Capital Corporation

* These yields are based on recent quarters and upcoming payouts, but since the payouts are based on quarterly income, they often vary by quarter.  The best measure may be a review of historical payouts and recent share price moves to see if the market is pricing in a downturn compared to their peers.

Surprisingly, I’ve yet to come across a BDC ETF, but I’m sure there’s one in the works somewhere.  At this rate, we’re going to have more ETFs than we do stock tickers (see this ETF List with over 800 issues going strong), so I’m sure someone’s working on it.  In the meantime, do your own research, watch out for red flags, don’t blindly just chase yield (since you often get what you pay for like these 11% Investment Notes) and maintain an appropriate asset allocation.

For other dividend and income ideas, check out Darwin’s other High Yield articles.

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{ 2 comments… read them below or add one }

1 20smoney January 15, 2010 at 3:28 pm

Interesting article. I’ve never looked into these companies. I’m going to look into these further. Thanks for the tip.

[Reply]

2 Derek June 12, 2010 at 5:17 am

There is an ETF that does track BDC’s – PSP, you can see it’s holdings here:

http://finance.yahoo.com/q/cp?s=^LSTPE

It also had a really bad tracking error last year:

http://finance.yahoo.com/news/ETF-Tracking-Error-Explodes-indexuniverse-1210261458.html?x=0&.v=14

I’m very interested in this ETF, as I want exposure to the asset class, however, it doesn’t seem to execute well and has an anemic 3% yield, which is pretty low considering how high BDC yields are. I’d trade in a higher yield for low yield with steady growth, but this ETF seems to be low yield with no growth.

It is probably better to buy an individual BDC right now until a better product comes along.

By the way I see you have a link to Dividends4Life, he is an amazing writer and is the man.

[Reply]

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