Business development companies or BDC are registered under the Investment Company Act of 1940, like mutual funds. But instead of investing in public securities, they generally invest in private companies. They are required to make loans as well as equity investments, and the loans carry relatively high interest rates to reflect the underlying risk of the smaller private companies the BDC deals with. Under the Investment Company Act, the BDC is required to pay out 90% of its income, just like a mutual fund or REIT, if it wants to avoid paying taxes.
Most business development companies provide long-term debt and some equity capital to middle-market private firms in the $50 million to $500 million revenue range. Under the law, they also have to offer managerial expertise and consulting to the client companies, who typically are high cash flow operations that have been in business for many years. These are not start-ups, or in industries with long incubation periods like biotechnology.
Some BDCs focus on the interest rate on their loans, while others will take a lower interest rate plus an equity kicker for capital gains. In either case, 90% of the income has to be distributed to us shareholders.
Many mutual fund prospectuses forbid the fund from investing in another company registered under the ‘40 Act, a provision originally intended to protect shareholders from paying double management fees. There are very few BDC analysts on Wall Street, and little institutional interest in these companies. That’s perfect for the income investor looking for consistent high yields – there’s not a lot of competition.
In an article I wrote recently for MarketWatch, I mentioned one of these BDCs, BlackRock Kelso Capital (NASDAQ: BKCC), now with an 11.9% yield. A few others to look at:
• Apollo Investment (NASDAQ: AINV) – 11.2% yield
• Ares Capital (NASDAQ: ARCC) – 9.6% yield
• Fifth Street Finance Corp (NYSE: FSC) – 12.3% yield
• Kohlberg Capital Corp (NASDAQ: KCAP) – 13.3% yield
• PennantPark Investment Corp (NASDAQ: PNNT) – 10.0% yield
• Prospect Capital Corp (NASDAQ: PSEC) – 12.2% yield
Business development companies are a target-rich environment for high-income investors looking for ideas for the safe end of their “barbell portfolio.” That is, a portfolio with a group of low-risk and investments at the bottom providing stability and decent dividends, paired with a smaller group of aggressive but high reward investments at the other end of the spectrum.
As of this writing, Michael Murphy did not own a position in any of the stocks named here.
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