by Will Ashworth | May 29, 2012 10:00 am
In an excellent primer May 24, InvestorPlace contributor Lawrence Meyers highlighted the ins and outs of business development companies. This relatively anonymous investment vehicle was created in 1980 by an act of Congress to help public equity capital flow to private businesses. Like REITs, BDCs must distribute at least 90% of their “investment company taxable income” to be considered a regulated investment company, or RIC for short.
The main thing to remember about BDCs is that they fill a gap in commercial lending. As a result, they often make loans with higher interest rates than usual — and while this generates higher income for the BDC, it also can lead to a higher rate of nonperformance.
Keeping this in mind, I’ll recommend three BDCs that stand out from the crowd:
My first recommendation is Main Street Capital (NYSE:MAIN), a Houston-based company that provides equity and debt investments to small- and middle-market firms with revenues of $10 million-$150 million and EBITDA of $3 million-$20 million.
Many of the companies Main Street lends to aren’t household names; nonetheless, a few that should ring a bell include The Tennis Channel, Golden Nugget hotel, Totes Isotoner and Ziegler’s New York Pizza Department.
Once Main Street completes its due diligence, a presentation is made to its investment committee. The next step is to go to its credit committee and make a second presentation. Only when a majority of both committees green light an investment are the legal documents drawn up for funding.
Upon funding, MAIN implements an ongoing rating system ranging between 1 and 5, with 1 being a portfolio company that is performing significantly beyond expectations, and 5 a portfolio company that is significantly underperforming. As of the end of December 2011, 96.8% of its $548.6 million in investments were meeting expectations or higher. It finished 2011 with 22.9% of its investments at the highest rating possible, up 790 basis points from 2010. Should you invest in Main Street, it will be important to watch this number at least annually.
The other two metrics you’ll want to keep an eye on are net realized income and net change in unrealized appreciation. If both of those are going up, life is good. In the first quarter ended March 31, net realized income increased 184% to $21.0 million, and the net change in unrealized appreciation increased by 14.5% to $4.7 million. MAIN’s net realized income was significantly higher in Q1 2012 compared to Q1 2011 because it partially or fully exited from two investments for a gain of $8.1 million.
MAIN, up about 14% in 2012, has outperformed the S&P 500 every year since becoming a public company in 2007. Best of all, it currently yields 7.4%.
Did you know it now costs $1 million to buy a corporate taxi medallion in New York City? In 10 years, the cost of one of these babies has risen 400%! It’s no wonder then that there’s a market for medallion loans in New York City and other parts of the country.
Alvin Murstein, CEO of Medallion Financial (NASDAQ:TAXI), has been in the taxi business for more than 40 years and funding medallions since 1979. Today, Medallion is a specialty finance company that does more than make loans for taxi medallions.
Although the medallion business represents 63% of its $1.14 billion in assets under administration, another 13% is for commercial lending, 20% for consumer lending and the remaining 4% of its assets are investment securities and equity investments.
In 2011, Medallion originated $471 million in new investments. In most years, it delivers between 30 cents and $1 per share in net investment income and 20 to 50 cents per share in unrealized appreciation. It’s because of this consistency that TAXI is able to distribute between 60 and 80 cents per share in dividends annually.
That’s critical given Medallion’s mandate as a regulated investment company. During the past 10 years, it has averaged a yield of 5.8% with another 4% to 5% in appreciation, and it currently yields around 8%. Income investors should enjoy TAXI’s stability.
Lastly, I like the look of TCP Capital (NASDAQ:TCPC), a BDC that only went public in April. Its investment manager is Tennenbaum Capital Partners, a provider of middle-market financing since 1999. Tennenbaum created TCP Capital in July 2006, combining two funds it managed and $419 million in shareholder contributions.
Originally established as a closed-end fund, TCP Capital became a BDC immediately before its initial public offering, which sold 5.75 million shares at $14.75 for net proceeds of $81.4 million. Shareholders on board since 2006 have received $196 million in distributions, or $12.43 for every post-IPO share, which works out to an annualized yield of approximately 8.1%.
Of course, that’s the good news. The bad news is that TCP’s net asset value in July 2006 was $26.64; today, post-IPO, it is $14.77 a share. Investors involved from the beginning have basically broken even, which isn’t all that bad when you consider the Russell 2000 is only up 9% in the same time frame, and it has a lot more diversification.
Investors who buy into TCP Capital are getting in after much of the pain already has been felt. At the company’s inception in 2006, its total liabilities were $289 million, or 33% of total assets. At the end of March it was $76 million, or 17% of total assets. With the exception of its big down year in 2008 when its net assets from operations declined by $189 million, it has been an extremely positive situation. From where I sit, this looks like a great entry point.
I like BDCs because they lend and invest in businesses that often can’t expand without it. They’re not like JPMorgan Chase (NYSE:JPM) and the rest of the big banks who spend more time betting on derivatives than they do lending money to businesses. It’s important that you understand how each BDC works before you invest (because they’re all slightly different), but the three above are good places to start.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
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