You may have heard a lot about stock investments called business-development companies (BDCs) because they must pay out 90% of their annual taxable net income each year. That has traditionally resulted in 10%+ dividends. The good news is that this trend is likely to continue.
For the most part, BDCs provide customized debt and equity financing to lower middle-market (“LMM”) companies with annual revenues of $10 million to $100 million that operate in diverse industries. BDCs invest primarily in secured debt instruments, equity investments, warrants and other securities of LMMs.
The BDCs’ principal investment objective is to maximize the portfolio’s total return by generating current income from debt investments and capital appreciation from equity and equity-related investments, including warrants, convertible securities and other rights to acquire equity securities in a portfolio company. LMM investments generally range in size from $5 million to $25 million. BDCs look for solid management at established companies with positive cash flow that have a defensible competitive advantage and allow for an exit strategy.
BDCs exist to fill the current financing gap for LMMs, which have limited access to financing by commercial banks. The under-served nature of the lower middle market creates opportunity for a well-managed BDC to meet the financing needs of LMMs while negotiating favorable transaction terms and equity participation. Most BDCs aim to have a low correlation to the broader debt and equity markets.
BDCs will loan money for a three- to seven-year term, at 12% to 14%, and yet still get a first-position lien on company assets. Sometimes, though, they’ll take a mezzanine position. Since the BDC structure was created by the government to subsidize American businesses, BDCs can’t invest in foreign companies, they must be diversified to a certain degree, and they can’t have a debt-to-equity ratio of greater than one to one.
Here are a few interesting selections:
Prospect Capital (NASDAQ:PSEC) invests in late-stage venture, middle-market, and mature companies. It also gets involved in buyouts and recapitalizations. It pays a monthly dividend (11.3% annual rate).
Triangle Capital (NASDAQ:TCAP) focuses more on leveraged and management buyouts, acquisition financing and growth financing for LMMs. It pays 9.36% annually and distributes quarterly.
BlackRock Kelso (NASDAQ:BKCC) has the advantage of a insider-director buy earlier this month for $160,000. It yields about 11% and is one of the premier names in private equity.
UBS E-TRACS Wells Fargo Business Development Company ETN (NYSE:BDCS) pays about 7.5%.
You may want to diversify across several BDCs, thus spreading out your risk even more. While a few failed investments in one BDC could torpedo the stock, owning many of them will blunt any failures.
There are many available BDC stocks to choose from, and you need to perform your own due diligence to see if any given one has an investment profile you respond to. BDCs got hammered during the financial crisis because many of their LMM businesses struggled to generate revenues and were credit-constrained. So the state of the overall economy is also a potential downside risk.
Lawrence Meyers does not own shares in any company mentioned.