Business development companies (BDCs) are great places to invest your money, particularly because they pay very large dividends. But the other reason to pay close attention to BDCs is the way they handle their own investment research: The due diligence they perform isn’t much different from how you should perform yours.
The difference is that most investors don’t do nearly the research that BDCs do, yet both have the same thing at stake: money.
While BDCs raise some of their capital by going public, much of their initial capital comes from high-net-worth individuals who place their money into these private equity funds. They do this to gain exposure to the kind of middle-market opportunities the average retail investor doesn’t have access to. Plus, these deals tend to provide market-beating returns.
BDCs go for debt investments that yield at least in the low teens, and often higher, and they take an equity position or ask for warrants from the companies they invest in. They’ll invest in leveraged buyouts, management buyouts, recapitalizations, growth financing and acquisition financing. Unlike the average investor, however, they also offer their own expertise to assist the companies they invest in.
The criteria BDCs look for include the following:
- Seasoned and proven management team with meaningful financial commitment: This is at the top of the list. BDCs don’t invest in a product, they invest in people. They will research management’s background and have numerous phone conversations, arrange site visits and spend time getting to know management. As an individual, you can’t meet management, but if you read the transcripts of enough earnings conference calls, you’ll learn very quickly if your management is on ahead of the curve.
- Positive historical free cash flow: BDCs aren’t going to throw money at a company that hasn’t turned the corner yet. The only reason you might be lenient here is if you’re dealing with a microcap that has great history but is just on the cusp on free cash flow.
- Reasonable free cash flow margins and return on assets: BDCs don’t like companies that have thin margins. The slightest change in revenue or expenses could turn a profitable business into a loser. They want to see their money get a good return based on the company’s assets.
- Traditional businesses but niche market position/potential for market leadership: BDCs aren’t interested in start-ups. They like products that many people use every day — but products that are niche in nature. Take a look at this list from Triangle Capital (NASDAQ:TCAP). Notice how most of these companies operate in a niche within a larger more familiar sector.
- Defensible competitive advantage: BDCs don’t want to invest in a commodity business. Competition is always trying to kill you. The smart money doesn’t go there.
- Reasonable exit alternatives: BDCs will often want to invest in a business that might get purchased, earning them multiples on their investment.
Now, do any of these criteria sound odd to you? None of them should. These are all essential for any retail investor to look at. Of course, you should also take a hard look at the financials. You must be vigilant as you go over the financials for anything that seems odd or out of place. If you don’t understand how things like inventory or long-term debt affect the business you’re considering, then learn about these factors, or move on.
Some of the BDCs I’ve looked at that maintain these high underwriting standards include Prospect Park (NASDAQ:PSEC), Blackrock Kelso (NASDAQ:BKCC), TICC Capital (NASDAQ:TICC), Apollo Investment (NASDAQ:AINV) and Main Street Capital (NASDAQ:MAIN).
As always, do your own due diligence on these BDCs, or you’ll have missed the whole point of this article.
As of this writing, Lawrence Meyers didn’t own any securities mentioned here.