Investing in high-risk startups to which traditional banks refuse to lend doesn’t really sound like the best income strategy at first blush.
However, business development companies are filling an important gap for distressed and startup companies. If you can find one with a good manager, these financial entities can provide investors with a steady stream of income — 9% to 11% — by borrowing low and lending anywhere from 12% to 15% to startup businesses that would have trouble funding themselves otherwise. They also include equity kickers as a bonus in the event the borrower executes a successful public offering or sale of their company.
BDCs are providing a much-needed service as banks scale back on risk, but they’re still only covering about 10% to 15% of the backlog. So there’s plenty of growth potential in BDCs themselves, even if not all of the startups they lend to succeed.
You might be wondering how these BDCs can afford to dish out such high yields despite their seemingly risky investments in young startup companies.
The fact is, they have to … by law.
The BDCs that we hold at Cash Machine have chosen to be taxed as “regulated investment companies,” or RICs, as opposed to the more typical “C corporation” status. Thanks to Subchapter M of the Internal Revenue Code of 1986, RICs avoid corporate tax on the income and capital gains they distribute to shareholders, but with a catch — they must distribute at least 90% of their income to shareholders (who are then taxed). This avoids double taxation.
Their tax treatment is very similar to a mortgage REIT, but BDCs also have the luxury of using leverage and derivatives that REITs are restricted from.
BDCs also are subject to special regulations from a 1980 amendment to the Investment Company Act of 1940 to protect your investment. Some of these requirements include having a well-diversified portfolio to minimize risk and providing managerial assistance to the startups they invest in to increase their chances of business success. As you can see, it’s a pretty good deal for shareholders, especially when you consider the expertise and research these companies put into their investment choices.
One that I’m currently recommending is Fifth Street Capital (FSC). It currently has loan/equity positions in 97 companies with an average yield-on-debt-investments of 11.4%. Currently, that translates to an 11.22% yield for holders of FSC.
I’m not alone in liking FSC. Fitch Ratings initiated the company’s debt to a stable “BBB-” rating a couple months ago, and noted five-star hedge fund manager David Einhorn of Greenlight Capital is one of the top five holders of FSC. He’s in good company with BlackRock Fund Advisors and Vanguard.
Investing alongside institutions that have conducted extensive due diligence and taken big positions should offer us a level of confidence.
Bryan Perry is editor of Cash Machine, a newsletter focused on dividends and income investing. His newest service, Extreme Income, also focuses on dividend investing with “income boosters” like momentum plays, option strategies, and more.