Today’s investing landscape might seem worlds away from that of the 1980s – but as they say, the more things change, the more they stay the same. That is certainly true for the financial sector, and it’s why business development companies (BDCs) have been going strong for the last 30+ years.
A Brief History of BDC’s
Although these tax-friendly specialty financials are just now becoming more widely known, the federal law that created them was actually a product of the dismal economic climate of 1980. With all the inflation, oil shocks and general malaise that was going on at the time, private equity and venture capital firms simply couldn’t provide financing to small, growing businesses. Because of tight regulations, that left small business with really only one option: getting funding from banks.
Just like today, though, traditional banks were playing defense and were extremely hesitant to make smaller loans with greater perceived risks. In response, Congress passed the Small Business Investment Incentive Act of 1980 that essentially created business development companies – a new kind of publicly-traded corporation that could sell stock on the major exchanges.
The law is still in effect, and the rules set up for BDC’s still hold for today:
- Required to invest 70% of their assets in the small companies in their portfolio.
- Must make available “significant management assistance” to those same portfolio companies.
- Must follow all the rules of publicly traded companies, including filing quarterly reports and having their books audited.
- Can use leverage in their own operations. For example, if one of these investment companies has $50 million in equity, it can borrow another $50 million to have a total of $100 million in investable funds.
- Can avoid taxes at the corporate level. As long as they distribute at least 90% of investment income to shareholders annually, these companies can qualify for “pass through” tax treatment of income and capital gains distributed to shareholders.
That second bullet feature is one of the biggest reasons why BDCs are viewed as a solid investment. Because BDCs are required to play a role in supporting the management of their small-business clients, they are devoted not only to picking the right companies to invest in – but in helping them succeed after writing them the loan.
While many of the big banks were hanging everyone out to dry in the 2008 financial crisis due to liquidity and pricing issues, these BDCs were quietly helping their clients work through their company’s issues, often attending board meetings or even serving as board members.
Another feature of BDCs that makes them so appealing to income investors is that they can charge 10% – 14% on their small-business loans. After all, the banks just aren’t lending, and in the current climate of wholesale budget cuts, the Feds aren’t either.
So it’s not hard to see why BDCs have been doing well in recent years, and in my view is the sector is fundamentally very sound, with rising backlog for loan demand.
Now is a great time to get in on the increasingly popular asset class of business development companies (BDCs) – and I’d like to share a few names with you now that I believe are just the ticket to add to your portfolio.
2 BDC’s For Your Portfolio
My first BDC recommendation for you is Hercules Technology Growth Capital (HTGC). Based in Palo Alto, Calif., Hercules is a leading specialty finance company that provides venture debt and equity to venture capital and private equity-backed technology and life-science companies.
We all want to be on the ground floor of new tech, and HTGC has the due diligence to drill down and discover them for us. We don’t have to pick through all that research if we just invest alongside a BDC that already is doing the research.
Hercules Technology reported its fifth consecutive earnings beat after the closing bell on Feb. 27. The company’s fourth-quarter 2013 distributable net operating income came in at 34 cents per share, outpacing the consensus estimate of 31 cents per share. This also compared favorably with the year-ago figure of 27 cents.
The company’s figures benefited from interest and fee income improvements, in addition to disciplined expense management. Overall, Hercules ended the quarter with an impressive performance, comprising a higher level of liquidity.
For the full-year 2013, HTGC recorded earnings per share of $1.34 versus $1.07 in 2012 and easily beat the consensus yearly estimate of $1.23. For the full year, distributable net operating income came in at $79.0 million, rising 51% from $52.3 million in 2012.
When I first recommended HTGC to my Cash Machine subscribers in May 2011, more than 93% of the company’s debt investments were in a senior secured first-lien position, and more than 88% of the debt investment portfolio was priced at floating-rate interest rates with a LIBOR floor. It was my view that after the bond rally, long-term rates would rise, benefiting HTGC’s interest income. Sure enough, Hercules shares are up more than 50% since then, and that’s not even including the 8% quarterly dividend.
I also believe that this BDC is solidly footed to keep rewarding its investors, so I recommend that you buy HTGC up to $17.
E-TRACS 2x Leveraged Long Wells Fargo BDC ETN (BDCL) is a mouthful but worth every bite, and my second recommendation in the BDC world.
Keep in mind that it’s a leveraged business development exchange-traded note, not an exchange-traded fund that holds all the underlying stocks of those publicly traded BDCs. Rather, it is a debt note secured by the United Bank of Switzerland (UBS), and is tied to the Wells Fargo Business Development Company Index (WFBDC) the only index to be made up completely of BDCs. This index is based off of 32 BDC holdings, which the BDCL ETN leverages by 2X.
This exchange-traded note is only as strong as the financials of UBS, a global enterprise with a market cap of $79 billion. But UBS is one of the most conservative investment banks in the world. Like BDCs themselves, the dividend for BDCL will be adjusted each quarter to reflect the performance of the underlying index, but with the fundamentals playing to the favor of the sector, the yield looks reliable.
BDCL was down a good chunk in Q4 2011, but I stayed with it because I thought the fundamentals were better than what the stock was showing. Certainly the BDCs got thrown out with the banks, and very few people have confidence in banks with one scandal after the other in recent years. Since then, however, it’s been prime time for BDCs — and BDCL’s chart speaks for itself: the price is up 63.7% since the beginning of 2012.
As you can see, it pays not to buy into media hysteria. BDCs are financials, but they’re not banks. I made the right choice, and it’s paid off for me and for Cash Machine subscribers. Even with a 60.2% total return on our position, BDCL is currently trading not far from my buy price, so as a newcomer, it’s a great time to get in on the hefty 14.5% dividend yield.
I think BDCL can make its way toward $35 in the next 18-24 months, given its lofty yield that leaves plenty of room to keep moving higher.