When I keep reading how difficult the lending environment is for midsize private companies, it only makes sense to take a hard look at the business development companies (BDCs).
It’s been a catch 22 for the banks. They are awash in cash — but after getting shell-shocked by the recession, they aren’t willing to put that cash in the system in the form of new small-business loans, as the Fed had intended under its current policy. This conundrum drives businesses to borrow from BDCs at 10% to 15% rates with equity kickers attached to every deal, translating into fat dividends for investors, who get 90% of the income generated by these cash machine-like assets.
And there are several other reasons to own a few stocks in this sector:
- The gene pool of talent working for publicly traded private equity firms is cutting-edge — and we want it that way, because a successful fund manager can take home a rock-star-sized paycheck tied to strong performance.
- The demand curve for middle (mezzanine) market financing has legs, and most BDCs target these types of deals.
- The growth in the number of midsize companies during the current economic upturn has provided BDCs with a new “sweet spot” of opportunity.
Just like any other sector of the stock market, there will be winners and losers. Success in these companies rests purely on the talent of its management team. The pressure to invest fresh funds is great, and the long-term winners in this sector have deft and opportunistic management teams that are aggressively putting new capital to work.
That’s what’s allowing these select companies to thrive despite extraneous events like certain indexes and exchange-traded funds (ETFs) letting BDCs go, which was mainly to drive down their expense ratios. (I find the marketability of these products to be a lousy excuse to come out of a stock that pays as much as 9% or 10%, when they’re growing the top and bottom lines sequentially quarter to quarter.)
So as long as the bullish trend for the broader market stays intact and bond yields keep rising along the way as a byproduct of an improving economy and Fed tapering, then I would expect shares of the following two companies to continue ticking higher in the second half of 2014.
Apollo Investment (AINV)
In its May earnings report, Apollo Investment (AINV) scored a win for shareholders, announcing first-quarter net investment income of 22 cents per share that topped estimates by a penny while earning an upgrade to “outperform” from JMP Securities. Since the same quarter one year prior, revenues rose by 13.6%, coming in higher than the industry average of 5.1% and helping fuel that significant earnings per share boost.
This 9.5% yielder has demonstrated a pattern of positive EPS growth over the past year, which suggests that Apollo’s business performance is improving — especially as banks are facing more restrictive underwriting guidelines set out by the Federal Reserve back in March 2013.
PennantPark Floating Rate Capital (PFLT)
I’m looking for a continued rise in GDP growth in the next year. So if a BDC can generate a 7.7% current yield from a portfolio of floating-rate loans while paying a monthly dividend, I’m very interested in getting involved while short-term rates are still artificially down near zero. If that’s our base rate, and it’s only going to go higher going forward, then we’ll be sitting fine.
PennantPark Floating Rate Capital (PFLT) is just such a BDC that fits right in with this thesis. Normally, PFLT expects that at least 80% of the value of “managed assets” (net assets plus any borrowings for investment purposes) will be invested in floating-rate loans and similar investments. Additionally, PennantPark’s credit facility recently was upsized to $200 million from $125 million, showing strong lender support while also providing growth capital.
PFLT’s portfolio of high-quality companies, senior debt and floating-rate assets means it’s well constructed to withstand market and economic volatility — a must for any buy-and-hold investor.
Bryan Perry is the editor of Cash Machine, a newsletter focused on high-yield income investing with the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income, which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.