One of the more intriguing investments to emerge in the market over the past decades are business development companies, also known as BDCs. These entities are required to distribute 90% of their annual taxable net income every year. For BDCs that are well-managed, this can generate distributions that yield 10% or more annually. These well-managed BDCs are the kind of investment that my forthcoming stock advisory newsletter, The Liberty Portfolio, will seek to own.
So what are BDCs, and who do they serve? BDCs provide specialized debt and equity finance to what is commonly known as the “lower-middle market.” These are usually corporations with revenues ranging from the low eight-digits on up to one hundred million dollars. And they can be in just about any industry. The best BDCs create debt that is secured, often with some form of equity kicker such as warrants, or some form of preferred stock.
BDCs have a specific mandate: Make as much money as possible in the form of total return, usually from high-yielding debt along with an exit strategy from the equity position. Other forms of investment are the creation of convertible securities that can be purchased in one of the BDCs portfolio companies.
The trick, then, are finding BDCs that are smartly invested to the point where their income exceeds their distributions — just as you hope any dividend-paying company will generate enough cash flow or net income to fund the dividend. There are several of these BDCs, and I think these three have the best chance at remaining in that category.
High-Yield BDCs to Buy: Alcentra (ABDC)
Part of BNY Alcentra Group Holdings, Alcentra Capital Corp (NASDAQ:ABDC) makes nice, small investments that are carefully vetted for risk and little leverage. The company is among the world leaders in sub-investment grade credit assessment, boasting more than 50 investment funds with more than $24 billion in assets, so it has plenty of capital to back it up.
Its investments include companies spanning the gamut, from tech to energy to industrials, such as Champion One, LRI Energy Solutions and Limbach (NASDAQ:LMB).
In its fourth quarter, total investment income came in at about $11 million. With operating cash flow totalling $28.5 million in FY16 and $18.37 million paid out in dividends, its coverage is approximately 155%. That means that while ABDC sports a high distribution yield of 9.52%, it’s in more than capable hands.
High-Yield BDCs to Buy: PennantPark Floating Rate Capital (PFLT)
It’s difficult to ignore a consistent winner like PennantPark Floating Rate Capital Ltd (NASDAQ:PFLT), which has traditionally been right on the nose as far as dividend coverage, at 100% when looking at its cash on hand relevant to dividend payments for 2016.
PennantPark attempts income and capital appreciation through its investment in “floating rate loans,” which are dubbed so because of their adjustable rates. A floating rate loan could be anything from a bond, mortgage or credit, so long as the rate is not fixed. PFLT is invested in 98 companies, allocating a median $6.7 million to each. Those companies include Verizon Communications Inc. (NYSE:VZ), FishNet Security and API Technologies Corp (NASDAQ:ATNY), among others.
The fund uses a “value oriented philosophy,” spreading its wealth around focusing both on companies that would be rated “BB” or “CCC” if rated by a national agency, but also micro-cap stocks. It yields a mouth-watering 8.34% with more than enough net income to cover its payments.
High-Yield BDCs to Buy: Gladstone Capital (GLAD)
Gladstone Capital Corporation (NASDAQ:GLAD) is also a consistent payer with its dividend coverage on lock. GLAD yields 8.7%; and with $25 million in operating cash flow and $20 million in dividend payments over the trailing twelve months, it’s coverage is a solid 125%. That’s because GLAD tends to go for slightly larger investments in companies that tend to have much higher revenues.
GLAD will invest in each company within a range of $7 million to $30 million. That way, the lower-middle-market companies get the financing they need to grow and BDCs get a solid rate of return if they invest wisely. In fact, the very best BDCs will invest in companies that don’t even correlate to changes in the equity or debt markets. That includes entertainment company Flight Fit N Fun, auto firm Meridian Rack & Pinion, Inc. and the telecom NetFortris Corp.
The loan terms of business development companies will vary. Loans may be shorter term in nature, like three years, or run as long as seven years. All will generate interest payments in the 11%-15% range, which is usually the rate a second-position or junior position would get. In this case, however, business development companies often end up in senior position. GLAD is no exception.
Lawrence Meyers is the CEO of PDL Capital, and manager of the forthcoming Liberty Portfolio stock newsletter. As of this writing, has no position in any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.