Updated on July 28th, 2021 by Bob Ciura
Business Development Companies, otherwise known as BDCs, are highly popular among income investors. BDCs widely have high dividend yields of 5% or higher.
The strongest BDCs also have the ability to raise their dividends on occasion. This makes BDCs very appealing for income investors such as retirees, especially in a low interest rate environment.
With this in mind, we’ve created a list of BDCs (several of which we cover in The Sure Analysis Research Database).
You can download your free copy of our BDC list, along with relevant financial metrics such as P/E ratios and dividend payout ratios, by clicking on the link below:
Of course, before investing in BDCs, investors should understand the unique characteristics of the sector. This article will provide an overview of BDCs, as well as our top 4 BDCs right now as ranked by expected total returns over the next five years.
Table Of Contents
The table of contents below provides for easy navigation of the article:
Overview of BDCs
Business Development Companies are closed-end investment firms. Their business model involves making debt and/or equity investments in other companies, typically small or mid-size businesses. These target companies may not have access to traditional means of raising capital, which makes them suitable partners for a BDC. BDCs invest in a variety of companies, including turnarounds, developing, or distressed companies.
BDCs are registered under the Investment Company Act of 1940. As they are publicly-traded, BDCs must also be registered with the Securities and Exchange Commission. To qualify as a BDC, the firm must invest at least 70% of its assets in private or publicly-held companies with market capitalizations of $250 million or below.
BDCs make money by investing with the goal of generating income, as well as capital gains on their investments if and when they are sold. In this way, BDCs operate similar business models as a private equity firm or venture capital firm. The major difference is that private equity and venture capital investment is typically restricted to accredited investors, while anyone can invest in publicly-traded BDCs.
Why Invest In BDCs?
The obvious appeal for BDCs is their high dividend yields. It is not uncommon to find BDCs with dividend yields above 5%. In some cases, certain BDCs provide 10%+ yields. Of course, investors should conduct a thorough amount of due diligence, to make sure the underlying fundamentals support the dividend. As always, investors should avoid dividend cuts whenever possible. Any stock that has an abnormally high yield is a potential danger.
Indeed, there are multiple risk factors that investors should know before they invest in BDCs. First and foremost, BDCs are often heavily indebted. This result is commonplace across BDCs, as their business model involves borrowing to make investments in other companies. The end result is that BDCs are often significantly leveraged companies.
When the economy is strong and markets are rising, leverage can help amplify positive returns. However, the flip side is that leverage can accelerate losses as well, which can happen in bear markets or recessions.
Another risk to be aware of is interest rates. Since the BDC business model heavily utilizes debt, investors should understand the interest rate environment before investing. For example, rising interest rates can negatively affect BDCs if it causes a spike in borrowing costs. That said, BDCs may benefit from falling interest rates. In the current climate of low interest rates, many BDCs could see a tailwind.
Lastly, credit risk is an additional consideration for investors. As previously mentioned, BDCs make investments in small to mid-size businesses. Therefore, the quality of the BDC’s portfolio must be assessed, to make sure the BDC will not experience a high level of defaults within its investment portfolio. This would cause adverse results for the BDC itself, which could negatively impact its ability to maintain distributions to shareholders.
Another unique characteristic of BDCs that investors should know before buying is taxation. BDC dividends are typically not “qualified dividends” for tax purposes, which is generally a more favorable tax rate. Instead, BDC distributions are taxable at the investor’s ordinary income rates, while the BDC’s capital gains and qualified dividend income is taxed at capital gains rates.
After taking all of this into account, investors might decide that BDCs are a good fit for their portfolios. If that is the case, income investors might consider one of the following BDCs.
Tax Considerations Of BDCs
As always, investors should understand the tax implications of various securities before purchasing. Business Development Companies must pay out 90%+ of their income as distributions. In this way, BDCs are very similar to Real Estate Investment Trusts.
Another factor to keep in mind is that approximately 70% to 80% of BDC dividend income is typically derived from ordinary income. As a result, BDCs are widely considered to be good candidates for a tax-advantaged retirement account such as an IRA or 401k.
BDCs pay their distributions as a mix of ordinary income and non-qualified dividends, qualified dividends, return of capital, and capital gains.
Returns of capital reduce your tax basis. Qualified dividends and long-term capital gains are taxed at lower rates, while ordinary income and non-qualified dividends are taxed at your personal income tax bracket rate.
The Top 4 BDCs Today
With all this in mind, here are our top 4 BDCs today, ranked by a combination of factors including strength of business model, competitive advantages, dividend yield and dividend coverage.
BDC #4: Sixth Street Specialty Lending (TSLX)
Sixth Street Specialty Lending is a specialty finance company focused on providing flexible, fully committed financing solutions to middle-market companies principally located in the US. The fund provides primarily first-lien senior secured loans, mezzanine debt, non-control structured equity and common equity.
Management aims to co-invest with other firms to maximize the potential for organic growth, acquisitions, market or product expansion, restructuring initiatives, recapitalizations and refinancing.
Source: Investor Presentation
Sixth Street’s portfolio includes 68 investments, with no company making up more than 3.6% of its total assets. Additionally, the portfolio aims to achieve adequate industry diversification, with business services, financial services and consumer products accounting for 22.2%, 14.7% and 11.4% of its exposure, respectively, among 14 other industries.
On May 4th, 2021, Sixth Street Specialty Lending reported its Q1–2021 results. Net investment income declined 4.1% from the previous quarter, while net asset value increased 3.8%. NII/share continued to be a function of robust net interest margins attributable to its floating rate liability structure in a low–rate environment, which remained relatively stable.
The drivers of this quarter’s NAV/share growth were the accretion from the company’s follow–on equity raise, the continued over–earning against its base quarterly dividend, as well as gains related to company–specific events in its portfolio.
The company’s Weighted Average Total Yield on Debt remained robust at 10.1%. Its Weighted Average Interest Rate of Debt also remained stagnant, at 9.4%. Finally, LIBOR sank further QoQ, by 3 basis points to 0.19%. All variables combined led to the company’s spread holding stable at 9.3%, similarly to the previous quarter.
We expect FY 2021 NII/share of $2.15. Along with its base quarterly dividend ($0.41), the Board declared a special cash dividend per share of $1.25. The regular annual dividend payout of $1.64 per share represents a 7% yield.
BDC #3: Prospect Capital Corporation (PSEC)
Prospect Capital Corporation provides private debt and private equity to middle-market companies in the U.S. The company focuses on direct lending to owner-operated companies, as well as sponsor-backed transactions.
Prospect invests primarily in first and second lien senior loans and mezzanine debt, with occasional equity investments. Prospect’s investment objective is to generate current income and long-term capital appreciation. The company went public in 2004 and currently has a market capitalization of ~$3.2 billion.
Source: Investor Presentation
In the most recent quarter, Prospect’s NII was $0.19 per share, flat from the year-ago quarter. NII-per-share declined 9.5% from $0.21 in the previous quarter. Net asset value ended the March quarter at $9.38, up from $8.96 in the December quarter. Interest as a percentage of total investment income was 87.5% in Q3, up from 84% in the prior quarter, but down from 89.8% in the year–ago period.
Total investment income was $160 million, up from $155 million in the year–ago period. Total expenses were $86 million, flat to the year–ago period. The company has also completed $67 million in originations in the June quarter to date, with repayments of $85 million.
Growth has been tough to come by for Prospect for the past decade. Since 2012, net investment income has struggled to grow. Part of this is due to Prospect’s prodigious share count, which is about six times higher today than it was a decade ago. While it is typical for a BDC to issue shares to fund acquisitions, Prospect’s dilution has been excessive.
Given this history of dilution and weak net investment income performance, we don’t expect NII growth on a per share basis. This will weigh on future returns. Fortunately for investors, the stock has a very high yield of 8.8%.
Note: PSEC had to issue amended 1099s several times which may cause additional headache during tax season if the trend of needing amended 1099s continues.
BDC #2: Main Street Capital (MAIN)
Main Street provides long-term debt and equity capital to lower middle market companies and debt capital to middle market companies. Main Street defines lower middle market companies as generally having annual revenues between $10 million and $150 million. The company’s investments typically support management buyouts, recapitalizations, growth financing, refinancing and acquisitions.
Source: Investor Presentation
On May 6th, Main Street Capital released first quarter results. Net investment income of $39.8 million was a 9% increase compared to $36.5 million a year ago. The corporation generated net investment income per share of $0.58, up 2% from last year’s income of $0.57. Distributable net investment income per share totaled $0.62, up 2% from $0.61 in the first quarter of 2020.
Main Street’s net asset value per share increased compared to the end of 2020, from $22.35 to $22.65. The corporation declared monthly dividends of $0.205, representing an annual dividend of $2.46 per share.
As of the end of first quarter 2021, the corporation had aggregate liquidity of $818 million, consisting of $65 million in cash and cash equivalents, $693 million of unused capacity under the revolving credit facility, and $60 million remaining in the Small Business Investment Company debenture capacity.
Main Street has put together a solid record in the past decade. From 2011 through 2020, Main Street grew net investment income by an average compound rate of 2.4% per year, despite the pandemic weighing on 2020 results. From 2010 to 2019, NIIPS grew 8.9% per year.
Main Street is an attractive dividend stock, not just because of its nearly 6% yield, but also because Main Street is a monthly dividend stock.
BDC #1: Ares Capital Corporation (ARCC)
Ares Capital Corporation is a specialty finance BDC. It focuses on generating both current income and capital appreciation through debt and equity investments. The company invests primarily in U.S. middle-market companies, as well as larger companies.
Its portfolio is comprised of first and second lien senior secured loans as well as mezzanine debt, diversified by industry and sector. The company was founded in 2004 and has a market capitalization of ~$9 billion.
Source: Investor Presentation
ARCC reported its Q2 results on July 28th. Core earnings-per-share rose 36% year-over-year, to $0.53. Net investment income rose 3.6% to $171 million, but was flat on a per-share basis. Net asset value rose 7% to $18.16 for the quarter.
The fair value of ARCC’s portfolio investments was $17.1 billion at the end of the second quarter.
Ares Capital is arguably the safest BDC given that its balance sheet is in a very strong position with solid and stable asset quality and a diversified long-duration liability structure. It also has very diversified holdings with strong interest coverage, which reduces default risk. Its competitive advantage comes from its superior size and scale as one of the largest BDCs. Shares have an attractive dividend yield of 7.8%.
Final Thoughts
Business Development Companies allow everyday retail investors the opportunity to invest indirectly in small and mid-size businesses. Previously, investment in early-stage or developing companies was restricted to accredited investors, through venture capital.
And, BDCs have obvious appeal for income investors. BDCs widely have high dividend yields above 5%, and many BDCs pay dividends every month instead of the more typical quarterly payment schedule.
Of course, investors should consider all of the unique characteristics, including but not limited to the tax implications of BDCs. Investors should also be aware of the risk factors associated with investing in BDCs, such as the use of leverage, interest rate risk, and default risk.
If investors understand the various implications and make the decision to invest in BDCs, the four individual stocks on this list could provide attractive total returns and dividends over the next several years.