Introduction: The Allure of BDCs
In recent years, Business Development Companies ((BDCs)) have garnered significant attention from income investors, particularly those seeking high yields. Originating from the Small Business Incentive Act of 1980, BDCs are Regulated Investment Companies (RICs) that offer debt and equity financing to middle-market companies in the United States. They operate under a structure similar to Real Estate Investment Trusts (REITs), where they avoid paying corporate taxes by distributing at least 90% of taxable income as dividends. This unique structure increases yields, making BDCs attractive to dividend investors.
Understanding the BDC Landscape
BDCs vary in their industry specialization and loan types. For instance, Hercules Technology Growth Capital (private) focuses on technology companies, while PennantPark Floating Rate Capital (PFLT) deals in floating-rate loans. It’s crucial to distinguish between internally and externally managed BDCs. Internally managed BDCs like Main Street Capital (MAIN) generally have lower costs and better-aligned compensation incentives with shareholders. In contrast, externally managed BDCs often have higher cost structures and potential conflicts of interest, as their management is provided by an external financial company and is compensated based on assets under management (AUM).
Screening for Quality BDC Investments
When evaluating BDCs, consider the following criteria:
1. Avoid “Empire Building”: Be wary of BDCs that aggressively raise capital, leading to shareholder dilution and reduced cash flow per share. This can be checked objectively as follows:
Share count increase: A consistent increase in the number of shares outstanding can indicate dilution, which often happens when a company is aggressively raising capital without corresponding growth in shareholder value.
Debt-to-Equity ratio: A rising debt-to-equity ratio may suggest that the company is leveraging excessively to fund its growth, which can be a form of empire building.
AUM growth vs. revenue/profit growth: Compare the growth