Table of Contents
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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:
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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.
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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.
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AUM growth vs. revenue/profit growth: Compare the growth rate of assets under management with the growth in revenue or profits. Disproportionately high AUM growth without similar increases in revenue or profits may indicate empire building.
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Capital Allocation Decisions: Assess the company’s history of acquisitions and investments. Frequent, large-scale investments, especially those outside the company’s core competencies, might be a sign of empire building.
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Management compensation structure: Look into how management is compensated. If their compensation is heavily tied to the size of assets under management rather than performance metrics like ROI or shareholder value, this might encourage empire building.
2. Leverage Caution: Opt for BDCs with responsible use of leverage, as over-leveraged companies can suffer significantly during economic downturns. A debt-to-equity ratio of around 1:1 is typical for BDCs due to regulatory limitations. However, some may operate with slightly higher ratios. A ratio significantly higher than 1:1 could indicate higher risk.
3. Specialization Advantage: Prefer BDCs with clear industry specialization or specific competitive advantages.
To objectively measure the specialization advantage in BDCs, consider the following:
- Industry focus: Review the company’s portfolio to see if it concentrates on specific industries or sectors. A narrow focus could indicate specialization.
- Management expertise: Examine the backgrounds and track records of the management team. Specialization is often reflected in a management team with extensive experience in particular industries.
- Portfolio performance in core areas: Analyze the performance of investments within their specialty area compared to their broader portfolio. Superior performance in the focused area can be a sign of a specialization advantage.
- Market position: Look for evidence of a strong market position or unique competitive advantages within their chosen niche.
Key Metrics for BDC Analysis
1. Portfolio Yield: Assess the risk profile of a BDC’s loan portfolio. A lower portfolio yield suggests a more conservative approach, indicating loans are more senior and secure.
When evaluating the portfolio yield of a BDC, there isn’t a strict “ideal” yield to look for, as it can vary based on market conditions and the specific risk profile of the BDC. However, some general guidelines can be:
- Compare with industry average: Look at the average yield for the BDC sector and compare the specific BDC’s yield against this benchmark.
- Risk assessment: Higher yields often indicate higher risk. If a BDC’s yield is significantly higher than the industry average, it might be taking on riskier loans.
- Sustainability: Ensure that the yield is sustainable given the BDC’s financial health and market conditions.
A balanced approach, considering both the attractiveness of the yield and the associated risk level, is key.
2. NAV/Share Trend: Track the Net Asset Value (NAV) per share over time to gauge management’s ability to create long-term shareholder value.
To objectively measure the “NAV/Share Trend” of a Business Development Company, you should:
- Historical analysis: Look at the historical NAV/share data over several years. A consistent upward trend indicates good management and investment decisions.
- Comparison with peers: Compare the NAV/share growth of the BDC with its peers. This helps in understanding if the BDC is performing above or below the industry average.
- Correlation with stock price: Sometimes, the NAV/share and stock price may not correlate. Understanding why this is the case can provide insights into investor sentiment and the intrinsic value of the BDC.
3. Non-Accruing Loan Ratio: Monitor the proportion of non-performing loans, as a high ratio can signal underlying credit market issues.
To objectively measure the “Non-Accruing Loan Ratio” for BDCs:
- Calculate the ratio: Divide the value of non-accruing loans (those not currently generating interest income due to delay or default) by the total loan portfolio.
- Industry Benchmark Comparison: Compare the BDC’s ratio with industry averages. A higher ratio than peers can be a red flag.
- Thresholds: While there’s no strict cut-off, a non-accruing loan ratio significantly above industry norms or a sharp increase over time should be cause for concern.
- Trend Analysis: Look at the trend over several quarters or years to assess if the ratio is improving or worsening.
4. Net Investment Income (NII) Payout Ratio: Ensure the dividend payout ratio is sustainable, ideally below 100%.
To objectively measure the “Net Investment Income (NII) Payout Ratio” for a BDC:
- Calculate the Ratio: Divide the total dividends paid by the net investment income (NII). NII is essentially the income generated from investments minus the expenses.
- Cutoff Value: While there is no fixed cutoff, a sustainable payout ratio is typically below 100%. Ratios above 100% may indicate that the dividends are being paid out of capital rather than income, which can be unsustainable in the long term.
- Trend Analysis: Examine the trend over several quarters to see if the payout ratio is stable, increasing, or decreasing. A consistently increasing ratio can be a warning sign.
Risks and Tax Considerations
While BDCs offer high yields, they come with significant risks, such as exposure to subprime borrowers and cyclical economic impacts. They are generally not suitable for low-risk investors seeking steadily rising dividends. For tax efficiency, holding BDCs in tax-sheltered or deferred accounts like IRAs and 401Ks can be beneficial, as they generate no unrelated business taxable income.
Top BDC Investment Ideas for 2023
1. Prospect Capital Corporation (PSEC): It is known for its diverse middle-market focus and consistent dividend payouts, and is focused on providing debt and equity financing to various middle-market companies across various industries. It offers different types of debt financing, including senior secured loans, subordinated debt, and mezzanine financing. Known for its attractive dividend policy, Prospect Capital Corporation has been paying regular monthly dividends to shareholders for over 70 consecutive months. As of November 2023, PSEC announced a monthly dividend of $0.06 per share, leading to an annual dividend of $0.72. The forward dividend yield for PSEC stands at 12.39%
2. Trinity Capital Inc. (TRIN): It is a business development company that provides debt and equity financing to growth-stage companies in various industries. It primarily serves as a capital source for smaller and middle-market businesses. Trinity Capital has demonstrated a strong track record of dividend growth, making it an attractive choice for dividend investors. The company’s forward dividend yield stands at 14.61% as of 2023.
3. Gladstone Capital Corporation (GLAD): It is an American business development company offering financial solutions to lower-middle market companies. Along with debt financing, it also makes equity investments in the companies it supports. It has shown a commitment to dividend growth, with several increases in its monthly dividend, demonstrating its stability and reliability as an income-generating investment. As of 2023, the company announced a monthly cash dividend of $0.083 per share. The forward annual dividend rate for GLAD is $0.99, with a forward annual dividend yield of 9.88%
4. Capital Southwest Corporation (CSWC): This is a Dallas-based internally managed BDC, that specializes in providing flexible financing solutions to support the acquisition and growth of middle-market businesses. The company announced a cash dividend of $0.63 per share for the quarter ending December 31, 2023. The forward annual dividend rate for CSWC is $2.52, with a forward annual dividend yield of 11.21%.
5. Goldman Sachs BDC, Inc. (GSBD): It offers tailored debt structures to middle-market businesses with a robust dividend yield. It specializes in first lien-centric debt investment, with 91% of its portfolio in highly-rated first liens as of Q3 2023. Despite a challenging credit environment, the company reported robust gross originations of $168.2 million in the third quarter. However, there was an increase in the non-accrual ratio, signaling heightened credit risk. The company demonstrated strong dividend coverage with $0.67 per share in investment income and a quarterly dividend payout of $0.45 per share. The forward dividend yield for the company stands at 12.10% as of 2023
Conclusion
BDCs represent a high-yield, high-risk investment avenue within the income investing spectrum. Thorough due diligence, focusing on the management quality, financial health, and sustainability of dividends, is paramount for successful BDC investing. While they offer attractive yields, investors must be cognizant of the risks and integrate BDCs as part of a diversified income-generating portfolio.