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Business development companies (BDCs) have been spotlighted in the news lately, including a Barron’s report forecasting “6 BDCs that Could Issue More Stock This Year.” It seems the financial media are rallying around BDCs to tell others what many of us already knew: BDCs are a great investment.
In a 2015 blog post, No News is Good News? Why Not Seeing BDC Headlines is a Good Sign, I wrote that potential investors shouldn’t be put off from the BDC sector simply because you don’t hear much about this particular investment landscape in the news. As I said back then, the good news about BDCs is that they don’t typically make for “sexy” headlines because they are doing everything just as they are supposed to, without much volatility.
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The Barron’s story that I mentioned certainly doesn’t qualify as splashy, but it does indicate the positive news that’s consistently coming out of the sector and the benefits of looking at BDCs from an investment perspective.
Why BDCs make sense for smart investors.
For an explanation of what BDCs are, see my primer on Quora. To summarize, BDCs are publicly registered companies that provide financing to small and mid-sized businesses. The rise of BDCs as of late points to their growing value in the world of investment and alternative lending. As banks consolidate and grow larger, BDCs are becoming more ideal for middle-market borrowers. Their associated high distribution yields relative to more traditional fixed income investments make them a smart portfolio addition. As of today, the average market yield on BDCs is over 9 percent.
As closed-end investment companies, BDCs invest in small to mid-sized businesses across the United States. BDCs are quite similar to venture capital funds. Some have called them a hybrid between a traditional investment company and an operating company where shareholders’ money is invested to generate investment income and turn a profit.
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Unlike venture capital funds, however, BDCs are open to the public. Translation: Non-accredited investors can purchase shares in the open market and pool their money toward investments in private companies and startups. And because of the detailed financial statement disclosures, investors can see exactly what companies BDCs are invested in.
Most BDCs have regulated investment company (RIC) status, which means they must distribute at least 90 percent of their taxable income to shareholders every year. BDCs declare regular recurring dividends to their investors, with yields beating most asset classes returns.
What to look for when buying shares in a BDC.
As mentioned earlier, BDCs are registered investment corporations and, therefore, are required to pay out 90 percent of their earnings every year. What does that mean, you ask? Well, when you look at stock price over a period of time, it doesn’t typically tell the whole story of what the total return has been because it doesn’t capture all the dividends that have been paid. Take Saratoga Investment Corporation’s stock as an example. There’s almost no comparison between Yahoo Finance’s stock chart summary and a total return graphic. But when you go looking for a company’s total return data, you’ll likely come up with no answers (as Yahoo Finance certainly isn’t providing it).
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The key to analyzing a BDC is total return. To get to the total return, you have to get your hands dirty and take some additional steps. This means researching bank deposit rates, 10-year treasury maturity rate, high-yield bond rates, and investment-grade corporate rates. You want to get an idea of what your money would have looked like if you owned their stock in the last six years, on top of what the current yield is. It’s estimated that loans held by the larger BDCs have an average 11 percent yield-to-maturity, according to Bloomberg.
Remember: With a BDC, you’re not just investing in the stock, but everything that lies below its surface. The returns can be a welcome addition to your investment portfolio.
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