Looking For High Yield In Out-Of-The-Way Places: Business Development Companies

Includes: ARCC, PSEC, TCAP
by: Marc Gerstein

OK. You're among friends, so just admit it. When the Fed loosens, traders, economists and talking heads whoop with delight, but that's not what you do. You cringe and mutter all sorts of nasty things that would never get past the Seeking Alpha editors. You could care less about all the economic gobbledygook that tells us how low interest rates are supposed to boost the economy (as if!). You want rates to rise because you are sick and tired of being told to stop whining about being saddled portfolio income that's within hailing distance of zero and about being told you have to grow the #$%& up and buy stocks for capital appreciation, and if you insist on being a crybaby, then at least go for dividend growth.

Straight Talk about Yield

Let's get real here. Yield is important. It's very important. And this isn't just for weenies that are afraid to invest for growth.

It's unfortunate that academicians never came up with a concept like "duration" for the equity market because it's badly needed. Duration is standard fare in fixed income (and you really, really, really need to be looking at this if you are still investing in bonds or fixed-income mutual funds). Without getting technical, it's a measure of how quickly you get your money back through the combination of maturity repayment, income receipts, and returns you earn from reinvesting cash as it comes back to you (e.g., interest on interest). That last thing, interest-on-interest, is very important. If you buy a zero-yielding investment, how much can you boost your total return by investing money you get while you still own the security? Answer: Zero! If you own a conventional bond, how much can you boost your total return by investing money you get while you still own the security? The answer will vary depending on the coupon and maturity, but assuming it's not a "zero coupon bond," the answer will definitely be a positive number, and if the coupon is high enough, it could amount to a lot - enough to justify paying more than the maturity value for the bond (buying at a premium) and allowing interest plus interest on interest to more than overwhelm the capital loss you lock in by paying more than you can get at maturity. This can be especially crucial if you think interest rates might rise; many securities will drop in price, but if you manage duration right, rising streams of interest on interest can at least partially bail you out.

Unfortunately for fixed-income investors, many premium-priced high-coupon bonds have matured or been called. That's their problem. Equity investors have a different concern. Duration doesn't exist in stock analysis because equities don't have maturity dates. But interest on interest can and does exist even for equities (and will become more important here, too, if rates rise) and is something you can cite if you're at a party with a bunch of investment snobs and might feel embarrassed to say you want dividend income so you can spend it. So don't let the far-cooler concept of "total return" blind you to the fact that income is important, not just in an emotional sense or as a behavioral-finance thing (something easy to cite because it always seems to mean whatever someone wants it to mean), but even in terms of plain-vanilla quantitative financial doctrine.

But what should we do about the risks? Are the gurus off base when they warn us away from high-yield because of the risk of dividend reduction or elimination or the market's potential frustration with poor dividend growth potential? No. They are absolutely right. The concerns are real. The part that's wrong is the often subtle and sometimes blatant suggestion that the existence of these risks should automatically compel you to scream and run away. In truth, it's perfectly OK to pursue yield (I was going to say "chase" yield, which is what we REALLY want to do, but didn't because the word "chase" sounds so - well, you know) as long as you are willing to work for you money. Don't run from risk. Analyze it! (Pause to process feeling of disappointment because I know you were hoping for a free lunch; i.e. no need to analyze - sorry about that. But analysis is do-able.)

That's what I've been trying to do, as discussed in some past Seeking Alpha articles. I have to confess that I still have work to do at the higher end of the yield spectrum. But I have been making some progress in the mid-range with yields that are conspicuously higher than what dividend investors are typically told they ought to accept but not so high as to be overwhelmed by the bad stuff. A portfolio known as Equity Income - Aggressive, which I created for the new Portfolio123.com Ready-2-Go offering, holds 10 stocks and has an average yield of about 6%. In a 10-year point-in-time back-test (i.e. companies that existed in the past but are now gone are included in the test up until the time they vanished, and data-points aren't used as of the period they cover but as of the later times when they becomes available to the investment community), average annual total return was around 20%, indicating that notwithstanding the risks, the model was able to produce decent capital gains which, although not sought, won't be rejected if they continue to come. Details, as well as the tracking of live out-of-sample performance, can be done on the model's home page.

Potential Sources of Yield - Business Development Companies

In looking at the stocks, now and at various times in the past, I noticed the conspicuous presence of what is known as business development companies (NYSEARCA:BDCS). This area became a big conversation piece during the 2012 presidential election thanks to Mitt Romney and Bain Capital. That - making equity investments in privately-owned firms and sometimes owning them outright, sometimes through public-market takeovers - is part of the package. (Bain is not on my list: It's a privately-held firm.) Another involves making loans that fit in between bank loans (made to the largest and most creditworthy customers - cough, cough) and the public markets (i.e. junk bonds).

The first temptation among many equity-income investors is to tune out when it comes to BDCs because they aren't "real" businesses, so to speak, and presumably can't be analyzed using all the techniques you learned in the how-to books crowding your shelves or e-reader drives. I get it. That's a fair point. Indeed, strictly speaking, some of these entities, including all three discussed below, are typically closed-end funds that chose to register and operate under rules that apply to business development companies, especially noteworthy for us is the fact that BDCs are required to pay out substantially all income, as defined in the regulations, to the shareholders as dividends. Such income is not taxed at the corporate level but shareholders pay income taxes on the distributions.

But don't get the idea BDCs should be treated just like all other closed-end funds. The latter typically invest in and regularly trade publicly-traded securities, just like the typical open-end fund. There is logic to the BDC classification. These outfits, for all practical purposes, really are business corporations that happen to be in the business of making longer-term debt investments (sometimes with equity kickers) in privately-owned companies with the idea of active involvement with management and holding to maturity. You can almost picture BDCs as commercial banks that gather funds from the capital markets rather than depositors and which take credit analysis and monitoring much more seriously.

But there's another angle you might not have considered - seeing BDCs as alternative to junk bonds or junk-bond (or in respectable parlance, "high yield") mutual funds or ETFs. I'm serious. I used to manage a junk bond fund and I'll tell you straight out that the situations in which BDCs invest often resemble those you'll find in the portfolios of junk bond funds. To the extent there are differences, I believe they work in favor of the BDCs. Personnel at the latter are able to do much more intensive analysis than junk-bond managers, who have to operate within the constraints of what can is disclosed publicly (junk-bond road shows are pathetic relative to the up-close under-the-hood investigation associated with a privately-negotiated loan). Not only do BDCs have the staff (huge in-house teams that dwarf the puny analytic resources available to the typical junk-bond fund manager), expertise and legal right (by virtue of the deals being privately negotiated) to analyze more closely when forming a deal, they can monitor more closely while their investments are live. Since the "securities" they own aren't public, insider rules are irrelevant. In fact, BDC representatives often attend board meetings and sometimes, they serve as a board members.

Also, BDCs are far better able to negotiate terms they deem reasonable, as opposed to the typical junk bond manger who's negotiation repertoire consists pretty much of "Yes sir, whatever you're offering sir." Actually, I'm being kind. I remember back form my fund-manager days a situation where a Wall Street firm was pitching a dog of a company based on a great covenant which the bankers persuaded management to accept in order to better protect bondholders. My reaction: "@$&# that. You know damned well that as soon as the company wants, they'll offer to add a few pennies to the coupon and watch as the bondholders salivate and trip over each other racing to kill the covenant." The salesman couldn't argue because his firm had already helped some other debtor-companies emasculate similar covenants.

And suppose something goes wrong, which, actually, is pretty-much inevitable. BDCs are far better able to negotiate restructurings than are public bondholders, and sometimes, BDC representatives can play active roles in the operational matters. As to bondholders, I long ago concluded that one should not put stock in textbook pabulum to the effect that equity holders rank last when it comes to dealing with a company in default. Members of management typically hold equity and you can be darn sure they and the consultants they engage will be quite proficient in finding ways to put the interests of the equity holders ahead of those of negotiation-challenged public bondholders. I've seen way too much of that. Give me a hard-boiled BDC that knows how to use negotiating leverage.

So, knowing what I know about the junk bond portfolios and how that stuff gets there, if I'm looking for income to the point where I'd have to consider junk-bond funds, I'll give high-yielding BDCs some serious thought.

Below are discussions of the three BDCs that appear presently in my Equity Income - Aggressive portfolio. All have portfolios that are well diversified across different industries and investment types (various forms of debt - many ranking as senior in the capital structures of the borrowers and many coming with security interests against assets owned by the borrowers - and some investments including various forms of equity participation).

Ares Capital Corp. (NASDAQ:ARCC)

Among the three BDCs covered here, ARCC is the largest in terms of assets as well as the potential size on an investment it is willing to make - up to $400 million. The top 15 investments outstanding comprise about 54% of ARCC's portfolio, and about 80% of the portfolio consists of various forms of senior secured debt obligations. As of 12/31/12, it had investments in 152 companies and had board seats or observation rights in about 50% of them.

As with pretty-much the entire financial sector, ARCC's portfolio felt the impact of the late-2000s economic crisis. In 2008, the percentage of investments on non-accrual status amounted to 4.4%. And as with many lenders, ARCC has made considerable progress in cleaning up its balance sheet. The percent of non-accrual loans as of 12/31/12 was down to 2.3%.

The company's target debt-to-equity ratio is 0.65-0.75 (regulations permit it to go up to 1.1). At present, it's at 0.55, below the bottom end of the target range.

Dividends rose briskly before the financial crisis but, obviously dropped (from $1.86 in 2008 to $1.47 in 2009 to $1.40 in 2010) in the wake of those events. But after a trivial uptick in 2011 (to $1.41), a noticeable recovery ensued in 2012, when the payout was $1.60 per share.

ARCC stock presently yields 8.28%, well above what we see for some well-known junk-bond ETFs; 6.6% for iShares iBoxx high Yield (NYSEARCA:HYG) and 6.7% for SPDR Barclays High Yield (NYSEARCA:JNK). ARCC's price dropped more steeply during the 2008-09 crisis, but interestingly, its distributions held up better over the longer term. ARCC's 2012 distribution was above the 2009 level and 14% below the 2008 peak. At the junk-bond ETFs, distributions have been slipping steadily with the 2012 payment being for JNK being 41% below the 2009 level and 26% lower for HYG.

Prospect Capital Corp. (NASDAQ:PSEC)

PSEC is the largest of the three BDCs discussed here (in terms of market capitalization) and the one with the highest yield (11.9% based on a distribution policy that was switched from quarterly to monthly effective mid-2010). Like ARCC, it focuses on middle market private firms which PSEC defines in terms of annual revenues being less than $500 million.

On paper, you might suspect that PSEC's portfolio could be less risky than that of ARCC: PSEC tends to keep its stakes smaller, with amounts invested ranging from $5 million to $75 million. But that isn't the way it turned out. Even though PSEC didn't go as far out on the limb as did ARCC in terms of the size of a potential investment, it did seem to slip more often. As of 6/30/09, its non-accrual loans shot up to 7.3% of assets from 0.8% a year earlier. The good news is that PSEC was very modestly leveraged going into the crisis: the debt-to-capital ratio was only 0.21. It's higher now, at 0.48. But even this figure is below those of the other BDCs being considered here. Another item of good news: PSEC has been successful in working its portfolio back into shape; the non-accrual percentage was 2.9% at 6/30/12 and 1.7% at 12/31/12.

This outfit's annual payout, which started to nudge up gently from its recent trough, is 23% below the 2009 level (compared with 41% for JNK and 26% for HYG). PSEC's substantially higher yield potentially indicates a point of inefficiency in the market.

Triangle Capital Corp. (NYSE:TCAP)

TCAP is the new kid on the block having come public in 2007. It's also the smallest, with a market cap of about $815 million (compared with $3.6 billion for PSEC and $1.6 billion for ARCC). It also aims small in terms of the investments it looks to make, ranging in size from $5 million to $30 million and in terms of its focus on companies with revenues ranging from $20 million to $200 million and EBITDA ranging from $3 to $25 million. Management maintains that the smallish subset of the middle market that it targets contains more than 65,000 companies 90% of which are privately held.

Although the smallest of the BDCs being discussed here, TCAP seems to rank on top in terms of loan performance. Non-accruals as a percent of assets was just 3.5% in 2009, much lower than what we saw for ARCC and PSEC. As of 11/30/12, this percentage was down to 2.1%.

The market seems to be willing to credit TCAP with the loan quality it appears to have delivered relative to the others. Its yield, 7.1%, while still better than what we see for the aforementioned junk-bond ETFs, is below those of ARCC and PSEC. But the cynic in me can't help but wonder how much we can assume going forward: Had TCAP been around a few years earlier, might it have had more time to have flexed some aggressiveness and to have found its way by 2008 into a greater number of lesser credits? We can't really know the answer, but here's something we do know: TCAP is more aggressive in terms of its willingness to use debt. Its present total debt to equity ratio is 0.87, which is perfectly OK for a BDC, but demonstrative of a willingness to be a bit bolder relative to its bigger peers. Some might infer that such boldness might translate to more aggressive lending and a higher non-accrual rate the next time the economy turns south. But this is not fact: It's pure speculation on my part. And for what it's worth, Mr. Market is not thinking this way at all, as evidenced by the low (relative to the other two BDCs) yield.


These high-yielding BDCs seem to constitute a neglected corner of the equity market, one that does not fit cleanly into any established category. They are like banks in that they lend to businesses, but they differ in that they are more intensively relationship- and analytically-oriented. They are like funds in that they represent stakes in lots of other companies, but they differ in that they eschew trading in the public securities markets and the protocols relating to Regulation FD, 10-Qs, 10-Ks, quarterly conference calls, publicly issued guidance, etc. and instead act like and sometimes even become business insiders.

I make the junk-bond fund comparison because when I look at the portfolios, I tend to notice the same kinds of companies - I'm not sure how many investors realize this but junk-bond funds don't just invest in the high-profile LBO deals; the meat-and-potatoes of that market often consists of "original-issue junk," bonds issue by companies you never heard of whose equity is all or almost all privately held and for which the junk bonds constitute the only thing that pulls them into the public-market regulatory scheme. And for reasons discussed above, I think any of these three BDCs are preferable to junk-bond funds for those who really need or want high yields.

Disclosure: I am long ARCC, PSEC, TCAP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.