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We thought readers might find interesting our Top Ten Reasons to invest in the relatively unknown world of Business Development Companies (BDC).

1. Required To Pay Regular Dividend Pay-outs

BDCs are required by the Investment Act of 1940 to distribute a minimum of 90% of their taxable earnings quarterly to maintain their one-level tax paying status. In practice, most BDCs pay out to their shareholders 98% of taxable income and all short term capital gains, and some pay out to shareholders all long term capital gains received from the sale of equity interests in portfolio companies. Many BDCs even pay-out their dividends monthly.

2. Dividend Pay-Outs Are Stable During Economic Expansions

BDC dividend levels tend to be highly stable, changing little from quarter to quarter, when economic conditions are favorable. One of the main reasons for this is the fact that the bulk of the industry’s investments are in debt securities. These consist of either senior secured, second lien secured, or unsecured subordinated, all of which are paid by borrowers monthly or quarterly. (Only a handful of BDCs rely on less-predictable equity investments for the bulk of their annual income).

We have reviewed the history of all the 21* BDC companies in our prospective pool of investments during the economic expansion of 2003-2007 and have determined that only two BDCs reduced their dividend from one quarter to the next over that period, and none had to eliminate its dividend altogether . (* Includes Compass Diversified, a Grantor Trust).

3.Most BDCs Continued To Pay Dividends During The Economic Downturn

Since the onset of the current recession (usually pegged to have begun in December 2007) BDCs have faced the worst economic conditions in a generation. Besides confronting defaults from financially stressed portfolio investments, many lenders to the BDC industry have withdrawn from the market or hiked borrowing rates, causing numerous BDCs to de-leverage. Nonetheless, more than three-quarters of the BDCs we track have continued to make dividend payments during this economic crisis. At year-end 2009, 6 of the 21 tracked companies had not undertaken any dividend cut (CODI, TICC, TCAP, PSEC, MAIN and TAXI) ;11 other BDCs have reduced their pay-outs and only 4 have suspended any distribution. For what it's worth we're encouraged that no BDC has yet filed for Chapter 11 (by contrast with other financial institutions during this crisis such as investment banks, banks, mortgage companies and Real Estate Investment Trusts).

4. BDCs Have A Diversified Asset Base

BDCs, both due to governmental requirement and as a sound business practice, seek to build diversified portfolios of investments where no single investment accounts for more than 25% of total holdings. Most BDCs have dozens of different investments on their books, spread over numerous industries. The typical BDC has over 50 different loans or investments in portfolio in over 20 different industries. We estimate that at December 31, 2009, the 21 BDCs we track have investments in over 1,100 different companies in every region of the country.

5. BDCs Have Low Leverage

By law, BDCs are required to maintain low leverage, with total debt outstanding not allowed to exceed equity. This amounts to 1:1 maximum leverage. In fact, most BDCs do not even reach the maximum allowable leverage. ( By comparison, most banks have leverage of 10:1 or more, and investment banks leverage can exceed 30:1). The ongoing recession has caused BDCs to de-leverage further, as the cost of debt capital has risen, which will result in further drops in the industry’s leverage ratios.

6. Many BDCs Have Capital Available For Growth

Notwithstanding the de-leveraging pressures which some BDCs face, half the BDCs we track have capital available to take advantage of the next economic expansion and the related need for capital. The capital comes from a variety of sources. Many of the BDCs have tapped SBIC (Small Business Investment Corporation) monies funded by the U.S. Government. For every dollar invested by the BDC the U.S. Government makes available two dollars of long term debt (10 years at a fixed rate) under the SBIC program. Half the BDCs have applied or are planning to apply for SBIC monies, which can reach $225 million per company. BDCs which successfully tackled de-leveraging their balance sheets early in the recession have been able to raise additional equity and additional debt facilities. A few BDCs have capital left over from selling investments during the economic expansion. Moreover, BDCs will be receiving repayments-both scheduled and unscheduled- which can be redeployed at higher margins than in the past, which should boost earnings in the medium term.

7. Many BDCs Are Developing New Sources Of Income

Many BDC companies are finding new sources of income. Both long standing BDCs and some newly public companies are setting up asset management subsidiaries. The goal is to use the BDCs expertise in middle market buy-outs by investing third parties capital and receive a stream of fee income. Other BDCs have set up Small Business Investment Companies (“SBIC”) subsidiaries, which provide capital for small private companies. One company-Medallion Financial Corp has set up a bank as part of an income diversification strategy. More recently more than a third of all BDCs have taken to buying back their debt and stock at a substantial discount to improve earnings results.

8. The BDC Industry Is Growing And Attracting More Investor Interest

The BDC market is in the early stages of growth, although the regulation which created the sector was passed in 1980. Until 8 years ago, there were only 4 major public BDCs listed on the U.S. exchanges. Today, there are over 23 major participants, ranging in asset size at FMV from $ 50 million to over $6,800 million. The total market capitalization of the industry is over $7 billion. [We don't track BDCs which do not pay regular dividends].

We believe there are parallels between the BDC sector and Real Estate Investment Trusts (“REITs), which has become a highly successful asset class. Like BDCs, REITs are single level tax paying entities that invest in real estate assets. The REIT sector began in 1960, but did not attract many players or capital until the mid-1970’s. In 1968, there were only 10 public REITs and aggregate assets under management of only $1bn. By 1975, however, REIT assets had mushroomed to $25bn, as multiple new companies joined the market. As of 2009, there were nearly 200 REITs in the U.S., with a market capitalization over $400 billion. Furthermore, the REIT structure has been adopted in Europe and the Far East with considerable success. Pension funds, insurance companies and other institutional investors who were initially wary of investing in publicly listed real estate companies have become the largest single source of capital and transformed the sector into an established and well respected asset class. We expect the market capitalization and the number of participants in the BDC sector to increase substantially in the years ahead as the equity and capital markets become more familiar with the BDC format.

9. Many BDCS are sponsored by top tier asset management organizations

Many of the Business Development Companies which we follow, and which the Fund will invest in, are amongst the most experienced and successful participants in the private equity market for acquisitions. Well known asset managers who are sponsoring BDCs include Ares Capital Corporation, which is managed by an affiliate of Ares Management LLC (“Ares”), an independent Los Angeles, New York and London based firm that controls investment funds with over $10 billion of committed capital. Apollo Investment Corporation (NASDAQ:AINV) is managed by Apollo Investment Management, an affiliate of Apollo Management (“Apollo”). Founded in 1990, Apollo is a leader in private equity and debt financing. The firm has invested more than $13 billion in over 150 companies since it’s founding. NGP Capital Resources (NASDAQ:NGPC), a BDC that specializes in the energy sector, is a subsidiary of NGP Energy Capital Management, which owns a $3.65 billion family of funds. A newer BDC is BlackRock Kelso (NASDAQ:BKCC), which is affiliated with BlackRock Inc., one of the world’s largest publicly traded investment management firms, with assets under management in excess of $1.1 trillion. We believe the experience; management depth and reputation of many BDC managers will be reflected in the performance of the companies over time.

10. BDC financial reporting is detailed and transparent.

Unlike private equity funds, BDCs provide generous amounts of information about their financial results, acquisitions and dispositions, investment portfolios and business strategies. Moreover, BDCs re-value their portfolios every quarter, usually with the oversight of an independent valuation firm. Quarterly, management reviews the financial performance of the Company on conference calls with investors and analysts. Furthermore, the BDCs provide detailed information about non-performing and distressed assets on a quarterly basis.

Disclosure: Long ACAS, AINV, ARCC, BKCC, FSC, HTGC, GNV, KED, MAIN, TAXI, NGPC, PNNT, PSEC, TCAP, CODI. No position: ALD, GLAD, GAIN, KCAP, MCGC, TICC.

Source: Top 10 Reasons to Invest in Business Development Companies