Why Income Investors Should Consider Business Development Companies

by: Alan Brochstein, CFA

With the historically low bond rates persisting now for the past few years, it's not surprising that many investors (rightly, in my view) have looked to the equity market for alternatives. I have written over the past couple of years about three of the more popular sectors: REITs, Utilities and Dividend Growth stocks. Another popular area that I haven't addressed is MLPs.

All of these areas have performed reasonably well, especially in 2011. The SPDR Utility Index (NYSEARCA:XLU), which represents all of the utilities in the S&P 500, has increased in price by almost 12% this year. The iShares Dow Jones Real Estate Index Fund (NYSEARCA:IYR), has retreated of late after a very strong 2010, but is still up marginally ahead of the S&P 500. The JPM Alerian MLP Fund (NYSEARCA:AMJ) is up almost 4%. The S&P 500 Dividend Aristocrats (Large-Caps that have hiked their dividend for at least each of the past 25 years) are up 2.6% in price so far this year.

So, clearly the focus on yield is helping the equity prices of many higher dividend paying segments of the market, but there is one area that has not fared well: Business Development Companies (BDCs). Before I go on, I need to point out that I am not particularly knowledgeable about these companies, but I do believe that I have a reasonably good understanding of the big picture here.

BDCs have been around for 30 years. In exchange for following several rules, these lenders are able to operate with favorable taxation (like REITs and MLPs to some degree). Specifically, they are limited in their leverage (Assets must be at least twice as high as debt, which effectively means Debt to Capital will be less than 50%). They also have to distribute 90% or more of their income. At least 70% of their investments must be in eligible securities. There are several regulatory authorities governing BDCs. So, in a nutshell, these are closed end funds making investments in or lending to small and middle-market businesses, employing limited financial leverage and paying out the bulk of their income to investors.

Before I go on, here are 15 BDCs that I have identified with market caps above $150mm (I may have omitted some):

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The total market cap of the entire list is about $13 billion, smaller than a single typical Utility in the S&P 500. I included the net debt to capital - clearly, they are all relatively low leverage for Financials. Several have no net debt, and other are fairly overcapitalized. More on this later.

As I suggested, these income-producers have suffered capital losses. Most of the stocks have declined, with only non-dividend paying American Capital (NASDAQ:ACAS) not losing value. I included the price to tangible book value - typically they trade near TBV, which makes sense. The dividend yields are typically 11%. Not surprisingly, payout ratios are high, with some apparently returning capital. Several of the companies have been boosting dividends for the past few years.

I don't intend to dive too deeply today into specific names. Fellow Seeking Alpha contributor Nicholas Marshi is an excellent resource, and he has profiled many of these companies. Instead, I wanted to share some initial observations.

Many are turned off by Financials these days. Once again, the sector is the worst in the S&P 500 in 2011 (-17% roughly). Unlike banks, though, the BDCs operate with lower leverage and more transparency and most likely are more nimble and focused due to their size. I can't prove that last point, but as far as transparency, the BDCs list each and every investment in their SEC filings, allowing investors to understand exactly what the underlying exposures are. This is great, unless you are like me and aren't a credit expert! Still, it gives everyone a flavor and more informed investors clarity.

Another issue that BDCs are forced to raise capital to grow since they pay out earnings as dividends. This serves to keep the tangible book value close to one. I can't envision an environment where the sector would command much of a premium on that front. The good news, for now, is that many of these guys are undercapitalized, meaning that they can make additional investments and perhaps boost the dividends subsequently.

A final observation is that many of these companies aren't very well known. None are in the S&P 500, and only a few are in other Standard & Poors indices. While several have a surprisingly large number of analysts (the far right column), several have few or even none. Despite all the focus on yield these days, this group seems somewhat obscure, which is a good thing for those looking for a potentially good deal.

One column that's not included (because it's not yet done!) is perhaps the most important one as far as I am concerned: Insider ownership. When investing in these types of investment funds, there are many things we need to understand better and to potentially avoid, such as embedded conflicts of interest (which exist here!) and structual or credit risks. One way to mitigate these risks is to see how much skin-in-the-game management has. I haven't completed this exercise, but I intend to do so and may post the results in a subsequent article. Please comment or message me if this would be of interest. I am impressed with CEO holdings of Hercules Technology (NASDAQ:HTGC) and Solar Capital (NASDAQ:SLRC).

So, in conclusion, BDCs may be a neglected potential source of income for yield-hungry investors. The amount of diligence required to pick a specific name might be high, but the ones I have looked at tend to be highly diversified. While Financials have inherent risks, the limited leverage mitigates some of the concern.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.