I recently suggested that business development companies merit further investigation for income-oriented investors. Given the complexity of some of the management structures, as well as the risky nature of the underlying investments made, investors interested in this niche should pay careful attention to the alignment of interests between management and shareholders.
I had indicated that I would follow up with a review of this dynamic if readers were interested, and that was overwhelmingly the case. Therefore, I am reviewing each of the 14 dividend-paying BDCs I had highlighted in order to assess the amount of "skin in the game."
So far, I have reviewed Ares Capital (ARCC), the largest of the group, Apollo Investment (AINV), the worst in terms of alignment, Prospect Capital (PSEC), Fifth Street Finance (FSC), BlackRock Kelso (BKCC), PennantPark (PNNT), Solar Capital (SLRC), Hercules Technology Growth Capital (HTGC), Main Street Capital (MAIN), Triangle Capital (TCAP), MCG Capital (MCGP) and TICC Capital (TICC). Gladstone Investment (NASDAQ:GAIN), which has a market cap of about $166 million, has traded publicly since 2005:
The company filed its annual proxy statement on June 17th. Like most of its larger peers, where management is provided by an affiliated company, GAIN is managed by its investment adviser, Gladstone Management. Gladstone is named for its founder, David Gladstone (69), who is involved in several entities, including sister BDC Gladstone Capital (NASDAQ:GLAD), Gladstone Commercial (NASDAQ:GOOD), a REIT, Gladstone Securities, a broker-dealer, Gladstone Partners Fund, L.P., which co-invests with the two BDCs, Gladstone Land Corporation and Gladstone Lending Corporation.
Total ownership of directors and officers is listed at 1.5%, which puts it a well below average for the BDCs. Gladstone's ownership stake represented about 2/3 of the beneficial ownership at just 237K shares. His ownership of GLAD is substantially higher at over 5% (1.1mm shares) at the time of their proxy a year ago.
Due to the common structure of outside management, BDC investors are often unable to clearly weigh the alignment of interests, as there is no disclosure regarding salary and incentive pay levels (or metrics) for the individuals involved in running the company. While MAIN is structured with outside management, it still discloses this information, but most don't. GAIN discloses limited pay information, indicating that its administrator paid its CFO less than $50K in salary, bonus and benefit. The CFO works for several other Gladstone entities. As the 10-K describes, there are many potential conflicts of interest. Reviewing sister BDC GLAD, I learned that the Mr. Gladstone defaulted on $5.9mm loan (related to stock options exercise) in August 2010. Both GLAD and GAIN have made loans to his daughter, Laura, who is a managing director. Perhaps the low ownership and the conflicts of interest justify the large discount to book value.
While there is one more BDC to evaluate regarding management's alignment with shareholders, Gladstone Investment appears below average given skimpy insider ownership levels and an external management structure with limited compensation disclosure. Main Street looks superior to all of the previously reviewed BDCs, especially Apollo Investment and Gladstone. With the exception of MCG Capital and Fifth Street Finance, all of the BDCs I have reviewed are permitted to sell stock below the NAV, which I find to be a negative. The best alignment so far beyond MAIN has been Hercules Technology Growth Capital. I think that Solar Capital, Triangle Capital and Fifth Street Finance stand out from the crowd as well.
While many factors ultimately influence the level of future dividends, it is unclear if the ownership of GAIN's management team and outside directors creates enough of an incentive for its executives to steer it in a direction that sustains or even grows the payment without taking excessive risk.