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As we head into the home stretch with our series on Protected Principal Retirement Strategy investing, we turn to the Business Development Company asset class.

Business development companies [BDCs] are very similar to venture capital companies in that their purpose is to assist small companies in the initial stages of their development. They were initially created by Congress (see, Congress has actually done some good) in 1980. In the following paragraphs we will look specifically at what they are and how they function; what do we mid-rangers need to know to invest in them; and finally we will examine a few that are presently either a part of the portfolio, or are under consideration as portfolio additions.

What Is A Business Development Company?

A business development company is a publicly traded corporation that is listed on a major stock exchange. They typically loan money to small firms in return for loan guarantees or an equity position, and in some cases they will also provide consulting assistance.

The majority of BDCs are regulated investment companies (RICs). As such, they are required to distribute a minimum of 90 percent of their taxable income to their shareholders annually. Most BDCs distribute 98 percent, or more of their taxable income in order to avoid all corporate taxes. They are also required to remain diversified, and cannot invest more than five percent of their assets into any one security. BDCs that are RICs also cannot invest more than 25 percent of their assets into a small business that they control, or businesses within the same industry sector. They are also prohibited from buying over 10 percent of a company's voting shares.

These requirements do not hold for investments in U.S. government securities, or investments in other RICs.

The advantage of BDCs to small investors is that while purchasing an interest in a venture capital company, or in a hedge fund normally requires a large capital outlay, us little guys can buy as many shares of BDCs as we wish on the open markets.

Distributions to investors are taxed based upon the specific type of income earned by the business development company. A BDCs ordinary income would be taxed as ordinary income and capital gains as capital gains.

The common stock of BDCs is traded on the exchanges the same as other stocks. Most BDCs pay their dividends quarterly, although some have, in recent years switched to a monthly dividend (Prospect Capital for one). There are 30 +/- BDCs currently trading, so finding a few that are suitable for the Protected Principal Retirement portfolio shouldn't be difficult.

BDCs come in several sizes and flavors. The majority diversify their investments over a wide range of small companies within different industrial sectors. However, a few tend to invest within one or two specific sectors. These would include the following, at minimum:

  • Hercules Technology Growth Capital (NYSE:HTGC) - Technology
  • NGP Capital Resources (NASDAQ:NGPC) - Energy
  • Prospect Capital (NASDAQ:PSEC) - Infrastructure
  • TICC Capital (NASDAQ:TICC) - Small Technology Companies
  • Medallion Financial (NASDAQ:TAXI) - Taxicab Medallions

There are other BDCs that are specialized, but these are just examples.

How Do We Evaluate A Business Development Company?

I believe that since BDCs are similar to stocks in many ways and similar to REITs in others, they are a bit easier to evaluate. The two principles to keep in mind is that BDCs are sensitive to the economy, and since they rely on financing, they are very sensitive to interest rates.

Where the BDCs virtually all hit bottom in the early months of 2009, unlike mREITs their dividends (while reduced) did not disappear entirely. Just about all of the BDCs remained in business, and most have seen their dividends return to pre-2009 levels.

I believe that many of the evaluation metrics that are used to evaluate a typical common stock are similar for BDCs - earnings per share, revenues, price to book ratios, and return on equity. I will not get into them in this article since they are basic for any diligent investor.

There are two metrics however that are critical to evaluating BDCs. These are: the dividend to earnings per share ratio and the price to the net asset value ratio.

If you have access to iVillage there is a page devoted to BDCs. If you search for postings by "factoids" you will find just about all of the information that you need on BDCs. His articles are well-written and include quarterly tracking of virtually all of the publicly traded BDCs. If you are interested, he provides the same type of insight for MLPs.

Dividend/EPS Ratio - Within the realm of BDCs, this ratio will generally vary from a low of about .80 to a high of well over 1.00, with the average being just above 1.00. Ratios in the mid - .90's are what to look for; lower is even better. I will note every business development company with a Dividend/EPS ratio that is below 1.00.

Price/Net Asset Value Ratio - In order to secure the correct net asset value each quarter, one can use the earnings reports, the tables generated on iVillage, or the book value (which is generally very close). Similar to the Dividend/EPS ratio, we are looking for BDCs with a Price/Net Asset Value ratio of less than 1.00. This gives a good indication as to whether or not the stock would be a value if purchased. I note all of those meeting this criteria also.

Once you have isolated the BDCs meeting each of these criteria it is easy to apply metrics like revenue trends, earnings per share trends, return on equity etc. to eliminate the laggards.

As of the beginning of August I found that the following BDCs met both of these evaluative criteria:

  • Apollo Investment Corporation (NASDAQ:AINV)
  • Gladstone Investment Corporation (NASDAQ:GAIN)
  • Gladstone Capital Corporation (NASDAQ:GLAD)
  • NGP Capital Resources Company (NGPC)
  • Medley Capital Corporation (NYSE:MCC)
  • Pennant Park Floating Rate Capital (NASDAQ:PFLT)
  • Solar Senior Capital Ltd. (NASDAQ:SUNS)

Note: Some of the BDCs are still releasing earnings so there could be additions/deletions to this list.

Finally, I look for total return on the portfolio's investments in BDCs. This metric (price appreciation + dividend) is also presented in the quarterly analysis that can be found on the iVillage site. Personally, I seek an annual total return rate of 15 percent or better from BDCs.

The Protected Principal Retirement Strategy Portfolio

At present, our portfolio allocation to BDCs is ten percent. There is only one business development company held at present in the portfolio , and I am looking at adding up to two more.

MCC - Medley Capital had its initial public offering in early 2011, and has been a solid performer since. Recent quarterly earnings were $.36, beating analyst estimates by $.03. The quarterly dividend was also raised from $.31 to $.36. When I purchased it, the price was a little below the net asset value, but in recent weeks it has moved slightly above the net asset value. At the present market price 0f $12.90, yields 11.16 percent.

I am considering adding either Fidus Investment Corporation (NASDAQ:FDUS), Prospect Capital , or possibly both to the portfolio.

FDUS - FIDUS is also a relatively new publicly traded company, having had its initial public offering in mid-2011. Since late July of this year it's price to net asset value ratio has moved a bit above 1.00 and the dividend to earnings per share ratio was tracking 1.00 until they recently increased the quarterly dividend to $.38. So, for the time being I will continue to closely monitor .

PSEC - Prospect Capital has been a long time favorite of mine. I have owned it in the past on more than one occasion, and since they have changed to a monthly distribution I am watching it ever closer. Until recently, was trading below net asset value and the dividend/earnings per share ratio was in the .80's. Earnings are due to be released on August 22, so I will do nothing until I have the chance to review them and monitor the conference call.

In addition, I continue to monitor the remaining six BDCs in the listing above.

I anticipate an additional four articles in this series, one each on foreign stocks and currencies/commodities, one discussing additional potential income-producing strategies, and one article that will attempt to put everything that we covered together into an updated portfolio allocation.

I continue to appreciate those of you whom are following this series.

Source: Protected Principal Retirement Strategy: Retiring Without A Million-Dollar Nest Egg - Part VIII