BDCs Continue to Offer Opportunities for Dividend Investors

by: Philip Mause

I have written in the past about Business Development Companies (BDCs) and the advantages they offer for dividend investors. Most BDCs make loans to small and middle sized businesses and use a very limited amount of leverage, which is restricted to a debt equity ratio of 1 by statute. Readers should be aware that there are certain BDCs - e.g., Capital Southwest (NASDAQ:CSWC) - that make primarily equity investments; many of the statements in this piece do not apply to such companies although I have pointed out the CSWC is attractive for reasons of its own. BDCs are usually treated as registered investment companies (RICs) and generally do not pay taxes on income but pass through income to stockholders as dividends which, in turn, are taxed as ordinary income. I have noted in an earlier article that BDCs generally performed well during the last interest rate increase period (2004-06), which gives them a significant advantage over many other yield oriented investments.

Certain prominent BDCs - Allied Capital and American Capital (NASDAQ:ACAS) - ran into serious problems during the Panic of 2008 (fittingly timed for the 100 year anniversary of the Panic that J.P. Morgan resolved one night in his house in Manhattan). This put the sector under somewhat of a cloud and there were very attractive entry points for many stocks in this sector between late 2008, and September 2010. Things have settled down and BDCs are now priced at reasonable levels - generally producing yields in the 7-11% range.

As we move forward, certain BDCs offer attractive opportunities by combining high yield with a prospect for price appreciation. BDC stocks generally trade fairly close to book value so one source of possible stock appreciation is the pricing of a BDC stock below NAV per share or book value per share. In addition, some BDCs offer the possibility of an increase in book value, which would, in turn, tend to pull up the stock price. Book value can increase if a BDCs assets are either sold for more than book value or are revalued at a new, higher level.

Other BDCs may have advantages, which the market does not fully appreciate or may be underleveraged and be able to increase earnings by deploying more assets into income producing loans.

The complete list of BDCs continues to grow longer as new companies enter the sector and, thus, this list does not purport to be complete. In each case, after the name of the company, I provide the stock symbol, Monday's closing price and the dividend yield based on the most recent dividend.

Full Circle Capital (FULL) (7.90) (11.4%) - FULL is one of the new wave of BDCs that came into existence after the Panic of 2008. It has yet to fully deploy its capital and still has net cash on its balance sheet. When the net cash is backed out, the stock is trading at a discount of roughly 15% below the book value of the invested assets. FULL's investments are almost entirely senior secured loans and the discount seems excessive. FULL is relatively small and there may be cost inefficiencies at its current size. In addition, there is somewhat of a "blind pool" aspect to the fact that additional investments will likely be made in the near future (this is, however, the case for almost all BDCs because they tend to make short term loans and must redeploy capital as the loans are repaid). FULL's price will probably close up on book value over the next year or so and investors are being paid to wait.

Hercules Technology Growth Capital (NASDAQ:HTGC) (10.37) (8.5%) - HTGC generally makes loans in the venture capital area and usually takes warrants on the stocks of companies it is financing. It has relatively low leverage. Looking back at its chart, it really did pretty well through the 2008 Panic except for a nasty dip in early 2009, and it recovered quickly to pre-panic levels. It has generally had a good history in terms of credit quality. The big advantage for HTGC is that it has a nice "kicker" in the form of the warrants. If it invests in the next Facebook, investors could win big. More likely, the returns on the warrants will be modest but positive. Again, an investor is being paid to wait.

Horizon Technology Finance (NASDAQ:HRZN) (15.73) (8.4%) - HRZN has many similarities to HTGC although it, like FULL, is one of the new kids on the block. HRZN made a lot of loans during the tight credit period after the Panic and many of these loans have double digit coupons. It is, therefore, a little surprising that HRZN is priced at a discount to its $17.23 book value. If anything, one would expect that high coupon loans made during a period of tighter credit would have a premium value. HRZN also has the warrant "kicker" advantage in many of its investments.

American Capital (ACAS) (9.51) (no current dividend) - The Lazarus of the BDC world, ACAS had a near death experience as assets were written down during the Panic, creating covenant and leverage problems. It has been rebounding nicely. John Paulson bought a bunch of stock a year ago at around 5.25. ACAS has a big portfolio of assets it acquired before the Panic and wrote down substantially during the past 3 years. In some cases, ACAS has been realizing good value on some of these assets and some of them are being revalued at higher levels. In the first quarter of 2011, NAV increased by $1.26. ACAS has also resolved what used to be a scary leverage situation and in the first quarter of 2011, paid down debt by $517 million. ACAS is still paying a high interest rate on its borrowings and this may provide another possible source of increased cash flow if the borrowing can be refinanced. ACAS does not currently pay a dividend but now that the leverage problem is under control may resume one soon. This is a stock that is trading roughly 18% below NAV and its NAV has been and may continue to be on the way up. I think it is more likely than not that a dividend will be resumed within a year. However, right now an investor is not being paid to wait.

TICC Capital (TICC) (10.05) (9.9%) - I have a soft spot in my heart for this one. It was one of my first investments in March-April 2009 as we came off the bottom.

I felt very comfortable with it because it had no debt and, thus, by definition, could not have any problem with its creditors (back then, this was virtually the only way to avoid having problems with creditors). It has done well and has the potential to do better by deploying the roughly $30 million of net cash on its balance sheet and perhaps taking on a little bit of leverage. This "coiled spring", unused cash and unused borrowing capacity, feature is true of many BDCs but TICC is probably the most striking case.

As noted above, BDCs are relatively conservative in the sense that they employ limited leverage. They generally performed well during the last series of interest rate increases but the sample size was limited and we now have a lot of new BDCs that have not yet been put through that particular mill. Although valuations have returned to a more normal range, there are still opportunities for price appreciation as well as a generous dividend yield.

Disclosure: I am long ACAS, TICC, HTGC, and CSWC.