In a recent article entitled "REITs Vs. MLPs: Which Is The Better Investment?", I go on to explain that both MLPs and REITs present lucrative opportunities for high-yield seeking investors right now. This is because both of these business models require companies to distribute a high percentage of cash flows to investors in exchange for being classified as corporate income tax-exempt pass-through entities.
Similarly, Business Development Companies, or BDCs, are regulated investment companies that must distribute 90% of their taxable income to shareholders. They are very popular among income investors and rightfully so:
- (1) High Dividend Yield: in a low yield environment with treasuries paying just north of 2%, BDCs catch all the attention with their 8-12% dividend yields.
- (2) Simple Business Model: BCDs source capital at cost X and attempt to reinvest it with return Y - aiming to earn the spread in between. It is simple to understand and particularly profitable if done well.
- (3) Strong Growth Potential: in an expanding economy, BDCs tend to outperform. Demand for loans is high, and BDCs are filling a void that traditional banks cannot fill. With GDP growing at 3%, BDCs are enjoying rapid growth - leading to price appreciation.
- (4) Prospects for High Total Returns: With high dividend yields and strong growth potential, BDCs are in a great place to produce superior total returns as long as the economic expansion continues.
With that said, it's important to recognize that:
Not all BDCs are created equal."
With high yield comes high risk, and many times do-it-yourself investors have gotten seduced by juicy yields and have been too quick to accept management's rosy projections of how future growth prospects will come to fruition without any hiccups and will, therefore, support their enormous distributions and shower investors with riches.
What these investors fail to realize is that management teams are often self-interested, make poor capital allocation decisions, and excessive risk taking is common. Needless to say, this is a sector where you need to be very selective to maximize returns and avoid landmines.
As an example, at High Yield Landlord, for every investment that we make in REITs, MLPs or BDCs, we reject about 10 other alternatives:
Source: High Yield Landlord Real Money Portfolio
BDCs can provide ample rewards to those who do their homework, but they are also remarkably unforgiving to those who ignore the problems.
Below we discuss the "dark side" of BDCs and explain how we seek to avoid landmines.
1. Closely Track The Actions of the Management
It's not a secret to anyone following the sector that BDCs can be very volatile - often even more so than other stocks. While this leads to opportunities, investors should know that it can be a bumpy ride - and the actions of the management team have significant influence on the volatility.
Management actions that lead to greater volatility in the BDC space:
- Issuing unit at discount to NAV.
- Pursuing dilutive growth.
- Overleveraging the balance sheet to make up for expensive equity.
Actions that lead to lower volatility in the BDC space:
- Pursuing the self-funding model.
- Appropriately timed buybacks.
- Reasonable capital structure.
Anything that leads to shakier fundamentals will lead to wider price fluctuations, and when dealing with BDCs, every management action has an amplified effect on the price. To increase your chances of being on the right side of the trade, it pays to closely monitor the actions of management teams.
2. Avoid "Growth-at-all-cost"
Every BDC wants to grow to achieve greater scale and "notoriety." Management teams are often conflicted because a larger portfolio size may justify higher salaries. This has often led to what we call "empire building" in that managers will seek to make more and more investments with little regard to the dilutive impact of raising more capital.
Growth can be profitable for shareholders, but only if it happens on a "per share" basis. In other words, it does not help to double cash flow if you also double the share count - leading to stagnant or even declining earnings per share.
To spot conflicted management teams that are likely to pursue dilutive growth strategies, we look for the following signs:
- They will often have an external management agreement.
- The managers will have little skin in the game other than their salary.
- The BDC will not hesitate to issue shares at a discount to NAV.
- The fees will be directly tied to the assets under management (AUM).
Trust but verify. If a BDC suddenly starts raising more equity, but its share price is at a very low level (high yield and/or discount to NAV) - there will likely be pain ahead.
This behavior of targeting "growth-at-all-cost" is the number one reason that leads to underperformance in the BDC sector in our opinion.
3. Lack of Independent Research
Today, the entire BDC sector lacks adequate coverage from investment research institutions. Making matters even worse is that there exists an entire industry of "company-sponsored research" in which BDCs will pay analysts to produce "independent research" on their companies. It should be clear to everyone that it leads to sizable conflicts, and while it's strictly forbidden on the Seeking Alpha website (fortunately!) - it remains a common practice in the research industry.
The consequence for investors, especially individuals, is that it becomes very difficult to access quality research on these high yielding opportunities. Analyzing BDCs is no walk in the park and it requires specialist skills that are not widely available.
Our point here is that you must know your limits. For us, we feel that we are able to adequately sift the wheat from the chaff in this challenging sector in both individual picks as well as actively managed BDC funds given that we are multiple analysts spending thousands of hours performing due diligence on opportunities.
However, if you lack an edge, you are better off pursuing well-diversified index funds or ETFs to avoid stepping on the landmines while still collecting attractive and growing distributions.
BDC Landmine - An Example
To put theory into practice, we will elaborate on one BDC that raised many of these red flags and ended up burning investors in the past years. Prospect Capital (PSEC) has seen its share price drop by nearly 40% in the past five years:
However, a prudent investor would have seen numerous red flags signaling the impending distribution cuts as it suffered from excessive leverage, dilutive equity issuances, poor management execution, and mistreatment from its conflicted general partner.
Management routinely failed to meet guidance as well as consensus expectations. The biggest red flag of all, perhaps, was that management made some disastrous investments and the general partner raised capital at a highly dilutive price to justify greater fees.
As a result, shares turned out to not be so cheap after all, and the BDC ended up cutting dividends, crushing investors in the process. Such steep losses could have been avoided had investors simply maintained disciplined in their insistence on quality management, a supportive rather than exploitive general partner (or better yet, none at all), a reasonable amount of leverage, and a capital allocation strategy that did not routinely dilute investors. In the meantime, many of its better managed peers including Main Street (MAIN) and Ares Capital (ARCC) produced very satisfying returns while paying high income to their shareholders.
Closing Notes: BDCs Are Wonderful (if you know how to pick the right ones…)
Priced at very high dividend yields, there's no doubt that there exist some lucrative opportunities in the BDC space today.
You must, however, exercise very prudent attention to your selection of individual investments as return disparities can be massive.
To illustrate this point, consider the following: The average returns of most asset classes over the past decades have vastly outperformed the results of the average individual investor over the same time frame:
Clearly, the average investor does NOT know what they are doing. They are consistently making the wrong decisions, trading too much, and stepping on landmines.
It is important to understand that you do not need to know how to pick the best 1% out of the BDC sector to earn good results. That is not realistic. It is enough if you know how to identify the bottom 20%, eliminate them from your list, and invest in the remaining good companies that are offered at attractive valuations. Investment performance is just as much driven by your worst losers as your best winners. Avoid the big losers, and your average performance will improve tremendously.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.