by Daniel Shvartsman
Income investing is popular on Seeking Alpha, and that does play out in the Marketplace. But income investing, like value investing or growth investing or other styles, can encompass many sectors or specific areas. There are flavors to the approach, whether it's high yield or dividend growth, corporate bonds or real estate. The Marketplace also reflects this diversity in the income space, where authors have had success in a number of different verticals that offer investors different ways to grow their income generation and principal.
One of those verticals is BDCs, or business development corporations. The companies generally lend to or invest in smaller private companies, giving investors exposure to a different part of the market. They are also set up to pay meaningful dividends, which can be attractive. On the flipside, a lot of the value is invested in small companies that are harder to do diligence on, and putting more stress on identifying high quality management teams. This places more value on having expertise in the sector.
One of the authors who has become synonymous with BDCs on Seeking Alpha and the Marketplace is BDC Buzz. He has been writing about BDCs since 2013 and has built up over 17,000 followers in that time, helping to raise the spotlight on these companies and how they can fit in investors' portfolios. He's gone further with Sustainable Dividends, a Marketplace service dedicated to the BDC category. And though it's a niche that only covers a select number of public companies, it has resonated with readers - the service has over 200 subscribers and has reached our top 15 services.
I emailed with BDC Buzz to ask about what brought him to the sector, what's under the hood on Sustainable Dividends, why investors should be interested in BDCs today, and what determines whether these dividends can stay sustainable.
Congrats on your success with Sustainable Dividends, reaching our top tier of services. What do you think has helped you stand out?
BDC Buzz: I have been writing for SA for almost 7 years building trust within my audience by consistently avoiding the ‘yield traps’. Also, my average returns are consistently higher than the S&P 500 usually around 20% annually thanks to the timing of investments in a volatile sector. I have publicly predicted upcoming credit issues, declines in book values and many of the dividend cuts and increases over the years. Notable examples:
- Dividend Cuts For The High-Yield BDC Sector
- Prospect Capital: Expected Dividend Cut Of 20% To 30%
- Oaktree Management Fees Driving Upcoming Dividend Cuts
What brought you to BDCs?
BDC Buzz: I wanted higher yields and volatility in a niche sector that I could take advantage of mispricings using highly focused research. Also, BDCs invest mostly in American companies providing a wide range of financing alternatives (beyond banks) allowing smaller private companies to grow, contributing to the overall economy.
How much does it cost to sign up for Sustainable Dividends?
BDC Buzz: Currently, it is $65 per month or $595 annually but I will be increasing later this year due to adding active coverage Baby Bonds. I am currently offering 14-day free trials through Friday, October 18, the first time free trials have been offered on the service.
Why do you name the service Sustainable Dividends rather than something BDC focused? In other words, what are you focused on with that name?
BDC Buzz: When I first started searching for higher yield investments it became clear that many were paying dividends that were not sustainable and investors were “eating the horse that they were riding”. My goal was to find higher income investments that could not only sustain their distributions but potential increase over time through quality management (critical).
I think many investors think of ‘high-yield’ as temporary or cyclical investments. However, BDCs lend to private companies with permanent equity capital which means that there are no “runs on the bank” or forced liquidations during volatile markets. BDCs can hold investments until maturity waiting out market volatility and then opportunistically reinvest the proceeds, likely at higher yields at some point. This is considered a positive for their borrowers which are willing to pay higher rates for more of a longer-term ‘partnership’ approach often with equity participation upside for the BDC investor.
What do people have trouble understanding about BDCs?
BDC Buzz: BDCs are mostly retail-owned due to certain SEC rules (discussed at the end) which contribute to lower multiples, higher yields, and increased volatility. Also, the sector has opaque and inconsistent reporting standards which often results in investors making poor decisions.
How did you learn and grow as a BDC investor?
BDC Buzz: My earlier mistakes were related to looking for a “deal” and higher yields but I quickly learned that paying for higher quality is a necessity for longer term returns. This led me down a path that I used in a prior life of assessing risk and then using to establish relative valuations. One of the best approaches to assessing risk in a BDC portfolio is using a “vintage analysis” that takes into account many aspects including the time frame that each loan was originated,l as asset class, maturity, directly originated vs. syndicated, industry sector, PIK and cash yields, etc. Then I use a balance of risk versus expected returns looking for mispriced opportunities using various yield spreads for valuation and technical indicators including momentum etc.
Additionally, I learned to be patient and understand that “volatility is your friend.” Investors can easily get higher yields from higher-quality investments waiting for volatility. I made 28 purchases of safer BDCs in 2018 with an average yield on cost of 10.5% and currently averaging 20% or higher annualized returns through Q3 2019.
You mention in your profile that you work with institutional investors as well - what sorts of things do you focus on with more professional investors, and what do you focus on with individual investors?
BDC Buzz: With institutional investors, I focus more on BDC management, fee structures, expense ratios and real-time information on the private portfolio holdings to assess credit quality before the BDC reports results publicly. Retail investors usually have less time and interest in details so they just want to know what to buy and when that fits their risk profile.
What type of investor are you and how does that apply to the way you invest in BDCs?
BDC Buzz: I consider myself to be a conservative type BDC investor due to having a larger portion of my equity investments in the sector. I primarily focus on capital preservation and sustainable dividend yields willing to give up a higher yield for what I believe to be a safer investment that is more likely to outperform during an economic downturn. I only invest in ‘Risk Rank 1 and 2’ discussed in the BDC Risk Profiles and then dividend growth potential ‘Level 1’ or at least sustainability ‘Level 2’ as discussed in the Dividend Coverage Levels. After those two criteria, I look at pricing and wait for general BDC pullbacks to buy these BDCs at lower prices.
How is investing in BDCs similar to other types of income investing? How is it different?
BDC Buzz: Many people associate BDCs with CEFs (closed end funds). However, BDCs are very different with regulations that require them to provide active management consulting to their private and smaller portfolio companies. BDCs often have a member on the Board of Directors as well as an equity position treating the company as a long-term investment. This is more of a partnership approach rather than a simple collection of assets in a fund.
What type of members do you have in Sustainable Dividends? Do you find more experienced BDC investors on the service, or is it more frequent to have people newer to the sector?
BDC Buzz: Members are often previous followers of BDC Buzz that are already invested in BDCs and have come to trust the recommendations but are looking for more actionable detail including pricing, recommendations and better timing of stock purchases and sales which more than makes up for the price of the service. I have plenty of articles that discuss “timing is everything” showing examples of a BDC reporting results and the delayed response from investors due the opaque reporting standards discussed earlier. Also, many of the subscribers are money managers or BDC management that are making trading decisions for others or assessing the competition.
How do you help people get up to speed on the nuances of BDC investing?
BDC Buzz: I have a Quick Reference Guide that walks through some of the basics including side-by-side comparisons reports discussing Risk, Dividend Coverage and Pricing as well as how to build a BDC portfolio that includes examples of my previous and upcoming BDC purchases:
- Identify BDCs that fit your risk profile by reading the BDC Risk Profiles report along with the individual Deep Dive reports provided for each BDC.
- Use the BDC Google Sheets with real-time pricing and recommendations to identify companies below or close to their short-term target prices.
- Initiate small positions to help gain interest and follow the stock (and management team) to develop a comfort level for future purchases.
- Dollar average your purchases using general market and/or sector volatility which is when I provide multiple Market Updates and announce real-time changes to my personal positions.
Are there any other sectors or assets you follow, either on your Marketplace service or just in general in your investing? How do they fit in with your approach?
BDC Buzz: I invest in BDC Baby Bonds to help overall volatility but lowers the portfolio yield and I use index funds for the rest of my investments which are safer and do not require as much attention as BDCs.
Why invest in BDCs as compared to other income classes?
BDC Buzz: I know this sounds cheesy but many investors like the idea of investing in American companies (which is a requirement for BDCs) especially given continued concerns over U.S. trade policies and tariffs but also the belief in helping American companies with access to growth capital. As mentioned earlier, BDCs are also required to provide management assistance to their portfolio companies which can benefit from having access to a much larger credit platform to compete with larger businesses. Plus, BDCs currently provide higher yields partially due to lower pricing multiples after being delisted from multiple fund indices discussed later.
What has surprised you about running Sustainable Dividends?
BDC Buzz: Again cheesy, but hearing from subscribers about the excellent trades based on the research and earning more than the annual fees each month. I typically do not have as much time to make as many trades as my subscribers as I’m constantly analyzing and producing content. I would like to be my own customer.
What greets new members when they sign up for the service?
BDC Buzz: There is a “Quick Reference Guide to Sustainable Dividends” which starts with “Upcoming BDC Buzz Purchases & How To Build A BDC Portfolio” and the most recent market update. Building the portfolio starts with assessing risk and then ‘dipping your toe in’ on select BDCs using the BDC Google Sheets for real-time pricing and recommendations.
What's your case for why someone should sign up for Sustainable Dividends instead of other options?
BDC Buzz: Finding yield over the coming quarters/years will become increasingly difficult and BDCs remain unnoticed and underpriced. BDCs, like REITs almost 20 years ago, want institutional investors and the scale that comes with them. Recently, the largest asset managers including Blackstone, KKR, Carlyle, Ares, TPG, Franklin Templeton, and Owl Rock have been actively entering into the sector and there will likely be positive changes to regulations over the coming quarters driving up multiples for current investors. For example, the acquired fund fees and expenses (AFFE) rules require investment companies and mutual funds investing in BDCs to include an additional line of expenses outlining the fees and operating costs charged by the BDC distorting expense ratios making them prohibitively expensive for a number of institutional investors that could have otherwise been attracted by the vehicles’ high dividend yields.
In December 2018 the SEC kicked off a consultation on a broader fund of funds reform proposal that included views on the impact of AFFE on BDCs. In September 2019, the Coalition for Business Development (“CBD”), a BDC lobby group, put forward a proposal to the existing AFFE:
“The current classification of BDCs harm institutional ownership and ‘Main Street’ BDC investments along with it,” said Joseph Glatt, chairman of the CBD.
“Under the CBD’s alternative proposal, a SAI disclosure would detail the BDC’s operating expenses. Any costs would be factored into the BDC’s trading price. The argument is that any expenses would be reflected in the fund’s total return. After the adoption of the AFFE rule, BDCs were delisted from multiple fund indices, including the S&P and Russell in 2014. Following the delistings, BDCs on average have traded below their net asset value and have since never fully recovered.”
The following was from a previous call with Main Street Capital’s (MAIN) CEO:
“Currently, our focus has been directed primarily on the Acquired fund fees and expenses or AFFE rule as it affects BDCs and the special deduction for individuals that receive dividend income from REITS and MLPs. The first item we are working with the SEC to either eliminate or at least modify the rule that effectively resulted in the elimination of BDCs eligibility for index fund inclusion. The second item we are working with congressional staff to include BDC dividends as being eligible for the deduction so as to level the playing field with REITS and MLPs”
This is the time to get into BDCs. Subsequent to the departure of Jonathan Bock (lead BDC analyst with Wells Fargo) last year, we at BDC Buzz and Sustainable Dividends have become the go-to place for in-depth research on this niche sector.
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. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Neither BDC Buzz nor I have any positions in any stocks mentioned in the article. BDC Buzz hosts Sustainable Dividends on the Seeking Alpha Marketplace, and Seeking Alpha is a partner with him and 170+ other authors on that platform.