For Dividends, It Might Be Time To Explore Business Development Companies

Includes: ARCC, BKCC, KKR, RIC
by: Regarded Solutions

Business Development Companies

As the old saying goes; "follow the money." The saying seems as evident now as ever before. The American economy has been going through a sea change financially. Ultra low interest rates have made borrowing money very cheap, but it has also made borrowing the money that much more difficult.

Banks do not want to take on any risk without a decent reward, so, no matter what some talking head on CNBC tells you, small businesses are having a very difficult time getting funding from them.

Therein lies the opportunity. Business Development Companies are in the business of "lending" money to small businesses, entrepreneurs and high-tech start-ups. They make money by either taking a stake (equity) in each company they invest in, or by receiving a higher interest rate than they can receive from any other form of fixed income investment.

The real strength of these companies is in the equity stake they could receive from the businesses they invest in. If the business is successful, the profit potential of the BDCs is tremendous. The risk of course is that if the business fails, and the BDCs lose their investment in either the equity, or the "loan" interest.

The Definition Of A BDC

I think it would be prudent to cite the definition of exactly what a BDC actually is. As per Wikipedia:

"A Business Development Company (BDC) is a form of publicly traded private equity in the United States that invests in small, upcoming businesses. This form of company was created by Congress in 1980 as amendments to the Investment Company Act of 1940. Publicly traded private equity firms may elect regulation as BDCs."

Direct and to the point, but what about the IRS rules governing BDCs?

"BDCs are usually taxed as regulated investment companies (RIC) under the Internal Revenue Code. Like real estate investment trusts (REITs), as long as the RIC meets certain income, diversity, and distribution requirements, the company pays little or no corporate income tax. As a pass-through tax structure, RICs must distribute at least 90 percent of taxable income as dividends to investors. Most BDCs distribute 98 percent of their taxable income to avoid all corporate taxation. (RICs fall under section 851 of the Internal Revenue Code; REITS fall under section 856.)"

98% of a BDC's taxable income is distributed to investors. The minimum being 90%, as this could be a wonderful source of income for dividend seeking investors as well as retirees depending on which BDCs we decide to invest in.

Another definition from Investopedia adds to the understanding as well:

"To qualify as a BDC, companies must be registered in compliance with Section 54 of the Investment Company Act of 1940. A major difference between a BDC and a venture capital fund is that BDCs allow smaller, non-accredited investors to invest in start-up companies. Some of the reasons why BDCs have become popular is that they provide permanent capital to their management, allow investments by the general public and use mezzanine financing opportunities."

Add to this ... that BDCs will NOT be subject to the "fiscal cliff" issues, as the dividends are taxed as regular income, not dividend income.

What Is The Market Telling Us?

As noted previously, there are businesses that will lend money to other businesses for either an equity stake or a flow of income greater that can be received through other fixed income investments.

This fills two needs: The need for income for the BDC and the need for small businesses to get capital, which might be more difficult to obtain through banks. To me that is a win-win situation. As noted in this New York Times report:

"It is a $1 trillion game: Use It or Lose It.

The private equity world is sitting on that 13-figure sum. It's what the industry calls dry powder. If they don't spend their cash pile snapping up acquisitions soon, they may have to return it to their investors."

Trust this; these companies will put all of this money to work.

"Many of the big private equity firms - Apollo Group, Kohlberg Kravis Roberts, Blackstone Group and Carlyle Group, among them - are public. And for the first time, it is possible that the interests of the public shareholders could diverge from the interests of the investors in the buyout funds, at least in the short term."

The market is telling us that the right public BDC stocks could be a great investment for individuals. The tough part is finding the stocks to actually buy.

Which Public BDC Stocks Are Worth Investigating?

I have identified 3 public BDC stocks that appear to be the best of breed at first glance. Here are some basic facts:

BlackRock Kelso Capital (NASDAQ:BKCC): Price: $9.96/share, Dividend Yield: 10.75%, ESS Rating: Neutral

  • A share price to book value of only 1.04.
  • An enterprise value of $1.15 billion.
  • A forward P/E ratio of 9.67.

Ares Capital (NASDAQ:ARCC): Price: $17.21/share, Dividend Yield: 8.75%, ESS Rating: Bullish

  • A forward P/E ratio of only 10.25.
  • 8 analysts have a strong buy rating, 5 have a buy rating and 3 have a hold rating. There are no underperforms nor sell ratings as of the last month.
  • In 2012, 433,000 shares have been purchased by insiders and only 1,500 shares have been sold.

KKR Financials (KFN): Price: $10.07/share, Dividend Yield: 8.50%, ESS Rating: Bullish

  • A share price to book value of only 1.02.
  • An extremely low payout ratio of under 60%.
  • An enterprise value of nearly $8 billion.
  • Profit margins of about 69% and operating margins nearly 73%.

In future articles, I will delve deeper into each of their business models. For now, these are 3 of the largest BDCs with excellent balance sheets and quite well known among many investors already.

For example, KFN has 61% institutional ownership of outstanding shares, BKCC has 51%, and ARCC has 50%. These are impressive numbers and obviously could give individual investors an indication of the breadth of ownership and institutional confidence.

Here Is A Look At Some Charts

All 3 have recovered from the 2009 lows, and some might say we are too late. I disagree because each of these companies have cash to deploy now, and we could begin to see further capital appreciation at an accelerated pace.

With the exception of KFN, the dividends have remained basically stable. Keep in mind that KFN has a lower payout ratio than the other 2, so they seem to have the ability to continue paying even at current yields. Sort of the "yin and yang" effect for KFN I suppose.

My Opinion

As of right now, I like all 3 of these BDCs. If I had to select just one, I would probably lean towards the largest of them all, KFN, which by no means infers that the others are not every bit as good.

Further analysis and investigation should be done by everyone prior to making any decisions, however, this business sector appears to be very compelling.

One Final Note

With many thanks to a very valued reader of ours, "TwistTie," I am writing about an area that is quite new to me. This article is dedicated to him and his family. All investors should give him the nod for asking me to write this article. Seeking Alpha readers are the most sophisticated on the internet, and any author would value a quality recommendation from them.

This is what makes SA the finest investment site on the web. We value our readers with a respect and appreciation more than anywhere else.

Disclosure: I 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.