One of the favorite investments for income-seeking investors that our colleague Tim Plaehn recommends is business development companies, or BDCs.

Business development companies provide equity and debt financing sources for small-to-medium-sized corporations. They act as commercial lenders to companies that cannot get financing through the banking system. Currently, BDCs hold a quarter of assets under management in the private credit market.

Here’s why now is a great time to be buying them…

What Is a BDC?

At the most basic level, a BDC is a tax-efficiency play. Under a 1980s law, BDCs were set up to channel funds towards those small and middle-market companies that lack access to capital markets bigger players enjoy. BDCs must invest 70% of their assets in private U.S. companies or smaller public ones.

In addition, BDCs are structured as pass-through entities, which means they do not pay corporate income tax if at least 90% of net investment income is paid out as dividends. These companies are limited to debt that is no more than two times equity. (Until 2018, the limit was a debt of one times equity.) Most BDCs have continued to manage close to a one-to-one debt-to-equity ratio.

BDCs are structured as closed-end funds: after they raise capital in a share issuance, investors can buy the shares from other investors, but these purchases do not contribute new capital to the fund. New capital comes from the issuance of more shares.

BDCs: Then and Now

BDCs have evolved over the years. A structure set up to get capital to up-and-coming businesses is now mostly a way to finance middle-market leveraged buyouts. According to Moody’s, 80% of BDC transactions involve a private equity-sponsored business.

The size of the BDC market has soared in the past couple years, in no small part because of the exceptional debut of the Blackstone Private Credit Fund (BCRED) in 2021. In two short years, BCRED has gone from managing $0 to $48 billion, making it the biggest BDC. However, there is no public trading market for shares of BCRED and an investor’s ability to dispose of shares is limited to repurchase by Blackstone, subject to the limitations (5% per quarter) described in BCRED’s prospectus. These limitations mean only wealthy individual investors can buy it.

This one BDC aside, how have they performed historically?

I would say BDCs have fulfilled the promise of near-stock-like returns from a fixed-income investment. BDCs have managed to compound returns at 7% a year for a decade, which is much better than a typical high-yield bond fund or bank loan ETF.

Of course—as with stocks—there will always be outperformers. If you look at the past 10 years, two firms stand out: Ares Capital Corp and Hercules Capital. Their BDCs have compounded returns at very close to the S&P 500 for the past decade, which has been a great decade for stocks.

Keep in mind, though, that these top BDCs have managed to deliver great returns despite their managers charging fees that are similar to those charged by hedge funds.

Many BDCs are run by asset managers, who take fees based on assets under management and investment income. At Ares, for example, the fees are 1% to 1.5% of assets, depending on the amount of leverage used to finance them and about 20% of net investment income that exceeds a hurdle rate of 2.2% return on net assets.

But what about now? Can the top BDCs keep delivering in the current tricky economic environment?

What’s Next for BDCs

The approximately 50 publicly traded business development companies all benefit from higher interest rates. That makes them a particularly attractive investment in the current financial environment. Here’s why…

By law, a BDC’s business structure limits the amount of leverage it can use. At the same time, the money it lends is almost 100% variable rate. As a result, as the Federal Reserve has jacked up interest rates, net investment income earned by BDCs has skyrocketed.

But how can you separate the wheat from the chaff—the good BDC managers from the bad ones?

For BDC investors, there is an easily accessible, if approximate, proxy to judge the managers: the BDCs’ net asset value per share over time.

BDCs are required to pay out 90% of their profits as dividends. This makes it challenging for them to increase their net asset value through the retention and reinvestment of interest income. But what BDC management can do is to not erode net asset value per share. This could happen by lending to borrowers who don’t pay the money back, or through heavy share issuance where the proceeds are invested poorly.

So, an easy thing for you to do before investing into any BDC is to look for stable-to-slightly-up net asset values over time. Don’t be tricked into investing into a BDC by just looking for a high dividend yield alone.

For example, the share prices of Ares Capital (ARCC) and Hercules Capital (HTGC) have been rather stable over the past five years, except for the 2020 pandemic swoon. And both yield well in excess of 9%, even approaching 10%. These two BDCs are up 3% and 22% year-to-date, respectively.

You can buy Ares at $19 or lower, and you can get Hercules for less than $17.

And if you are looking for broad exposure to BDCs, there is the VanEck BDC Income ETF (BIZD). It currently yields 10.7% and has posted positive share price appreciation (8.88%) year to date. You can purchase this ETF anywhere in the mid-$15s per share.

— Tony Daltorio

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Source: Investors Alley