Two years ago, on this site, I recommended buying a basket of Business Development Companies (“BDCs”). On concerns about higher interest rates and CLOs held by BDCs, the stocks had collapsed, and were trading often at 50% of their book value and with yields in the mid-teens. The bargains did not last. As the overblown concerns faded, amid a broad stock market rally, the sector jumped by almost one third, before drifting down again.
Companies differentiate themselves
Though not at the extreme levels of early 2016, the group is worth a look at again. Some stocks have held up far better than others, of course. Many sport yields over 9% and trade below net asset value. Over the last two years, there are been many developments in the sector, including the merger of the largest two companies in the space. As the space has become ever more competitive, there has been a growing dispersion of credit standards among the BDCs. Some have stuck to their high credit standards, looking for competitive advantages. Others have loosed quality to generate yields. The result: Some companies have been forced to cut their dividends, sometimes not once but several times. This only reinforces the need to be selective in the space. After all, a BDC is a structure; there can be high-quality and low-quality ones, just as there can be good and bad corporations or partnerships.
Business Development Companies lend money to small- and medium-sized private businesses. Like REITs, they do not pay tax at the corporate level provided they pay out essentially all of their net income annually. Thus, two attributes are common to BDCs: the yields tend to be high, while, without the ability to accumulate earnings, they must continually raise new capital. These attributes can provide the astute investor with good buying opportunities, as we’ll explain.
Not all BDCs are the same, of course. Some are very conservative, investing primarily in first-lien, collateralized notes, while others will happily buy mezzanine or junior debt (for higher returns); some invest in equity. Some focus on a particular sector (such as healthcare or technology). And so on.
Looking at the group I am recommending for current purchase, yields are between 7% and over 10%, all very attractive yields in today’s market place. Two trade just above NAV, while the other trade just under NAV. In all cases, the dividends are reasonably safe, as are the NAVs.
