Dividend Lovers May Appreciate Business Development Companies

By Harry Domash

Dividends paid by most corporations, are, in effect, taxed twice.

A corporation first pays taxes on the income that it generates to fund the dividends given to its shareholders. Those same shareholders then are taxed when they receive the dividends.

However, Business Development Companies (BDCs) are an exception. These corporations don’t pay income taxes as long as they distribute at least 90% of taxable income to shareholders, and meet certain other requirements.

Business Development Company Advantage

Why do BDCs get this break?

Back in 1980, the U.S. Congress created BDCs, technically “regulated investment companies,” as a way of encouraging the flow of investment capital to middle-market-sized businesses. These are firms with annual revenues typically in the $25 million to $500 million range. They are too small to “go public,” but too large to borrow from their local banks.

BDCs make mostly short-term, unsecured loans from $20 million to $50 million to these clients. Such loans, when made to corporations, are often termed “mezzanine” financing.

To qualify for the corporate tax exemption, a BDC must loan at least 70% of its assets to private or thinly traded, public U.S. corporations, and must distribute at least 90% of its taxable income to shareholders in the form of dividends.

Further, a BDC must make significant managerial assistance available to its client companies. In fact, BDCs often take equity interests in their client companies to create the opportunity for the BDC to rack up capital gains when it liquidates those positions. BDCs can qualify for additional tax breaks (lower federal excise taxes) when they distribute at least 98% of ordinary income, plus 98% of any realized capital gains, to shareholders as dividends.

With many paying 9% to 13% yields, and some even paying monthly, BDCs are attractive investments. On the downside, because they don’t pay corporate taxes, dividends paid by BDCs are not subject to the 15-20 percent maximum tax rate. Instead, BDC dividends are taxed at ordinary rates. Thus, it’s best to hold them in tax-sheltered accounts.

BDCs Have Risk

BDCs suffered during the 2007-2009 economic meltdown when many of their clients were unable to service their debts. Almost all BDCs cut their dividends during that period and BDC shares prices got hit hard.

BDCs’ dividends and share prices recovered along with the economy in the 2009-2012 time frame. Business boomed and, with savings and money market accounts paying next to nothing, investors flocked to the often double-digit yields BDCs were paying.

However, all of that good news attracted competition, and many new BDCs were formed and went public in the 2012-2014 timeframe. Now, there are probably twice as many BDCs as before, but not twice as many potential clients. Thus, the business is more competitive, and hence, profit margins are lower than before. Consequently, less than 50% of the BDCs that I follow produced positive shareholder returns over the past year.

Results Worth the Effort

All that said, several conservatively financed, well-managed BDCs produced 11% to 14% total returns (dividends plus share price gains) over the past year. To put that into perspective, the overall market, at least as measured by the S&P 500, dropped 2% during that time. So, it’s worth taking the time required to pinpoint the best BDCs.

INVESTING CONSIDERATIONS

Categories

A few BDCs focus on particular investment categories, mainly technology, but most serve clients in a wide range of industries. However, while almost all say they serve middle market clients, some focus on the low end of that range, while others cater to larger firms.

Smaller is Better

All BDCs’ profit margins hinge on the difference between their cost of capital and what they charge their clients. BDCs catering to the very smallest firms can often access U.S. Small Business Administration sponsored low-interest loans, reducing their cost of capital.

Internally vs. Externally Managed

Most BDCs are externally managed. That is, they pay a third-party management company a percentage of total assets for their services. By contrast, a few BDCs are internally managed. They hire employees to do the job. According to a published report; management fees average around 3% of assets for internally managed firms vs. around 4.25% for those using outside managers.

Rising Interest Rates

Rising interest rates, which usually accompany a growing economy, should bode well for BDCs. Most of their clients would be prospering, and the BDCs could probably adjust client interest rates to the market.

Valuation

The market typically values BDCs based on trading price vs. tangible book value (see below for definitions). In theory, BDCs should trade at their tangible book value. However, in practice, in-favor BDCs trade higher, while underperformers typically trade below book value. Bottom line: you’re not necessarily getting a bargain if you pick a BDC because it’s trading below book value.

CATEGORIES

Here are more details on BDC categories, plus my category investment ratings, from A to F, where A is best, along with a major player in that category.

Small Clients: Rating A

BDCs in this category generally invest $3 million to $30 million in firms with $10 million to $100 million in annual sales. Main Street Capital (MAIN) is one of them.

Mid- to Large Clients: Rating B

Typically invest $15 million to $200 million in firms with $50 million to $500 million in annual sales. Prospect Capital (PSEC) is an example.

Startups: Rating B

BDCs in this category focus on startups, mainly in technology or biotech. Hercules Capital (HTGC) is part of this group.

Monthly Payers

Many income investors prefer to receive monthly dividends, rather than the more common quarterly payouts. The following BDCs pay monthly.

Full Circle Capital (FULL): Small Clients category.

Gladstone Capital (GLAD): Small Clients.

Gladstone Investment (GAIN): Small Clients.

Prospect Capital (PSEC): Mid- to Large Clients.

MORE ON ANALYZING BDCS

BDCs profit from the interest collected on their loans and from fees for providing management assistance to their clients.

The capital gains that BDCs earn when they sell their ownership positions in client firms also contribute significantly to income. Unlike interest and fee income, which is relatively consistent from quarter to quarter, capital gains come in lumps and are hard to predict.

That aspect makes BDCs difficult to analyze because in a quarter without capital gains, it may appear that a BDC is not generating enough income to cover its dividends. Another factor to keep in mind is that because they must pay out most of their profits to shareholders rather then reinvesting them, BDCs either must borrow or sell more shares to finance growth.

Valuation

Tangible book value growth is the best way to gauge a BDC’s performance from a shareholder value perspective.

Shareholders’ equity is assets minus liabilities. Book value is shareholders’ equity expressed on a per-share basis. Tangible book value subtracts intangible assets and goodwill from the assets used in the calculation.

Ideally, tangible book value should be growing from year to year. Most BDCs trip up in that department occasionally, but the closer they come to consistent growth, the better.

Debt

Debt is another important factor to consider. High-debt (overleveraged) firms tend to underperform. Use the debt/equity (D/E) ratio, which compares total debt to shareholders equity. The higher the D/E ratio, the higher the debt. Stick with ratios below 1.0 and lower is always better.