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.

What could go wrong?

There are three main reasons the stocks are so undervalued, to some extent misplaced or exaggerated concerns, in my opinion.

• Interest rates are moving higher.  When the market focuses on rates moving up, the BDCs often sell off. But the concerns are misplaced. 

  • First, most BDCs lend at floating rates; for Ares (as an example) 89% of their weighted loans are floating.  Yet, their own debt is usually at fixed rates.  Thus, rates moving up do not in themselves hurt BDC returns, and in the initial phase, can actually help.  The spread is what is important not the absolute level of rates.

• More important than the impact on the BDC returns is the impact on the companies to which the BDCs lend.  As rates move up, it has a negative impact on the ability of these companies to make money, and in the extreme, to survive. This comes into play only when rates move up very aggressively and the economy moves into a recession. Whether or not a recession is in the offing, we are a long way from rates moving up aggressively. 

• Typically, when rates move up and the economy slows, banks withdraw from small-business lending, meaning BDCs are able to lend to the best-quality small businesses who would otherwise go to banks. Banks have not been active lending to this segment since the credit crisis, but at the margin they can withdraw further.

All in all, I don’t think higher interest rates are a concern for BDCs in the foreseeable future.

• The second major concern is the impact of the new tax measure and specifically the limitations on interest deductibility.

  • Other things being equal, a lower corporate tax rate makes companies that do not pay tax (such as BDCs) relatively less attractive than at a higher tax rate.  But they are only relatively less advantageous.

• The limitations on interest deductibility do not affect the BDCs themselves, but could have an impact on the companies to which they lend.   Most BDCs have addressed this recently and the overarching themes are that they do not believe the businesses to which they lend carry so much debt that the limitations will have any or much effect.   After all, BDCs typically do not lend to over-indebted companies to begin with.  And the lower business tax rates will generally help small businesses.

• The third concern is of another recession. In a recession, some portfolio companies have difficulty servicing their debt, but most of the better BDCs see themselves as partners to their portfolio companies, rather than just lenders, so they work with them, and, in extremis, replace management.In addition, as mentioned, banks typically draw back from small business lending when the economy slows, leaving the field open to BDCs. No question, however, that a severe recession would cause some portfolio companies to default on their debt, reducing income for BDCs and even their ability to sustain their dividends.

  • More detrimental than a recession would be another credit crisis. In 2008-2009, some BDCs had difficulty borrowing money, or renewing their lines of credit. In some egregious cases, fully serviced lines were pulled without notice, forcing BDCs to liquidate quality assets at severe discounts.  The BDCs are fully alert to these potential hazards and have swore “never again.”  So we have seen more BDCs, even small ones, put in place more longer-term capital (through convertibles).

Strong companies

So, I believe the BDCs are in a much stronger position today than they were in 2008, having learnt their lessons from the credit crisis.  Other concerns are exaggerated or misplaced, and, in any event, the stock valuations fully discount these concerns.  In this environment, we want to emphasize the strong (often larger) companies more able to withstand economic turmoil, and also the ones that have a good history of focusing on credit at companies to which they lend. Right now, companies we like include the following.

• Golub Capital (GBDC, Nasdaq 17.91, 7.2%) is widely regarded, even by peers, as the most credit-conscious and high-quality of the BDCs. It focuses on first-lien, senior secured loans to healthy companies. It has not wavered from this approach, despite increased competition and lower returns. The company continues to fully cover its dividend, and indeed has paid bonus dividends in the last couple of years. Its non-accrual rate is just 0.6% at cost (and only 0.2% at fair value).

• Ares Capital (ARCC, Nasdaq, 15.76, 9.6%) is the largest and one of the more conservative of the BDCs. A year ago, it acquired American Capital, which held a lower yielding portfolio, including a lot of equity.In acquiring this portfolio, and increasing its share count, therefore, Ares’s income fell short of the dividend.Usually, this is a red flag for a BDC, but given Ares acquired the high-quality portfolio at a discount, it was far less of a concern to me.Ares’s outside manager agreed to waive up to $10 million of fee income per quarter for 10 quarters, sufficient to enable them to make up the short-fall in the dividend payout.As the rotation from the lower yielding portfolio into more traditional BDC-type assets has continued, Ares is getting closer to covering its dividend; last quarter it made 36 cents, compared with a dividend of 38 cents. Most analysts think it will once again fully cover its dividend during this year, and are even calling for a dividend increase.

Others to watch

These would be my top two BDCs for current buying, one best-in-class with a rock-solid dividend, and the other, also top-quality, with a depressed stock because of a special situation. We would also look at others, including Monroe Capital (MRCC, Nasdaq, 14.05, 9.96%), a smaller BDC ($285 million market cap), which it has just completed its 14^th consecutive quarter with a fully covered dividend.  And it continues to hold 30 cents of undistributed net income as a cushion for future dividends. Gladstone Capital (GLAD, Nasdaq, 9.1%) is another smaller BDC, but with a strong balance sheet (debt-to-equity ratio of just 0.65x) and conservative management which nonetheless continues to make loans.  Smaller companies are more likely to suffer in a serious recession, though the quality of the loans and the balance sheet are more important factors.

Given that the BDC sector is dominated by retail investors—an arcane rule requiring fund managers to add BDC management fees to their own fee ratio means that funds avoid the sector—the stocks tend to be volatile, which often offers good buying opportunities. Stocks can drop after a dividend is paid (often by more than the dividend), or when a company announces a new equity financing (remember, the companies must repeatedly raise new capital in order to grow since they distribute all net income, which includes capital gains).  Such dips can offer good entry points for investors.

In short, if you are an investor looking for steady and growing income, and not overly concerned about a volatile stock price, BDCs are a good place to look.