High Yield Income from Business Development Companies

U.S. Dividend Stock Investing for Canadian

Investors

High Yield Income from Business Development Companies

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High Yield Income from Business Development Companies

High Yield Income from Business Development Companies

The list of publicly traded business development companies (BDCs) is a small, unique

sector of the stock market. BDCs are attractive to investors because when they operate

well the shares provide steady dividends with attractive yields. Typical yields in the group

range from high single digits to low double digits. A lot of investors like the idea and want

8%, 9%, even 10% cash flow yields flowing into their portfolios.

Business development companies operate under the Small Business Investment Incentive

Act of 1980, which was an amendment to the Investment Company Act of 1940. The

1940 Act is the primary law governing investment products such as mutual funds, closedend funds and exchange traded funds.

The 1980 Act provided some exceptions to Investment Company Act rules. The purpose

was to open a new source of financing for small to medium size businesses that do not

have access to the public debt and equity markets. In structure, a BDC is closely related to

a closed-end fund.

A BDC operates under a strict set of rules. First, a BDC can only make loans or equity

investments in small to medium sized corporations that meet the criteria in the law. The

next rule is that a BDC can only have debt equal to the equity capital of the company. For

example, a new BDC sells stock and has $500 million from the sale. The company can

then borrow another $500 million, bringing the company¡¯s total investment capital to $1

billion.

By law, a BDC cannot over leverage itself. Finally, a BDC must pay out at least 90% of net

income as dividends to investors. If a BDC pays out 95%, it gets an additional tax break.

BDCs are ¡°pass-through¡± companies, which means if they pay out the 90% of income,

they don¡¯t pay corporate income tax.

The rules under which BDCs operate produce companies that have certain features. The

companies in the sector are primarily in the lending business. They make high rate loans

to companies that cannot qualify for traditional bank loans.

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High Yield Income from Business Development Companies

The interest income is passed through as dividends to share owners. A BDC may also take

equity positions in the client companies. These positions can be actual ownership or

equity warrants that pay off if a client is bought out or goes public with an IPO. A BDC

also provides management advice to portfolio companies. The typical BDC will have

hundreds of portfolio investments, which produces a wealth of information concerning

good business management practices.

A BDC will be either internally managed or have an external management agreement.

The companies in the sector are about evenly split between the two management

structures. Internal management is self-explanatory. The people that operate the BDC are

employees of the BDC. With external management, the BDC has a contract with an

outside asset manager to handle the investments and administration of the company.

The external manager will earn a base fee of about 2% of assets and incentive fees when

the portfolio exceeds a preset return, typically above 8% annually. In general, an

externally managed BDC will suck off significantly more money for management expenses

as a percentage of assets than the expenses of an internally managed one.

Business Development Company Challenges

The way the BDC rules are structured leads to several hurdles which can prevent a BDC

from providing long-term positive investment results to investors.

Risky Business. By law, a BDC provides debt and equity capital to small to mid-sized

corporations. These are companies that cannot get bank financing due to the riskiness of

their business operations. They are too small to tap into the public debt and equity

markets.

The core business of every BDC is to make high rate loans to companies that likely cannot

get business financing from any other source. A BDC will experience some level of loan

losses. In a good economy the losses will be smaller. If the economy has problems, the

BDC could experience significant losses in its loan portfolio.

This is a serious problem for a company operating as a BDC. Remember that by law, a

BDC must payout 90% of its net earnings. This rule prevents a BDC from setting aside loan

loss provisions, as regular banks do. For a BDC, loan losses will lead to an inevitable

drawdown of the company¡¯s portfolio value and the equity capital in the company.

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High Yield Income from Business Development Companies

A BDC can only have debt to a maximum of one times the equity, loan losses can force

the BDC to find some way to reduce its debt load ¨C not an easy task for a company that is

shrinking in size.

As a result, each BDC must have a plan to offset the inevitable loan losses. The most

common strategy employed by management teams in the sector is to grow their way out

of declining portfolio values. This is done by issuing new shares of common stock, which

allows a BDC to take on debt equal to the capital raised from the stock offering.

This new capital is put to work making new loans, and the growth covers up loan losses.

With this strategy, a BDC must make regular offerings of new stock shares, and issue new

debt to support the current dividend rate. Often, a BDC will also take equity positions in

client companies. These ownership stakes can pay off with higher returns which will

offset some of the loan losses and support a BDC¡¯s book value.

The bottom line is that a BDC management team needs to peddle fast just to stay even

with its ability to generate interest income and support the current dividend rate.

Management vs. Investor Conflicts. As I noted above, the majority of BDCs are operated

by an external money management company. The management fees charged by external

management contracts are almost always higher as a percentage of assets compared to

BDCs with internal management.

External management fees can top 3% of assets per year, while a well-run internally

managed company will have expenses below 2%. Since most of the external management

fee is based on the amount of assets in the BDC, an external manager grows its income

by growing the asset base.

This growth may not result in better results for common stock shareholders. You saw

from the previous section, that a BDC must grow its assets just to stand still as far as its

ability to pay dividends.

Share Price vs. Book Value. Investors like to find opportunities where a security is trading

at a discount to its net asset or book value. For a BDC, having the share price trade for

less than the book value is a very big danger signal. First, if the stock is trading for less

than book, a BDC cannot issue shares without an approval vote from shareholders.

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High Yield Income from Business Development Companies

As noted on the previous page, BDCs need to issue shares to grow, and selling shares at a

discount dilutes the book value. When a BDC is trading at a discount it is on the wrong

side of the grow or die equation. If the BDC share price is at a premium to book value,

that is a powerful benefit for investors.

Each time a company with a strong share price issues shares, it is accretive to book value.

The share price to book value is a very important metric when evaluating a BDC for

investment. My rule is to never buy or own shares of a BDC trading at a discount to its

book value.

Conclusions

The business development company sector is attractive to investors because of the high

yields and the apparent safety of rules that limit the amount of debt leverage one of

these companies can use. However, the restrictions that keep a BDC from having loan

loss reserves is, in practice, a big detriment for one of these companies to operate as a

steady and dependable dividend paying stock.

The BDC sector is littered with companies that got behind the loan losses and low share

price to book value curves and were forced to slash dividends. As an income investor you

want to dig out those BDCs with business operations that produce stable to growing

dividend payments. You want to own shares in the companies that trade at a premium to

their book values. Currently only two business development companies meet my criteria

to be Dividend Hunter recommended stocks.

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