Yields over 10 percent sound too good to be true—and they often are. But there is one reputable sector that has routinely paid out way-above average income: business development companies, or BDCs.
Established by Congress in 1980, BDCs are essentially closed-end funds that lend money to small companies, usually in the form of secured or unsecured bonds. To avoid taxes, BDCs typically pay out 90 percent of their income to shareholders, hence the extra-high payouts.
One BDC we especially like now is Greenwich, CT-based TICC Capital Corp (NASDQ: TICC), which recently yielded 11.4 percent. TICC provides debt funding—from $5 million to $30 million—to small companies mainly in the tech sector.
We’re particularly impressed with TICC’s management. Like all BDCs, TICC runs a leveraged operation—it borrows money and lends it to smaller companies, many of which are themselves highly leveraged. But management has shown that it can consistently make the most of this leverage by borrowing at relatively low rates and finding good places to lend that money for substantially higher rates.
Most of the investment analysts at BDC have been with the company since its 2003 start, and they all have impressive backgrounds at Wall Street investment banks. CEO Jonathan Cohen, for one, managed technology research at Merrill Lynch, UBS and Salomon Smith Barney.
Because of a spate of new investments, TICC has been beating earnings estimates—by 48 percent in the second quarter of 2012. Given a year-to-date return of 20 percent, and a recent history of beating expectations, this equity is worth a look for a small sliver of an aggressive-income portfolio.
The CLO Kings
We have been particularly impressed by TICC’s ability to maneuver the debt markets since the financial crisis of 2007-2008.
TICC raised close to $44 million through a 2003 IPO, shortly after it was formed. It used this money to invest in mostly tech companies, with good results. But then the 2007-2009 financial crisis hit, and like all BDCs, TICC posted major loan write-offs, cut its dividend (to 60 cents annually) and sold assets to pay off debt.
But management never stopped looking for good deals. And they realized that the
“lower tranches” of Collateralized Loan Obligations—then yielding 20 percent or more—
presented a major buying opportunity. (CLOs are financial instruments that bundle payments from many different types of business loans and pass them on to different classes of owners grouped in various tranches. The higher tranches get less of the loan interest, in exchange for assuming less risk, while more of the interest goes to the lower tranches because they agree to get the brunt of any defaults.)
CLOs were being indiscriminately dumped in 2008-2009 because they have similar structures as Collateralized Mortgage Obligations (CMOs), many of which were filled with highly risky mortgages. But TICC realized that CLOs had little to do with the troubles of CMOs. So it invested up to 30 percent of its assets in CLOs, allowing it to reap very high yields and increase its dividend. (see graph, below).
In 2011, after CLOs became more pricey, TICC issued its own CLO to raise money: a TICC subsidiary raised $225 million by issuing investment-grade senior debt backed by TICC’s own portfolio of mostly senior loans (outside the tech industry), and with TICC serving as the first-loss party.
This new source of funding allowed the TICC to bulk up its balance sheet, and benefit from the spread between what it pays out on its own CLO vs. the income from its loan portfolio, including other types of CLOs. In fact, TICC is the leader in CLOs, among the business development companies.
And so far in 2012, TICC has had no problem raising money. A total of $138 million has come into its coffers ($105 million in 7.5 percent convertible notes maturing in 2017 and $33 million from selling 3.45 million shares at $9.65).
As of June 2012, around 43 percent of TICC’s $439 million in assets was in technology companies, and another 29 percent in “Structured Products,” various CLOs that are not individually identified.
In total, the company recently had bond holdings valued at roughly $211 million, with an average maturity of close to 4.5 years. Most of TICC’s portfolio companies pay interest and preferred dividends on a quarterly basis, except for a few companies that pay semi-annually.
Good Business Sense
To maximize returns, TICC has strict criteria that companies must meet to receive funding. Companies can be private or public but must have an experienced management team with a solid track record in their industry, and allied with well-known financial backers or strategic partners. TICC looks for companies with enterprise values (or market capitalization) of less than $300 million and annual revenue of less than $200 million.
As of September 2012, TICC had 46 companies in its portfolio, with a continued focus on technology: software and hardware, the Internet, IT services and infrastructure, network systems, the semiconductor industry and telecom (see table below). In addition to technology, TICC makes opportunistic investments in other industries, such as health care and advertising.
The Bottom Line
TICC’s income has fluctuated over time: from $44 million in 2007—down to a low of $21 million in 2009—and back up to $45 million in 2011. But we see the current uptrend continuing, as TICC continues to benefit from putting its new assets to work.
For the second quarter of 2012, TICC had total investment income of $20.5 million, up 84 percent from the year-ago quarter, partly boosted by a one-time fee of $3.4 million from one of its portfolio companies (American Integration Technologies, LLC), and partly from higher invested assets.
We are long TICC shares and recommend buying up to $10.50 (the recent price was $10.17). One concern: under worsening credit conditions (which we consider unlikely at this time), the CLO market will be among the first to be affected. And since TICC is the first-loss party on its CLO, it would have to absorb the initial losses, leading to a potential reduction or suspension of the dividend.
What do you think of this article? Please post your feedback in the “comments” section below!
Todd Johnson publishes Dividend Lab, a web site focused on income investing.
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