Know Your BDCs

Investors often lament that the so-called “smart money” benefits from opportunities that elude the average investor. But the market does offer retail investors a class of securities that gives them a stake in the portfolios of some of the most skilled investors in the country.

Business development companies (BDCs) are closed-end funds that were first organized as a result of the Small Business Investment Incentive Act of 1980. The legislation was intended to create financing vehicles to offer middle-market firms access to financing that the capital markets had failed to provide on their own.

From a certain perspective, BDCs are equivalent to publicly traded private equity firms. They provide mostly private companies with long-term debt and some equity financing.

Although BDCs have been in existence since the 1980s, there were few BDCs prior to 2000. But during the last decade’s credit bubble, the number of BDCs burgeoned alongside the growth of private equity. Today there are nearly 30 publicly traded BDCs tracked as part of the Wells Fargo Business Development Company Index, which was created to capitalize on investor interest in this sub-sector earlier this year.

Although BDCs’ largely illiquid investments in small, growing companies makes them extraordinarily risky securities, their debt portfolios throw off handsome yields—often in excess of 10 percent—to compensate investors for enduring their volatility. That yield is partially the result of the high rates they charge such companies for financing and partially the result of legislation. Like real estate investment trusts (REIT), BDCs are required to distribute at least 90 percent of their income and short-term capital gains to investors.

Despite such enticing yields, the current economic environment means that BDCs are only suitable for investors who have the patience to hold them in their portfolios through a full market cycle. Although most BDCs maintained some form of dividend during the last downturn, some temporarily suspended payments, while many others reduced the level of their distributions.

As a consequence of the Great Recession, many BDCs winnowed troubled loans from their portfolios. Of course, as major borrowers themselves, BDCs were forced to deleverage with asset sales.

But that dismal experience caused BDCs to become better prepared to endure the next downturn. Many BDCs’ debt-toequity ratios are now below 0.5. Beyond deleveraging, some BDCs improved their capital structures further by shifting their own sources of capital from bank revolvers, whose borrowing rates fluctuate over time, to fixed-rate medium- and longer-term debt.

Because most BDCs have been beaten down in sympathy with the broader financial sector, they currently trade at steep discounts to their net asset values. That may present an opportunity for risk-tolerant investors to buy their assets on sale.

Ares Capital Corp (NSDQ: ARCC) is one of the leading firms in the BDC space and currently yields 9 percent. It specializes in providing first and second lien senior loans and mezzanine financing to middle-market companies. In recent quarters, Ares has been busily deploying its substantial liquidity. During the third quarter, the firm made commitments to new investments that amounted to nearly a third of what it reported as its total assets at the end of the prior quarter.

In October, the company filed for a $2 billion equity offering. Although this move will dilute existing shareholders in the short term, Ares will likely take advantage of current financial sector turmoil to buy the valuable assets of one of its competitors at a deep discount.

Gladstone Capital Corp (NSDQ: GLAD) is considerably smaller than Ares, but it’s part of a suite of asset managers that includes a REIT and a buy-out fund. Gladstone yields 10.4 percent and its dividend is distributed to shareholders on a monthly basis.

The fund specializes in providing small businesses with senior loans and junior subordinated loans. During the third quarter, the company negotiated more favorable terms on its bank revolver and added two new investments totaling roughly $42 million to its nearly $220 million portfo.

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