ABCs of BDCs

03/25/2015 10:00 am EST

Focus: STOCKS

Bob Frick, editorial director of Investing Daily, discusses a high-yielding sector within the Maximum Income for Retiree portfolio maintained at Personal Finance newsletter. Here, he discusses the Business Development Company sector and highlights four favorite investments within the market.

Steven Halpern:  Joining us today is Bob Frick, Editorial Director of Investing Daily and contributing editor to Personal Finance, one of the Nation’s longest running and most widely read financial newsletters.  How are you doing today, Bob?

Bob Frick:  Doing great Steve, how are you?

Steven Halpern:  Very good, thanks for joining us.  Today we’re going to look at a sub-sector of your portfolio that’s designed for maximum income for retirees and that segment is known as Business Development Corporations (or BDCs). First, could you explain a little about how these vehicles work?

Bob Frick: Yeah, they were actually started in 1980 when, if you remember, the economy was kind of in shambles—banks weren’t lending—so congress said, alright, we’re going to give some special tax breaks to encourage lending to small- and medium-sized businesses.  

So, basically, it’s a financial firm which does lending and does equity investing in small- to medium-sized businesses and they’re given tremendous tax breaks that they can pass along high yield to investors.

Steven Halpern: Now, why are BDCs so attractive for income oriented investors?

Bob Frick:  Well, they pay high income, I mean, that’s the mainstay. The average is 9%—9%—and not only is it high but it’s relatively low in risk just because of how these companies are structured.

Also, these are structured like a closed-end mutual fund, basically, and because of that and because of the nature of how these things are put together, they tend to have very steady prices so you don’t have a lot of volatility.

Steven Halpern:  Now, you also highlight another reason to consider this sector and that’s the chance for smaller investors to gain exposure to private equity. Can you expand on that?

Bob Frick: Sure. Private equity is one of, say, the three things that small investors—Venture capital is one of the other things—that small investors cannot invest in by law, because you have to be an accredited investor, which means either you have to have a lot of money or be making a lot of money and if you know what you’re doing, you can get superior returns to the stock market by investing in private equity.  

So, the great thing about private equity then is it gives you a higher return but also, it’s not correlated to the stock or bond markets, so it tends to just kind of travel depending on its own winds.  If you have some BDCs in your portfolio, it will actively decrease the overall volatility of your portfolio because they are an entirely different animal.  

Steven Halpern:  So, let’s look at some specific business development companies and one is Ares Capital with the symbol (ARCC). What’s the attraction here?

Bob Frick:  Well, there’re a number of things to look at when you seek a BDC. One of those things is stability. Just, kind of by charter, they have to have certain financial measurements that make them inherently stable, but added to that, is the experience, the depth of experience of the company that manages the BDC.  

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Now here you have Ares Capital, which manages this one. It’s run by Ares Management, it’s a huge multinational, international finance company, manages about $86 billion of assets, so they put together this BDC, about half of it is made up of senior term loans, which means that if the company gets in trouble, these loans are paid off first so they’re the safest kinds of loans.  

The other thing that I really like about Ares is 19% is in equity, so they owe equity stakes at 19%, or 19% made up of equity stakes, and equity tends to help increase the value overall of the portfolio.  While the pound is steady, having a higher degree of equity can perhaps move the price of it higher.  

Steven Halpern:  Now could you tell us about BlackRock Kelso Capital, with the symbol (BKCC).

Bob Frick:  Right.  Just as with Ares, which is one of, you know, the dominant financial firms in the world, BlackRock, as I’m sure you know, is also—is the largest fund company in the world—and they partner with Kelso Capital to put together the BDC.  

It’s a closed-end fund, again, like all of these are, and one of the great things about it is not only does it invest solely in high credit rated, or high equity type of investments, with these small- or medium sized firms.  

Currently its net asset value is about 990 a share but it trades for 870 a share, so like a lot of closed-end funds, sometimes you can buy it at discount.

Steven Halpern:  Now you also point to Gladstone Capital with the symbol (GLAD).  What do you like about this company?

Bob Frick:  Well, Gladstone is a smaller company, so it kind of doesn’t have the pedigree of a BlackRock or of an Ares however, it’s extremely well run.  

It has paid a consistent dividend for 143 consecutive quarters, so they have extremely tight financial regulations—all these companies got hit during the great recession and Gladstone is no exception—but it pays, it’s remarkably consistent.

Now I should say, Gladstone pays about a 9.8% yield right now in distribution. BlackRock is the top of our list with a 10.3% distribution. Ares is about 8.9%, so all of these are extremely high paying vehicles.

Steven Halpern: Now, finally, let’s look at Main Street Capital with the symbol (MAIN). Could you tell our listeners about this outfit?

Bob Frick:  Yep. Main Street is a little bit of an odd duck in that it’s not managed by an external firm, basically, it’s managed internally.  For that reason, for one reason, that makes it a very low cost operating structure.  It’s about half the cost to its peer group, so it’s cheap.  

The other important distinction between Main Street is that—unlike some of these others—its share price tends to rise over time, so a lot of these, you know, and this is fine because you’re buying these for income.  

They trade within a certain range.  Ares tends to increase over time, so in 2011 for example, it was about $18.00 a share, right now it’s about $31.00 a share, so if you’re looking for a little bit more capital appreciation, Main Street is the way to go.

Steven Halpern:  Again, our guest is Bob Frick, of Investing Daily.  Thank you so much for your insights today.

Bob Frick:  Oh, my pleasure.  Thank you.

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