Business development companies (BDCs) lend money to private companies in the form of fixed and variable-rate loans that usually have an equity “kicker” attached to them; they fill a void between venture capital and conventional financing, explains Jim Pearce, senior editor of Investing Daily's Personal Finance.
Their creditor companies tend to be small to mid-size businesses that lack sufficient assets to fully collateralize a bank loan. However, most of these businesses have strong cash flows, which means they can pay interest on the loans out of operating capital.
The objective is to keep these companies growing until they can qualify for cheaper financing through a regular bank or equity offering, at which time the BDC is cashed out of the deal and moves on to the next small company to finance.
A typical BDC will lend to dozens of companies spread across several industries. In addition, it will limit the minimum and maximum loan amount to any one borrower to avoid being overexposed to a single risk factor.
At the end of every quarter, each loan is “marked to market” based on the degree to which it is performing or making timely interest payments.
BDCs must pay out at least 90% of net taxable income as dividends to their shareholders to avoid paying corporate income tax, similar to the rule governing real estate REITs and MLP.
The safest way to invest in BDCs is through an exchange-traded fund (ETF) that owns dozens of them to provide maximum diversification. Last month, we added the Van Eck Vectors BDC Income Fund (BIZD) to our fund portfolio. The current dividend yield for BIZD is 9.5%.
We also feel that holding a few high-quality BDCs is a great way to increase the overall yield on your equity portfolio.
For example, we own Gladstone Capital (GLAD) in our model portfolio. With net assets of $227 million, it is relatively small compared to some of the most popular BDCs. Gladstone is ranked 32nd among its peers in portfolio size, but its performance has been among the best.
Since we added it to the Maximum Income Portfolio four years ago, GLAD has returned more than 50% to its shareholders. Over half of that gain has been in the form of cash dividends, which GLAD currently pays monthly at an annualized rate of 9.2%.
Gladstone’s loan portfolio consists primarily of manufacturing companies with sustainable profit margins and rising cash flows. It avoids highly cyclical businesses and early stage tech companies. That keeps loan defaults to a minimum as evidenced by less than 1% of its assets being classified as non-performing.
Gladstone also protects its share price by having 90% of its portfolio in the form of variable rate loans. If inflation starts going up, so does the interest rate that Gladstone’s portfolio companies must pay on their loans.
Gladstone currently lends to more than 50 companies in 10 sectors. For that reason, the biggest threat to its share price would be a protracted recession that impacts the overall economy. The sector of the economy most vulnerable to sudden swings in input prices, oil and gas, makes up only 15% of Gladstone’s portfolio value.
