In these dividend-hungry times, investors have schooled themselves on the ABCs of MLPs and REITs, two investment vehicles noted for their hefty payouts. Perhaps another sector worth doing homework on is BDCs.
BDCs, or business development companies, invest in or lend to small- to midsize companies and provide managerial assistance in hopes of profiting as these businesses grow. They look and act like private equity firms, but most are publicly traded entities listed on the major stock exchanges. As such, they bring the private equity experience to retail investors with the click of a button, while also offering greater liquidity and, in theory, more transparency.
Like real estate investment trusts, BDCs are treated as regulated investment companies under the Investment Company Act of 1940, which grants them favorable tax treatment in return for distributing at least 90% of their taxable earnings to shareholders. And that means big fat dividends for BDC investors. How big? As of March 5, the median yield for the 33 BDCs tracked by SNL Financial was 9.1%. The stalwarts included MCG Capital Corp. (16.4%), Apollo Investment Corp. (15.9%) and Saratoga Investment Corp. (15.1%).
As an industry, BDCs rank near the top of the dividend food chain. According to Stifel Nicolaus, the only industry with higher dividend yields was mortgage REITs (13.9%). After BDCs, the next highest groups were master limited partnerships (6.1%), telecom (5.4%) and REITs (4.8%).
But a huge dividend can be a red flag, raising fears that it's masking underlying weakness in the issuing company and is simply unsustainable. And investors often punish the stocks of dividend cutters. To gauge the strength of BDC dividends, it helps to know the basics of this obscure sector.
BDCs are a relatively new industry created by the Small Business Investment Act of 1980 in response to a capital markets crisis during the 1970s when private equity and venture capital firms complained that ownership limitations imposed on their investment vehicles by the '40 Act made it hard for them to invest in small, growing businesses.
The 1980 amendments to the '40 Act paved the way for public entities to invest in private companies via debt or equity capital. But it took a while for the BDC concept to catch on, and it wasn't until earlier last decade that a steady stream of BDCs launched their IPOs.
The industry's growth took a breather during the recession, but the IPO pace regained steam the past two years, and there are a handful of BDC IPOs in the queue and ready to go out this year. (There are also a handful of non-traded BDCs that have hit the scene during the past few years.)
Their growing presence boils down to two main factors: Investors are starved for yield at a time when bond rates are low and bank rates are essentially nonexistent, and businesses are starved for capital to grow their operations.
"One could argue that BDCs are the solution in this current environment when banks don't have the money to lend to the middle market," says Steven Boehm, head of the capital markets and investments team at Sutherland Asbill & Brennan LLP, a law firm in Washington, D.C. "BDCs provide capital. Logically, this industry should be much bigger."