2012 was a watershed year for Business Development Companies (BDCs). Long considered an emerging asset class, the industry appeared to come of age, recording extraordinary growth. Consider that nine years ago, there were just four publicly-traded BDCs. Today, there are roughly ten times as many industry participants and total market capitalization is approximately $26 billion.

Although they may still lack widespread investor awareness, BDCs represent a powerful force in middle-market lending. In fact, they are playing an increasingly vital role in certain areas of the credit markets overall. Total growth in BDC investments have far outpaced growth in middle market loans themselves—a reflection of brisk BDC activity as well as the gradual retreat of larger banks from this sector.

As traditional banks have shied away from middle-market lending, alternative lenders like BDCs have filled the gap, earning lucrative rewards. Because small to mid-sized companies tend to be underserved, BDCs are able to lend at relatively higher interest rates than traditional banks. These higher rates are then passed back to shareholders in the form of a high level of dividend income, thanks to a structure which requires BDCs to pay out 90 percent of their income. It is a virtuous cycle that is set to continue as BDCs meet market demand -- and investors answer the siren call of attractive yields.

In fact, steady growth has led industry analysts to draw parallels between BDCs and two other investment vehicles – real estate investment trusts (REITs) and master limited partnerships (MLPs) – which also started out as relatively unknown, niche investments.

Decades ago, REITs and MLPs hovered at just a few billion dollars each in terms of industry market capitalization. Now, REITS and MLPs are each highly successful, well-established asset classes with market capitalizations of nearly $500 billion and $250 billion, respectively. Looking ahead, many believe that the BDC sector is poised to follow a similar trajectory. Industry analysts forecast continued growth both in terms of market size and sheer number of players as increasing awareness helps expand the industry’s investor base.

Numerous Advantages
Already there are signs of greater investor interest taking hold. Earlier this year, Van Eck Global launched the Market Vectors BDC Income ETF, an exchange-traded fund that tracks the performance of 25 companies, with a relatively high level of concentration in the top names.  According to Van Eck, “Investing in BDCs provides exposure to private companies that many investors could not otherwise access, allowing for potential growth and yield generation.”  Sponsors of the new ProShares Global Listed Private Equity ETF (PEX)—which includes global exposure to both BDCs and private equity—stressed investor access as well.

Yet, access explains only part of the allure. Liquidity is also a key consideration. There is a reason why the opportunity to invest in private, middle-market businesses has been typically reserved for institutional investors such as pension funds, family offices, foundations and endowments. Such sophisticated investors can meet the high investment minimums and stringent lock-ups that private limited partnerships typically impose. In contrast, with a publicly-traded BDC, investors retain the flexibility to enter and exit at any time with minimal transaction costs and exposure to the same assets.

Essentially, BDC shareholders capture the benefits of middle-market exposure without sacrificing daily liquidity -- and they do so with the convenience of one-stop diversification. Rather than investing in a single security, a BDC is more like a mutual fund that invests in a broad range of companies and industries.  As an extra safeguard, statutory guidelines require that BDCs take steps to minimize concentration risk and remain well-diversified. More than half of the portfolio must be in investments that represent less than 5 percent of total assets and no single investment can exceed 25% of assets.

With access, liquidity and diversification, it is no surprise that investors are warming to the BDC value proposition. But with interest rates near historic lows, there is one single advantage that seems to stand above them all: dividend yields that are much higher than other income-oriented investments, including REITs and MLPs. BDCs offer meaningful income thanks to yields that can reach double-digits—a rare commodity these days and one that has not gone unnoticed by retirees and other income investors.  

In the case of prudently managed BDCs, these attractive yields come with the added bonus of stability. Rather than stretching for yield, investors receive a healthy dividend without assuming undue risk. Since BDCs pay regular dividends based on the net investment income and capital gains they earn, their eye-catching dividends are supported by relatively stable, predictable cash flows.

Selectivity Counts
But that stability cannot be taken for granted: BDCs are not all cut from the same cloth. In fact, BDCs can invest in disparate asset classes and adopt very different approaches, depending on each management’s philosophy. For example, conservatively managed BDCs tend to target high-quality investments. In industry lingo, their portfolio emphasizes first lien loans, which are generally the highest priority in the event of the underlying company’s default. BDCs who favor first lien investments control the workout process. That way, if the loan sours, they are often able to capture meaningful recovery rates for shareholders.

The approach a BDC takes to structure its balance sheet can also reveal whether it is an efficient, well-run operation. For example, management can take proactive steps to defend against the impending threat of rising interest rates. By locking in borrowings at low fixed rates—and making predominantly floating rate investments -- select BDCs are well-positioned to profit as interest rates rise, a likely inevitability in this current economic climate.

The same cautious approach applies to leverage. By law, a BDC’s total debt-to-total equity cannot surpass a 1:1 level (with limited exceptions), which helps protect individual investors from unnecessary risk-taking. And on a relative basis, BDCs employ much lower leverage than banks and agency mortgage REITs. Yet even within those parameters, there is still variation. Some BDCs use more leverage than others to generate returns so it is wise to assess where a particular candidate falls relative to the peer group average.

One way to sift through potential BDC candidates is to look for those with an investment-grade rating from a nationally recognized rating agency. Think of an investment grade rating as a vote of confidence in terms of credit quality. Having such a rating confers a competitive advantage that can work in shareholders’ favor. For example, it should reduce a BDC’s overall cost of capital. Many banks have lower capital charges lending to companies with investment grade ratings, which can potentially improve profitability and facilitate an efficient use of cash flow.

In addition to an investment-grade credit rating, size can also be an important gauge of stability. Generally speaking, larger, well-established BDCs tend to attract a broader investor base for their shares and typically see a larger share of deal flow. They are more likely to deliver a higher quality and less volatile earnings stream with reduced funding risk for the benefit of their investors.

Taken as a whole, BDCs represent a compelling yield-oriented investment with a bright future. A dynamic, developing segment of the lending industry, they are attracting increased investor interest. Those who get in on the ground floor are likely to benefit from the attractive risk/reward potential of BDCs, but selectivity remains essential as industry participants proliferate.

Dean Choksi is senior vice president of finance and head of investor relations for Fifth Street Finance Corp. Fifth Street Finance Corp. is a leading alternative asset manager that provides financing solutions to private, mid-sized growing businesses. With a 15-year track record and investment grade credit ratings from both Fitch Ratings and Standard & Poor’s, Fifth Street ranks among the top five BDCs based on its market capitalization of over $1 billion. Fifth Street’s stock is listed on the Nasdaq Exchange under the ticker FSC. For more information, please visit www.fifthstreetfinance.com