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."

Non-Bank Lenders
BDCs are closed-end investment management companies that invest in businesses through various equity investments and debt securities--predominantly the latter, which can range from senior secured loans to non-investment-grade vehicles. "Basically, all they are is lenders," says Troy Ward, a BDC analyst at Stifel Nicolaus. "Their assets are all of these different loans they make to all of these different companies."

By law, BDCs must invest at least 70% of their assets in eligible portfolio companies. BDCs generally spread their bets across diversified portfolios with dozens of companies in different industries, although some have a strong focus on particular sectors.

Horizon Technologies, for example, makes secured loans to development-stage companies backed by venture capital and private equity firms in the technology, life science, health care information and services, and clean-tech industries. NGP Capital Resources Company invests in debt securities--and sometimes takes equity positions--in private small- to mid-size energy companies. Medallion Financial Corp. invests in companies that finance taxicab medallions, among other things (its ticker symbol is TAXI).

Some BDCs have relationships with financial heavyweights. One example is KKR Financial Holdings, which is managed by a unit of the private equity firm Kohlberg Kravis Roberts & Co. Another is BlackRock Kelso Capital Corp., an affiliate of global investment management firm BlackRock Inc.

By law, BDCs are limited to 1-to-1 debt-to-equity leverage (8-to-1 is typical at banks). But that didn't shield them during the recession, when share prices at BDCs went down the tubes. Problems occurred when some of the businesses in BDC investment portfolios couldn't service their debts, which negatively impacted the financials at many BDCs.

At the same time, BDCs had a hard time getting capital to invest in businesses because they were hurt like everyone else when the lending markets froze. In addition, they couldn't issue more shares in the secondary market because they're prohibited from selling shares if the stock price of these closed-end vehicles trades below their net asset value.

This all highlights the cyclicality of publicly traded BDCs. Some people consider BDCs to be alternative investments, but that's debatable--at least when it comes to traded BDCs--because their share prices tend to be correlated to swings in the economy. Whereas mortgage REITs are impacted by what interest rates do, BDCs are credit plays predicated on the underlying strength of the companies they make loans to.

"How well they do is based on how good the credit quality of the portfolio of loans does," Ward says. "If everyone pays back, BDCs do well. BDCs are cyclical to the business cycle. If we go into a deep recession, they will suffer."

And that's reflected in recent years by the share price performance of BDC stocks vis-à-vis the S&P 500. According to Stifel Nicolaus, total returns on BDC stocks outperformed the S&P 500 in 2005-06 when times were good; underperformed in 2007-08 during the recession; and outperformed in 2009-10 during the slow rebound. In 2011, BDC stocks tracked by the firm had a total loss of 7.4% versus flat returns on the S&P 500, a dip caused by recession fears during last year's summer swoon.

Sustainability
BDC stocks have rebounded this year, and many had posted returns that matched or exceeded the S&P 500 through early March. And robust stock prices at many BDCs have opened the door for additional funding through secondary offerings, enabling them to invest in more businesses to add to their portfolios. Issuing additional stock can be dilutive to shareholders, but because BDCs don't have retained earnings due to their pass-through tax status, they sometimes issue equity to grow.

"We've been working on about 10 of them [secondary offerings] during the past two months," says Steven Boehm from Sutherland Asbill & Brennan. "Many BDCs are back over their NAV and can go back to the markets, and underwriters are seeing strong demand for yield products."

Ward says one of the key metrics he and his BDC research team at Stifel Nicolaus focus on is operating earnings, which is based on the ability of companies in a BDC's portfolio to make interest payments on their loans. "We focus on earnings yield because we think of BDCs being a lot like REITs in that if you earn it, you have to pay it out to shareholders," Ward says.

Dividing recent BDC stock prices by their earnings, he notes, produces an earnings yield of 10%, or close to the group's collective dividend yield. "That's clearly sustainable because I think that's what they can earn," Ward says. "Nobody has a huge mismatch between their dividends and earnings right now."

Non-traded BDCs
In addition to publicly traded BDCs, there are also several non-traded BDCs which are touted to offer certain advantages over the traded variety. That said, these securities come with greater liquidity restrictions.

Philadelphia-based Franklin Square Capital Partners launched the first non-traded BDC in early 2009. That vehicle, FS Investment Corporation (FSIC), invests in senior secured loans of private U.S. companies across a range of sectors, with 78% of its capital in first and second lien positions.

FSIC's minimum investment is $5,000, and investors must either have a $250,000 net worth or both a minimum annual net income of $70,000 and net worth of $70,000. The offering price has gone from $10 a share initially to a recent $10.70.

Franklin Square CEO Michael Forman says the fund has raised more than $2 billion since inception and he expects it to reach $3.5 billion in gross assets when fund-raising is completed later this year. After that's done, Forman says they plan to launch FSIC II.

Last July, Franklin Square launched its second non-traded BDC, FS Energy & Power Fund (FSEP), to invest in the debt and equity of private companies in the energy and power markets. It has the same investor minimum requirements and initial offering price as FSIC, and so far has raised about $100 million.

Both BDCs are subadvised by GSO/Blackstone, the credit finance platform of the Blackstone Group. They're distributed through the independent broker-dealer channel, either with an up-front load in a commission structure or with no up-front load in an advisory fee structure. The recent yield for FSIC ranged from 7.5% to 8.1%, and the yield for FSEP ranged from 6.25% to 6.7%, depending on how it's sold to investors.

Non-traded BDCs have long holding periods of five years to seven years, and early redemptions generally come with a penalty. Forman says this enables Franklin Square to take a long-term view with their investments by tuning out the noise of market volatility. "We're able to build a portfolio of investments without needing to manage in a publicly traded environment," he notes.

The perception that non-traded BDCs are less volatile is appealing to some financial advisors. "When I talk to advisors about the pros and cons of non-traded vehicles, liquidity used to be a con, but in the past year it's almost gone to the pro side," says Susan Kelly, manager of alternative financial strategies at Commonwealth Financial Network, an independent broker-dealer whose platform includes Franklin Square's non-traded BDCs.

Ryan Wibberley, founder of CIC Wealth Management Group in Gaithersburg, Md., notes that non-traded BDCs aren't for every client. "I don't recommend this to clients who'll need that money within six to eight years," he says, adding that he puts no more than 5% of a client's portfolio into these securities. He says the non-traded BDC he's invested in has produced roughly 12% annual returns from current income, special distributions and capital appreciation. "People in retirement love them," he says.

Wibberley says he has used both traded and non-traded BDCs for clients, and considers the former to be more like equities, while the latter straddles the line between alternative investments and fixed income.

It's The Economy, Stupid
Investors can also invest in BDCs through two exchange-traded notes: the UBS ETRACS Wells Fargo Business Development Company (BDCS) and the UBS ETRACS 2X Wells Fargo Business Development Company (BDCL) funds. Both ETNs aim to track the Wells Fargo Business Development Company index, and both carry a 0.85% expense ratio.

In addition, Van Eck last May filed paperwork with the Securities and Exchange Commission to launch an ETF that would replicate the Market Vectors Business Development Company/Specialty Finance Index, a benchmark that is comprised of U.S.-listed BDCs and specialty finance companies. A company spokesman says no launch date has been set.

Investors who want to play in this space need to examine the pros and cons of traded versus non-traded BDCs, and to keep in mind the big economic picture. "BDCs are mainly a macro play," says Thomas Mason, senior analyst at SNL Financial. "If you believe an economic recovery is in the wings, BDCs are probably a good play."