Don't Count on "Spillover" Income to Save These Double-Digit Dividend Yields

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Business development companies make money by lending to and investing in companies deemed too risky for banks to touch, using the profits to pay dividend yields to their investors that frequently rise into the double digits. By paying out more than 90% of their earnings, BDCs can avoid corporate-level taxation, much like real estate investment trusts can, which only helps boost their yields to investors.

But if there is one thing investors should know, it's that a BDC's dividend isn't necessarily representative of the company's profitability, nor is any dividend ever truly safe from being cut. Increasingly, BDCs are encouraging investors to focus on less traditional earnings measures and putting more emphasis on so-called "spillover" income as an insulator against the risk of dividend cuts in the future.

Though they weren't the only ones to do so, Ares Capital Corporation (ARCC 0.44%), Main Street Capital (MAIN 0.55%), and PennantPark Investment Corporation (PNNT 0.44%) all referred to spillover income on recent earnings calls, making them a good sample for understanding what spillover is and why it isn't the safety net many purport it to be.

Getting technical

To know if a dividend is safe, you have to know how investors look at a company's ability to generate sufficient earnings to pay it.

Put simply, a BDC's portfolio isn't all that different from yours. On a $100,000 portfolio of stock and bonds, you might earn $750 a quarter in interest and dividend income, but the value of those stocks could easily drop to $90,000 or rise to $110,000 in a span of three months. You could logically conclude that the income produced from this portfolio is pretty stable. It might generate income of $700 one quarter and $800 the next, but the income it generates wouldn't be nearly as volatile as the fluctuation in the value of the investments from quarter to quarter.

This is how investors look at BDCs. Investors typically look at net investment income as a measure of a BDC's ability to pay its dividend over the short term. If net investment income per share exceeds dividends paid per share, then many conclude all is fine. "The dividend is safe," some might say, since recurring earnings covered the dividends that the BDC paid to its shareholders. To a lesser extent, BDC investors tend to look only at long-term trends in net asset value, as the quarter-to-quarter gyrations are often more noise than signal.

Of course, finance is a game of estimation and approximation. BDCs are actually required to pay out 90% of so-called taxable income, which can vary wildly from GAAP measures like net investment income. I'll spare the details, and say only that a common reason for the difference between them is generally due to the timeline for recognizing income.

Here's a great example: when a BDC makes a new loan, it will frequently accrue the origination fees it earned from writing the loan over several quarters or years. However, for tax purposes, the full amount of the origination fee is taxable income when the loan was issued.

Thus, a BDC which earns $50 million of fee income this year would have $50 million of taxable income in 2016. However, the BDC might accrue these fees into earnings at a rate of $10 million a year for the five-year life of the loans, for example. 

The heart of the issue

Let's get back to the whole issue of "spillover" income. That's the focus here.

BDCs do have to pay out 90% of taxable income, but they don't necessarily have to pay out their taxable income in the year it was earned. They can carry a portion into future years. This is known as "spillover" income, or taxable income that has not yet been paid out in dividends to shareholders.

Often, BDCs pitch the existence of spillover income as some form of protection against dividend cuts, suggesting they can fall back on spillover income to make a dividend payment if taxable income weakens.

You'll hear or read about "spillover" income on many quarterly conference calls and in earnings press releases. One would be forgiven for thinking it's a critical number for dividend sustainability. An amusing way to think about spillover is that it really has more to do with earnings in the past. The three BDCs we're looking at today all disclosed spillover income on recent conference calls.

Spillover income vs. dividends for a handful of BDCs:

Data sources: SEC filings, conference call commentary. Figures for spillover income are as of the company's most recent disclosure. Actual amounts of spillover income aren't known for certain until tax returns are filed.

The numbers can be striking. That Ares Capital has more than half a year of dividends in the treasure chest to pay shareholders is undoubtedly a reassuring factor to many investors who own it for its 10% dividend yield. With all that banked income, they could hit the golf course for 180 days and give their borrowers a pass on a payment and be just fine, right? Well, not exactly.

No free lunch

Theoretically, BDCs can cover any shortfall between earnings and their dividends by tapping stockpiles of spillover income. In reality, it isn't so simple. I'll explain.

Let's say Big Yield BDC has $0.50 of spillover income per share, and routinely generates $0.05 less in taxable income each quarter than it pays out in dividends. This BDC would run out of spillover income in just 10 quarters if these results continue. Many investors may be comfortable knowing they have at least 10 more solid dividends and shake it off.

But that's not the real issue. The real issue is cash. Investors want dividends that are paid in cash. If cash earnings can't support the dividend, the cash must come from somewhere else: selling some investments, borrowing the money, or issuing stock.

None of these choices are ideal. Selling assets generates cash today at the expense of lost income in the future, resulting in a widening gap between income and the dividend. (Think of this like selling 10% of your retirement portfolio each year to pay your bills; eventually you'll run out of investments to sell and you'll have to sell more and more assets with each passing year since the shrinking portfolio produces less income over time.)

Similarly, borrowing money brings increased interest expense and risk. (Think of this as taking a margin loan against your portfolio to pay your bills. You'll eventually run out of investments to borrow against, and spend more of the income generated by the portfolio on interest payments. In addition, your risk of a margin call will increase exponentially with each dollar borrowed. It's a quick fix, but not at all a good one.)

That leaves us with issuing stock, which simply isn't in the cards for most BDCs, as most trade under book value. Furthermore, issuing new shares results in more shares on which the company would need to pay a dividend, exacerbating the original problem of income that is too low to support a high dividend yield.

Spillover income in the real world

Of the three aforementioned BDCs, PennantPark Investment stands out like a sore thumb for potential risk of a dividend cut. Even after cutting expenses by cutting management fees paid to its managers, the company earned just $0.25 per share in operating income last quarter versus a dividend of $0.28 per share.

Take it to an extreme and stress test it to see how accessible its spillover income really is. Suppose the company were to pay out its $0.53 per share of spillover income. Book value, which stood $8.94 per share at the end of June, would necessarily drop to $8.41 per share to reflect the dividend payment.

Declining book value isn't the No. 1 problem here. Getting its hands on the cash is. PennantPark Investment would need to start selling assets, borrow more money, or both, none of which is good. (Total liabilities would rise to about 110% of equity, up from 102% at June 30, 2016, if it paid for the payouts with asset sales and new borrowings. Raising cash for the dividend isn't the only concern; creditors will eventually want the company to start deleveraging its balance sheet to offset the rising leverage as cash flies out the door in dividends.)

The same is also true of Ares Capital and Main Street Capital, albeit to a much lesser extent. Ares would need nearly $258 million in cash to pay out its spillover income, and liabilities would rise to about 80% of equity from 76%. This assumes Ares funds the spillover payments with asset sales and/or borrowings.

For Main Street Capital to pay out spillover income of $49 million would require it sell assets, borrow money or issue new shares of stock. Selling assets and/or borrowing the capital would result in liabilities that rise to 84% of equity versus 81% at the end of the most recent quarter.

Ares Capital and Main Street Capital earned their dividends in the most recent quarter, but by small margins. Neither is as levered as PennantPark, which gives them more wiggle room to pay dividends out of spillover income and hope for improvement, but it doesn't in any way mean that there is no consequence to doing so. A BDC that pays out more than it is earning will simply bleed assets; earnings should follow.

Ultimately, the main point I want to make is that spillover income is not cash set aside for emergencies. It's not some readily available fund for making dividends that can be tapped without consequence, even if BDCs that are on the brink of a dividend cut might suggest it is.

As a general rule of thumb, when a BDC starts pushing the issue of taxable income versus GAAP net investment income, you might want to step back and really reflect on whether its current dividend is sustainable. PennantPark Investment shareholders might want to do some particularly deep thinking. Profits from prior periods are no savior when a BDC is meaningfully under-earning its dividend despite a highly levered balance sheet.