Allied Capital (NYSE:ALD) is part of a rather unique sector in the public markets. It is a closed-end management investment company that makes long-term private investments. This type of operation is typically referred to as a business development company (BDC). For tax purposes, it is structured as a regulated investment company (RIC), which means that the company has to pay much of its taxable income out to shareholders as dividends -- hence the reason that Allied and other BDCs like American Capital and Apollo Investments (NASDAQ:AINV) all trade with substantial dividend yields.

The business
The company focuses on making business loans to middle-market companies. It provides long-term debt, as well as equity capital, in deals as large as $250 million. A key requirement for BDCs is that they offer managerial expertise to assist the company as needed; sometimes, Allied has to step in and more substantially assist a company if it begins to struggle. Keep in mind, though, that Allied seeks to invest in established companies with $50 million to $500 million in revenues and strong cash flows, companies that have been around for decades.

Using a centralized decision-making process and extensive due diligence, the company has compiled quite a successful track record. It has delivered a 22% annual internal rate of return on its investment exits since 1997, as well as a 19% annual total return to shareholders with dividends reinvested over the last 10 years. For the dividend junkies, this company has paid dividends continuously since 1963!

Allied Capital focuses on the total return to shareholders. It seeks to drive strong, sustainable investment results by earning current income from its debt investments and long-term capital gains from its equity stakes. For example, the company would much prefer a 20% total return complemented with capital gains, which can be difficult to forecast, rather than settling for a simple, easier-to-forecast 13% return on debt. As a result, the company's investment income is made up of both interest income from debt investments, as well as net realized gains from portfolio exits, whereas many other BDCs seek to build a sustainable dividend on interest income alone.

The portfolio's performance
That makes it all the more puzzling when we consider that Allied's dividend was flat from 2003 through 2004; wouldn't it benefit from such great investment results?

Dale Lynch, executive vice-president and director of investor relations for Allied Capital, clarified this for me. "Our dividend remained flat for a while as the economy weathered a recession," Lynch said. "It is common for portfolio growth to pause in recessionary periods, and we held off on any dividend increases until we were able to begin growing the portfolio again. Our Board's dividend policy is to announce increases to the regular quarterly dividend that it believes are sustainable over the long run, and in 2006 our regular dividend per share grew by about 5%."

And the portfolio gains have been coming in fast and furiously. Since 1997, Allied has recognized about $1.1 billion in realized gains, by far the largest in the BDC industry, much of it coming in the last several years -- $117 million in 2004, $274 million in 2005, and $543 million through September 2006, with much of the 2006 gains derived from two big scores -- Advantage sales and marketing, and STS operating.

Advantage is a leading sales and marketing agency for food products and consumer packaged goods, and it originally had a cooperative ownership structure. Allied was first introduced to Advantage by virtue of an earlier investment in Advantage Mayer in 2001, one of its cooperative members. The company invested $257 million in equity and debt in June 2004 to acquire Advantage. It focused on reducing costs and improving efficiency and cash flows by consolidating the cooperative structure, and in March 2006, Allied sold the business for a substantial gain. It is worth noting that Allied actually sources many of its investments from its current portfolio.

This leaves the company with a substantial $540 million carry-over, due to the realized gains. This is income that it can carry over year-to-year, subject to a 4% excise tax. "Instead of paying this out in a one-time extra dividend, we have elected to spill over the income in order to provide our investors with good visibility into the dividend for future years," Lynch said. While it does now have the income available to raise the dividend substantially, it wants to make sure that any increased regular quarterly dividend is sustainable over the long run.

Dealing with competition and managing risks
American Capital (NASDAQ:ACAS) has been fairly innovative recently, raising capital by entering the asset management space and making bond offerings -- tactics that are substantially different than the standard BDC secondary offering. But pushing the envelope might not result in the same type of gains that American has enjoyed in the past. Allied Capital also has an investment grade rating -- BAA2 and BBB+ from the rating agencies -- and has recently done a $250 million offering of five-year notes, as well as another $400 million offering last July. The crux of the issue with an external asset management effort is that typically only 20% of any realized gains trickle down to shareholders of the advisor. In an internally managed investment company such as Allied, 100% of the realized gains are available for the benefit of its shareholders.

Many people perceive commercial banks like Citigroup (NYSE:C), Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) as BDCs' toughest competition, but the companies really do not compete in this space. The banks typically focus on hard assets, and do not want to provide the type of operational hands-on management that BDCs typically do; they look to be passive, not active investors. Many of the companies that Allied invests in come to the company not only for the cash, but for the operational and management expertise. Even then, the company invests in a small fraction of the deals it sees -- it saw roughly $48 billion worth of deals in 2005, and $69 billion through October 2006. Also, many investors perceive BDCs as 'lenders of last resort' that investing in fly-by-night companies. That is incorrect; the typical portfolio company has been around for decades.

The biggest risk here is probably a substantial macroeconomic downturn. This would affect Allied's investment results, while making it difficult for its portfolio companies. However, the company attempts to mitigate that risk by investing at lower leverage multiples than the industry average.

"Allied has remained disciplined when considering investments, so we can achieve strong returns through credit and business cycles," Lynch said. "You can see that in our leverage multiples versus the industry averages -- for the first nine months of 2006, we estimate that our weighted average first dollar of debt capital invested was in at about 2.2 times EBITDA, and our weighted average last dollar of debt capital was in at about 4.6 times EBITDA. Industry averages for typical subordinated lenders over the same time frame had the first dollar of debt capital invested at about four times EBITDA, and the last dollar invested at about 5.8 times EBITDA." (That's a fancy way of saying that Allied's loans are less leveraged than the industry average.)

Lynch also explained some of the primary misunderstandings that investors have regarding BDCs and Allied Capital. "Some investors often lump BDCs together by dividend yield, and choose the one with the highest yield as the best buy, and the one with the lowest yield as the worst. This ignores many of the factors that are key to evaluating BDCs, such as portfolio results and management expertise, among other things," Lynch explained. Allied emphasized the fact that BDCs are not all alike and are not commodities -- indeed, they often operate with very different strategies. Allied Capital focuses on its total return strategy, and aims to deliver conservative, reliable, and sustainable performance for shareholders.

In a nutshell, that's what I think BDCs like American Capital and Allied have to offer. These companies are very well-managed, and have historically delivered very high returns for shareholders. With many companies seeking expertise from these two leaders, their excellent returns are expected continue for the foreseeable future.

Bank of America is a Motley Fool Income Investor recommendation. Click here to learn more about beating the market with dividend-paying stocks.

Fool contributor Stephen Ellis does not own shares in any companies mentioned. You can view the stocks he owns and check out his 99th-percentile ranking in Motley Fool CAPS, the Fool's new stock-rating community. The Motley Fool has a disclosure policy.