Investors have sought more income from their investments ever since interest rates on bonds and bank CDs plunged after the financial crisis. Business development companies offer one way that income investors can boost the yields on their portfolios, albeit with quite a bit more risk than an FDIC-insured bank account. Let's take a closer look at business development companies to see if they belong in your portfolio.
Understanding business development companies
In a nutshell, business development companies are the closest that ordinary investors can get to a private-equity investment. BDCs trade on public stock exchanges, but their main purpose is to create and manage portfolios of privately held investments. In many ways, this makes BDCs look like the private-investment equivalent of mutual funds or ETFs.
Indeed, the IRS has given BDCs the same tax advantages that ETFs and mutual funds enjoy: treatment as a registered investment company. As long as BDCs distribute at least 90% of their income to their shareholders, they qualify as pass-through entities that therefore don't have to pay corporate-level tax. Although shareholders have to include the BDC's income on their own tax returns, getting taxed only once gives BDCs an advantage over investing in regular corporations.
One size doesn't fit all
Income investors have gotten used to encountering little-known investment vehicles in their search for higher yield. Many of these vehicles, including master limited partnerships and mortgage-oriented real estate investment trusts, involve common aspects that make most of the members of a particular asset class look fairly similar. For instance, all mortgage REITs invest in mortgage-backed securities of one type or another, and the vast majority of MLPs have exposure to energy or natural resources markets, whether it be pipelines that transmit and distribute oil and gas or companies that produce mined products or fertilizers.
For BDCs, though, businesses vary greatly, as different business development companies have much different exposure in their underlying portfolios. Consider the following:
- Apollo Investment (NASDAQ: AINV ) , which yields nearly 10%, focuses primarily on secured loans and subordinated debt, with health care companies Aveta and inVentiv Health and HR specialist Ceridian among its investments.
- Prospect Capital (NASDAQ: PSEC ) provides both debt and equity capital to middle-market companies. With a nearly 12% yield, the BDC sports investments in dozens of different companies, ranging from formerly public Pre-Paid Legal Services to umbrella- and glove-maker Totes Isotoner.
- Ares Capital (NASDAQ: ARCC ) invests largely in senior debt and secured loans, with minimal exposure to subordinated debt and equity. Its biggest position is in asset manager Ivy Hill, but the portfolio includes more than 150 different companies. It currently yields a bit less than 9%.
As you can see, the particular investments that a given BDC makes have a dramatic impact not only on its current yield but on its overall return as well.
Know what you own
Because of BDCs' flexible nature, you have to truly understand and have confidence in what a business development company is doing before you invest in it. High yields may look attractive, but sometimes, you're bearing plenty of risk for which those sizable payouts have to compensate you.
For instance, American Capital (NASDAQ: ACAS ) is a BDC, but it also plays an important role in managing the mortgage-backed securities portfolios of mortgage REIT American Capital Agency (NASDAQ: AGNC ) . That doesn't expose American Capital shareholders to the risk of the mortgage REIT's portfolio, but it does mean that management fees flow from the mortgage REIT to American Capital's management subsidiary. If something happens to jeopardize those management fees, then American Capital could suffer.
Moreover, BDCs don't necessarily always pay dividends. American Capital, for instance, hasn't paid a dividend in more than four years, preferring instead to buy back shares at below book value as an arguably better way of returning capital to shareholders.
Are business development companies right for you?
BDCs have unique risk attributes that aren't right for everyone. If you're comfortable with exposure to the tiny companies that tap BDCs for capital infusions, though, then buying into a business development company might be just the opportunity you're looking for.
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