When you take away the nuances, Gladstone Capital (GLAD 0.39%) is a corporate lender with a monthly dividend yielding almost 9% at recent prices. That may sound pretty enticing to income-oriented investors. The problem is that the nuances matter a great deal. Here is what you need to know before adding high-yielding Gladstone Capital to your portfolio.
What exactly is it?
Gladstone Capital is part of the Gladstone Management family, which also oversees a publicly traded real estate investment trust (Gladstone Land) and other assets. Thus, Gladstone Capital pays fees to its parent, Gladstone Management, which handles day-to-day operations. There are potential conflicts of interests in this arrangement, most notably that there are incentive structures in the fee arrangement that could lead management to make investments just to inflate its fees. This doesn't appear to be a big issue, but it is one that investors need to keep in mind here.
Gladstone Capital, meanwhile, is structured as a business development company (BDC). Simplifying things, a BDC is an investment company that provides loans to other companies and passes the income it earns through to investors, avoiding taxes at the corporate level. Most of that income will be taxed as ordinary income at the investor level. This is similar in many ways to a real estate investment trust, which helps explain the high yield on offer here.
Gladstone Capital specifically invests in smaller and middle-market companies with EBITDAs in the $3 to $15 million range. Its investments range in size between $8 million and $30 million. At the end of September 2020, the end of the company's fiscal year, the total portfolio was worth roughly $450 million spread across 48 companies. It often invests along with other asset managers, including large private-equity shops. And it tends to take an active role in working with the companies in its portfolio, including board-level appointments.
In some ways, an investment in Gladstone Capital is sort of like investing in a small private-equity company. The key benefits are the dividends and the liquidity that comes with a publicly traded stock. However, there are some negatives to consider here before jumping aboard.
The first thing to consider here is that Gladstone Capital is investing in pretty small companies that likely lack the ability to get loans from other sources. That's not inherently a bad thing, as the average interest rate on the company's loans was a hefty 10.9% at the end of fiscal 2020. But that interest rate, when broader rates are near historic lows, speaks to the inherent risk involved in the loans Gladstone Capital is making. Diversification across many relationships helps limit the risk of any one investment, but it doesn't change the overall nature of the types of companies in which Gladstone Capital invests.
Add on to that risk is the fact that Gladstone Capital itself is a very small company, with a market cap of just about $300 million. It can punch above its weight because of its affiliation with Gladstone Management, which oversees around $3 billion in assets, but on its own it is an industry small fry. This could lead to more volatility in the share price and, perhaps, limits the types of companies it can work with. For example, its deal sizes are small partially because it can't afford to ink bigger ones.
The dividend, meanwhile, is highly dependent on the underlying performance of its investments. For example, the dividend was cut in half during the 2007-to-2009 recession. It was trimmed a less material 7% in early 2020, when the economic shutdowns used to slow the spread of the coronavirus pandemic upended the market and economy. Although the recent headwinds didn't lead to the same level of dividend cut as seen during the great recession, it is a poignant reminder that investors need to go in here knowing that periods of economic hardship can and do translate into reductions to the dividend.
Leverage is another point to keep in mind. Gladstone Capital uses debt to help fund its deals, making the spread between its cost of capital and the interest it earns. At the end of fiscal 2020 it reported a debt-to-equity ratio of roughly 96%. That's not an insignificant level, though not one that should be overly troubling for a business development company. The real issue is that leverage can exacerbate the downside if an investment the company makes doesn't work out as planned. It's inherent to the business model, but something that conservative investors might be leery of given Gladstone Capital's small size and history of dividend cuts.
The bottom line
There's nothing obviously wrong with Gladstone Capital, which has proven it can survive difficult times given that it lived through the 2007-to-2009 recession and the current pandemic headwinds. Muddling through may require dividend cuts, but investors who understand the company shouldn't be surprised by this. The bigger issue for those enticed by the high yield is whether or not the inherent risks here are worth the reward. That likely won't be the case for conservative dividend investors. This company, like most BDCs, is really only appropriate for more aggressive types that like to take a hands-on approach to their portfolios.