One of the best ways to create wealth is by investing in companies that pay a dividend. While many different types of companies pay dividends, business development companies (BDCs) represent a unique opportunity. BDCs are required to pay out 90% of their taxable income to investors each year. For this reason, BDCs tend to garner a lot of attention from investors looking to supplement their portfolio with some dividend income.
Investing $100,000 in the three ultra-high-yield BDCs discussed below could generate $10,000 of passive income for your portfolio this year.
Hercules Capital: 11.5% dividend yield
Hercules Capital (HTGC 1.85%) is a prominent BDC that lends money to companies in the technology, life sciences, and energy sectors. The company specializes in an instrument called venture debt -- or loans made at high interest rates.
Generally speaking, during the early days of a start-up, founders will raise money from venture capital or private equity firms in exchange for equity. However, this form of capital-raising eventually becomes less attractive because of ownership dilution. For this reason, once the start-up reaches a maturity point generating consistent cash flow, it may seek out alternative financing options like debt.
If you invest one-third of the proposed $100,000 investment, Hercules should provide more than $3,800 in annual dividend income at its current yield of 11.5%. Although there are always risks associated with any investment, I am not worried about Hercules. The company has a terrific track record, returning nearly 200% to shareholders during the past 10 years.
Moreover, one prediction I made for 2024 is that mergers and acquisitions will see a rebound this year. Given the unique deal structures that Hercules employs, obtaining warrants than can convert into equity, the company is well positioned to enjoy some nice returns in the event of an acquisition or initial public offering (IPO) from one of its portfolio companies.
Image source: Getty Images.
Horizon Technology Finance: 9.9% dividend yield
Another leading BDC is a major competitor to Hercules called Horizon Technology Finance (HRZN 0.35%). The company was founded 20 years ago and has completed more than $3 billion in venture debt transactions across more than 300 portfolio companies. Allocating another one-third of the proposed $100,000 investment could generate about $3,300 in dividend income given its 9.9% yield.
Similar to Hercules, Horizon typically includes equity warrants in its deal terms -- a feature that allows the company to benefit from the upside during a liquidity event. During the past decade, Horizon stock has a total return of more than 160%. Clearly the stock has been a multibagger investment for long-term investors, and I think it looks cheap right now.
Horizon stock currently trades at a price-to-book (P/B) ratio of less than 1.3, slightly below Hercules's P/B of 1.5. With a successful long-term track record and an improving macroeconomy, I think Horizon is an overlooked opportunity for dividend investors.
Ares Capital: 9.6% dividend yield
Ares Capital (ARCC +0.00%) is probably the most recognized name on this list. The company's returns have consistently crushed the S&P 500, making it a no-brainer for long-term investors.
While Hercules and Horizon typically compete for the same business, Ares is slightly different because it focuses on middle-market companies that may fall off the radar of investment banks and other BDCs. Moreover, the company's balance sheet strength and disciplined approach to due diligence provides Ares with some differentiated product offerings. What I mean by that is the company has the flexibility to work with much larger enterprises and even assist in more complex financing transactions such a leveraged buyouts.
The company's superior reputation and generous returns have attracted some of the largest investors in the world. In fact, even Warren Buffett owns a position in Ares through Berkshire Hathaway's subsidiary New England Asset Management.
The company's 9.6% dividend yield on the last third of the proposed $100,000 investment could generate roughly $3,200 in dividend income -- bringing the total amount to about $10,000 in passive income.
