What makes a high-yield business development company able to deliver such oversized rewards?

To answer this question, I think you have to understand what makes any investment outperform. And to answer that question broadly, the answer seems to be valuation. Finance 101 dictates that the less you pay for a future stream of cash flow, the greater your return should be.

More specifically, the lower the price you pay for earnings before interest, taxes, depreciation, and amortization, or EBITDA, the higher your returns should be. In fact, studies confirm that the cheapest stocks by EBITDA have historically rewarded investors with the biggest returns.

How does this apply to private markets?
Business development companies don't buy publicly traded companies. They invest primarily in the debt and equity of private companies. So what's the connection to BDCs?

Well, if you look at BDCs -- or more broadly, private equity -- you find that returns tend to be in the smallest companies. And, perhaps not surprisingly to those who survived the first 100 words of this article, the best returns in private equity come from the smallest companies, because they're the lowest priced.

To clarify, I'm not talking about the lowest-priced or smallest BDCs. I mean the lowest-priced and smallest portfolio companies of a BDC -- the companies the BDC owns and invests in.

So, to round it out, the way to outperform is to go smaller.

This is a chart from Flag Capital showing the pricing discrepancies between small and large private companies. You should notice a trend: the bigger the private company, the bigger the EV/EBITDA multiple you pay to buy it. Although the valuation obviously varies by industry, the general rule holds true that smaller companies beget smaller valuations, and vice versa.

The difference is not trivial. The largest companies are more than 50% more expensive than the smallest.

Astute readers should come to a few quick conclusions:

  1. BDCs that invest in smaller companies have an advantage over those that invest in the largest. Smaller companies can pay larger interest rates on debt, given their lower leverage. Additionally, smaller companies offer the best EBITDA bang for a BDC's buck, given their lower purchase multiples.
  2. A lot of money can be made growing a small business into a large one. Not only do the earnings grow, resulting in a higher price, but more earnings means a higher multiple on those earnings, effectively compounding the improvement. It is common practice for private equity investors to try to create valuation arbitrage by combining multiple lower-priced small companies into one larger, higher-priced big company. All in all, the larger the company, the more competitive the sale, and the better the price.
  3. BDCs that invest in smaller, "lower middle-market" companies actually have one more advantage in the form of raising cheap leverage. Right now this is 10-year fixed-rate debt at prices just basis points over what the U.S. government itself pays to borrow. The Small Business Administration makes this leverage available only for investments in super small U.S.-based companies. This is a clear subsidy; the government lends at rates well below what private capital providers would charge.

Who's who in the lower middle market
The smallest of private companies are considered to be the "lower middle market." Definitions vary, but I like Main Street Capital's (NYSE:MAIN) definition of companies that generate $3 million-$20 million in annual EBITDA. According to the Small Business Administration, about 175,000 domestic companies fit that definition.

Triangle Capital (NYSE: TCAP) defines lower middle market as companies with annual revenue of $20 million-$250 million, of which 65,000 fit that definition. Either way, it's a big market of really small companies relative to public companies.

Of the publicly traded BDCs, Main Street Capital and Triangle Capital appear to be the leaders in the lower middle market, if only by default. Both companies started as lower middle-market companies, and despite their growth, they remain largely invested and dedicated to finding new lower middle-market investments. Smaller Fidus Investment (NASDAQ:FDUS) also fits as a lower middle-market BDC.

In typical fashion, Main Street, Triangle, and Fidus all maximize the use of cheap leverage from the SBA.

TCAP Total Return Price Chart

TCAP Total Return Price data by YCharts.

If you look at their histories, you'll see that these three BDCs have been top performers. Main Street and Triangle Capital lead the pack of all BDCs, while Fidus ranks among the best externally managed companies. Main Street and Triangle Capital obviously have the advantage of lower operating costs, something Fidus doesn't have given its external management arrangement.

To round it all out, if you want to find top-performing BDCs, I'd suggest looking to the lower middle market. Lower middle-market BDCs invest in the cheapest of private equity companies, generating fatter spreads on debt and higher earnings returns on equity. All else being equal, that gives them an edge over your average BDC.

Those BDCs that compound the advantage with low-cost operating models -- such as Main Street and Triangle Capital -- only extend their advantage over their peers. Call it a win-win that has resulted in very clear outperformance over time.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.