How to Analyze BDCs
Business Development Companies
for BDC Directory
Dividends paid by most corporations, are, in effect, taxed twice. First
the corporation pays taxes on the income that it generates to pay the
dividends to its shareholders. Then, those same shareholders are taxed
when they receive the dividends.
Business Development Company (BDCs)
However, Business Development Companies (BDCs) are an exception. These
corporations don’t pay income taxes as long as they distribute at least
90% of taxable income to shareholders, and meet certain other
requirements. Why do BDCs get this break?
in 1980, the U.S Congress created BDCs, technically “regulated
investment companies,” as a way of encouraging the flow of investment
capital to middle market sized businesses. These are firms with annual
revenues typically in the $25 million to $500 million range. They are
too small to “go public,” but too large to borrow from their local
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make mostly short-term, unsecured loans from $20 million to $50 million
to these clients. Such loans, when made to corporations, are often
termed “mezzanine” loans.
qualify for the corporate tax exemption, a BDC must loan at least 70% of
its assets to private or thinly traded, public U.S. corporations, and
must distribute at least 90% of its taxable income to shareholders in
the form of dividends.
Further, a BDC must make significant managerial assistance available to
its client companies. In fact, BDCs often take equity interests in their
client companies, which creates the opportunity for the BDC to rack up
capital gains when it liquidates those positions. BDCs can qualify for
additional tax breaks (lower federal excise taxes) when they distribute
at least 98% of ordinary income, plus 98% of any realized capital gains,
to shareholders as dividends.
many paying 9% to 13% yields, and some even paying monthly, BDCs are
attractive investments. On the downside, because they don’t pay
corporate taxes, dividends paid by BDCs are not subject to the 15/20
percent maximum tax rate. Instead, BDC dividends are taxed at ordinary
rates. Thus, it’s best to hold them in tax-sheltered accounts.
got hit hard in the 2007/2009 economic meltdown when many of their
clients were unable to service their debts. Almost all BDCs cut their
dividends during that period and BDC shares prices got hit hard.
dividends and share prices recovered along with the economy in the
2009/2012 timeframe. Business boomed and with savings and money market
accounts paying next to nothing, investors flocked to the often
double-digit yields BDCs were paying.
However, all that good news attracted competition, and many new BDCs
were formed and IPO’d in the 2012/2014 timeframe. Now, there are
probably twice as many BDCs as before, but not twice as many potential
clients. Thus the business is more competitive, and hence, profit
margins are lower than before. Consequently, less than 50% of the BDCs
that I follow produced positive shareholder returns over the past year.
Worth the Effort
that said, several conservatively financed, well-managed BDCs produced
11% to 14%t total returns (dividends plus share price gains) over the
past year. To put that into perspective, the overall market, at least as
measured by the S&P 500, dropped 2% during that time. So, it’s worth
taking the time required to pinpoint the best BDCs.
A few BDCs focus on particular investment categories, mainly technology,
but most serve clients in a wide range of industries. However, while
almost all say they serve middle market clients, some focus on the low
end of that range, while others cater to larger firms.
All BDCs’ profit margins hinge of the difference between their cost of
capital and what they charge their clients. BDCs catering to the very
smallest firms can often access U.S. Small Business Administration
sponsored low-interest loans, reducing their cost of capital.
Internally vs. Externally Managed BDCs
Most BDCs are externally managed. That is, they pay a third-party
management company a percentage of total assets for their services. By
contrast, a few BDCs are internally managed. They hire employees to do
the job. According a published report; management fees average around 3%
of assets for internally managed firms vs. around 4.25% for those using
Rising interest rates, which usually accompany a growing economy, should
bode well for BDCs. Most of their clients would be prospering, and the
BDCs could probably adjust client interest rates to the market.
The market typically values BDCs based on trading price vs. tangible
book value (see below for definitions). In theory, BDCs should trade at
their tangible book value. However, in practice, in-favor BDCs trade
higher, while underperformers typically trade below book value. Bottom
line: you’re not necessarily getting a bargain if you pick a BDC because
it’s trading below book value.
MORE ON ANALYZING BDCS
profit from the interest collected on their loans and from fees for
providing management assistance to their clients.
capital gains that BDCs earn when they sell their ownership positions in
client firms also contribute significantly to income. Unlike interest
and fee income, which is relatively consistent from quarter to quarter,
capital gains come in lumps and are hard to predict.
aspect makes BDCs difficult to analyze because in a quarter without
capital gains, it may appear that a BDC is not generating enough income
to cover its dividends. Another factor to keep in mind is that because
they must pay out most of their profits to shareholders rather then
reinvesting them, BDCs must either borrow or sell more shares to finance
Tangible book value growth is the best way to gauge a BDC’s performance,
from a shareholder value perspective.
Shareholders equity is
assets minus liabilities. Book value is shareholders
equity expressed on a per-share basis. Tangible book value subtracts
intangible assets and
goodwill from the assets used in the calculation.
Ideally, tangible book value should be growing from year-to-year. Most
BDCs trip up in that department occasionally, but the closer they come
to consistent growth, the better.
Debt is another important factor to consider. High debt (overleveraged)
firms tend to underperform. Use the debt/equity ratio which compares
total debt to shareholders equity. The higher the D/E ratio, the higher
the debt. Stick with ratios below 1.0 and lower is always better.