DEVELOPING YOUR INCOME WITH BUSINESS DEVELOPMENT CORPORATIONS (BDC’S)

By The Sick Economist

Once you have become comfortable navigating the world of mortgage REITs, your next logical step is to learn about business development companies (BDCs). BDCs are a cousin of the mortgage REIT, both in corporate structure and business concept. If you can understand one, you can understand the other. Business development companies are somewhat more risky than mortgage REITs, but they offer stellar monthly cash flow. A few select BDCs can go a long way toward providing durable income diversification to fuel your retirement.

Much like a REIT, a BDC is a special corporate structure, authorized by Congress, that pays out 90% of its profits in the form of dividends. This means that, much like mREITs, the primary function of the entity is to kick off the maximum cash flow on a regular basis. Investors are only taxed once, at the personal level. It also means that, despite the complicated sounding jargon, the accounting is actually quite easy to understand. The cash flow sheet is what matters by far the most, so the vagaries of the profit and loss statement are less important.

BDCs are also like mREITs in the basic mechanism used to generate cash flow. Business development companies borrow money at very low interest rates and for short time periods, and they invest that money at very high interest rates for longer periods of time. In this case, however, they don’t buy mortgages. Business development companies make high interest rate loans to specialized businesses. The result for investors can be monthly income that can equal 10, 11 or even 12% of their total investment.

Why And How?

When I first learned about BDCs, my first question was, “why do these entities even exist?” If I wanted a loan for my business, why wouldn’t I just go to a bank? Why do BDCs exist when established, big name banks also give out loans?

The answer is related to risk, reward, and regulation. Most banks use the funds of depositors to make loans. This means the hard earned savings of grandmas and average working stiffs. These regular folks deposit their savings with a bank because they believe the savings are safe. This means that banks, by law, have very strict guidelines about how and when they are allowed to utilize depositors money to make loans. Banks are interested in low-risk, low-reward, long-term loans in businesses that are easy to understand.

These restrictions mean that there is a whole world of mid-market firms that would have trouble securing a loan from a bank. An example of a mid-market firm would be a family dry cleaner that had, over time, grown to a chain of one hundred dry cleaners. Or a firm owned by private equity investors that has hundreds of millions of dollars in revenue, but is not generally known on Wall Street or by the general public. For every big name, publicly traded firm like Apple out there, there are tens of thousands of mid-market firms; businesses that are growing rapidly, but not necessarily on any bankers short list of desirable credits.

In particular, BDCs tend to thrive by servicing niche markets. One example of a niche BDC that does very nicely is Horizon Technology Financial Corporation (HRZN). Horizon specializes in loans to mid-market companies in the biotech and IT sectors. Horizon makes secured loans, which can utilize intellectual property as collateral for a loan. Can you imagine your average loan officer at Bank of America trying to figure out the collateral value of a new molecule? This is why dozens of companies have turned to Horizon. They need a lender that understands their particular niche.

A lot of BDCs specialize in short-term, high-interest rate loans. One could use the term bridge loan. An example would be a biotech that is planning to go public in the next year. The time between the company filing it’s paperwork to go public and the day of the actual IPO could be 12 months or more. This would mean that the biotech is expecting a big influx of cash soon. In fact, they may actually be working with an underwriter on the IPO that has guaranteed a big influx of cash. But in the meantime, the biotech may actually need more cash to ramp up operations in expectation of this IPO. They wouldn’t want to sell stock, because they have this big liquidity event coming up, and they don’t want to dilute the ownership stake of the existing shareholders. Enter the BDC. The BDC provides a high interest loan, secured against intellectual property, that only lasts for a year. When the biotech client goes public, they immediately turn around and pay off the high interest loan. Meanwhile, the BDC has made great interest, and can now turn around and recycle the same money. If you repeat this same process while minimizing any loan losses, the situation gets lucrative very quickly. That high rate of income and the recycling of capital is why many BDCs can pay an investor double-digit dividend yields month after month.

Risks

So, BDCs share a lot of factors in common with mortgage REITs. One thing that BDCs do not share in common with agency mortgage REITs is that they are not investing in loans that are guaranteed. Which means BDC management teams are borrowing money to turn around and lend that money to smallish corporations that can default. In theory, this makes BDCs risky. But many BDCs have done a thorough job of managing risk.

If you want to see an example of how a sharp BDC management team can navigate risky waters, check out New Mountain Financial Corporation (NMFC). New Mountain focuses on what they call defensive sectors, i.e. business sectors that are resistant to economic downturns. This theory was put to a radical test during the worst of the coronavirus crisis. With America closing down, and businesses failing left and right, these were scary times for business development companies.

NMFC responded by providing extensive transparency to investors. They furnished frequent reports quantifying and explaining the financial situations of each of the loans that they had outstanding. They made some swift moves to limit their exposure to the worst hit sectors of the economy, and maximize exposure to sectors that “won” the coronavirus crisis.

The result? Not only did NMFC not go bankrupt during this time of national crisis, but investors would have barely noticed any crisis at all if they hadn’t been paying careful attention. The company did temporarily trim their dividend by less than 20%. But other than that, the cash flow kept rolling, month after month.
Not every BDC did this well, but a surprising number of lending corporations came through the entire ordeal unscathed. This means that BDCs have earned a place in the income portfolio of any investor who lives off of passive income.

How To Invest

There are dozens of different business development companies out there. Not all are created equal. How do you choose the right ones for your portfolio?

One approach is simply to go with the largest companies. Larger companies have deeper pockets, better connections on Wall Street, and larger stakeholders that make it hard for them to go bankrupt. According to theblalance.com, here are the ten largest business development companies by assets under management as of Spring 2021.

Ares Capital Corp (ARCC): $6.96 billion
Owl Rock Capital (ORCC): $5.70 billion
Prospect Capital Corporation (PSEC): $3.20 billion
FS KKR Capital Corp (FSK): $3.03 billion
Golub Capital BDC, Inc (GBDC): $2.35 billion
Goldman Sachs BDC Inc (GSBD): $1.57 billion
Main Street Capital Corp (MAIN): $1.43 billion
New Mountain Finance Corp (NMFC): $1.19 billion
Hercules Capital (HTGC): $1.18 billion
TPG Specialty Lending Inc. (TSLX): $1.14 billion

If you stick with the top half of this list, you gain a degree of safety due to sheer size.

Another way of selecting some good BDCs for your income portfolio is to choose companies that specialize in a niche that you know. For example, I know a lot about biotech (I actually wrote a book on the subject, Your First Biotech Million). That is why I chose Horizon Technology (HRZN). They make loans to a lot of biotech concerns. I feel that I am in a unique position to understand the quarterly reports they send me, and take action if necessary. (That would be rare, by the way. I almost always buy and hold).

There are dozens of BDCs that serve specialized niches. If you feel that you know a lot about construction, you can find a fund that specializes in construction lending. If you feel that you know a lot about IT, you can find a firm that focuses on information technology. Everybody knows about something. Leverage your knowledge to pick some winners.

Lastly, if you just want a taste of the sector, but don’t want to spend time and energy researching something that is not your core competency, you can always buy an exchange traded fund that represents the sector. This way, you will gain broad exposure to the asset class, without betting too much on any one sector. Because the BDC sector is itself considered to be a niche investment, one of the few pure play ETFs is BIZD (Van Eck Vectors ETF BDC INCOME ETF). This exchange traded fund is currently paying a meaty 9.4% yield, delivered to your inbox monthly. Many other alternative income exchange traded funds offer some amount of BDC exposure. One example would be the Global X Superdividend Alternative ETF (ALTY). Although this exchange traded fund does not focus purely on BDCs, it offers a broad range of high dividend, niche companies that favor big cash flow. ALTY pays slightly north of 8% dividend yield at the moment.

If you think of your retirement income portfolio as a savory gumbo, with many tasty ingredients all boiling together in a pot, you can consider the BDC sector as a dash of cayenne pepper to give the gumbo some kick. You would never want your portfolio to have more than 5 or 10% exposure to business development companies. But just a dash of these high dividend yield corporations can spice up your retirement income in a flash.