Friday, November 8, 2013

What are Business Development Companies?

As an income investor, I look for high yielding assets that are safe, sustainable, and will grow to beat inflation. Sometimes that can be a tough fit for traditional blue chip corporations. Business development companies offer another way for the income investor to hit these goals.

Business development companies (BDC) offer loans to other businesses. Often these other businesses are very small, $5-$50 million in total size. They cannot or unwilling to get loans through banks or other credit avenues. At that size they may not get the best terms. However $500 million to $1+ billion sized BDCs have the leverage to get good terms. In fact BDCs can turn to large banks and use their size and credit history to get a loan then turn around and give one to the smaller companies at higher rates. They get to keep the spread between the two interest rates.

Business development companies have many differences between a standard corporation that requires income investors to look at and value them differently. The most important is not to use EPS for your calculations. BDCs do not run their business that generally accepted accounting principals (GAAP) would work for. Their income comes from interest payments and they have costs that does not translate into earnings. However they do have a stat that works just as well, Net interest income (NII). This measures the income they get from their loans. We can use it in place of earnings. Instead of a P/E ratio we have a P/NII ratio. If you want to see if they can cover the dividend then use a payout ratio based on NII instead of EPS.

Its important to understand how a company makes their profit and BDCs can be a little tricky at first as loans and debt have a hierarchy of priority in case of liquidation. When investing in Coca Cola (KO) valued at $175 billion you don't have to worry about them going out of business. $5 million valued Joe's BBQ with 4 locations in a suburb of one major city has this concern. If Joe goes out of business and assets are sold the bond holders and creditor get first dibs on the assets, Joe's shareholders are last. The following is a rough hierarchy of loans.
Senior Secured Debt: Senior means it comes before the others. Secured means that specific assets are set aside that if liquidation occurs, those assets are guaranteed to be sold to pay off the loan.
Senior Debt: This level is still near the top but no specific asset has been tied to the loan.
Subordinate Debt: Second in line after senior debt as to who gets paid.
Mezzanine Debt: This is getting to the lowest level of loan. At this point we can assume the company has multiple other creditors who would be paid before this credit does.
The lower tiers of debt are not always bad and to be avoided. If they are second or third in line they are going to get compensated for that higher risk of not getting paid by receiving a higher yield on the loan they give to the company. One thing to keep in mind is that there can be multiple lenders within each category to a company seeking a loan.

Loans are not the only thing BDCs offer other companies. The financial arrangements could include warrants which can be a loan with an option to convert it into company stock. Sometimes the loan deal a BDC gives to a small company includes actual shares of the company's stock. This entitles the BDC to any dividends from the smaller company and these shares are an asset that can be sold. The capital gains on the sale of stock and the dividends are profit for the BDC but not listed under NII. So you can have two or three different profit or income metrics for BDCs. Since the dividends coming to the BDC are not bound in a contract they could be cut. The sales of shares of stock are one time events. Personally I don't look too closely at these I focus almost exclusively on NIII. Why? I want to be sure the dividend coming from the BDC to me is covered by legally binding agreements month in month. If the company is paying a dividend to me that is higher then their NII then they have to do one of two things. Either cut the dividend or they have start selling assets to make up the difference. This may force the BDC to sell assets at inopportune times or when they are undervalued. This also leaves them in a bind next month when they have to go through it again.

Business development companies seems a lot more complex then a corporation to keep track off. Is it worth it? Yes they can because BDCs often choose to classify themselves as a regulated investment company (RIC) for tax purposes. That means that just like with REITs, BDCs have to give at least 90% of their taxable income as a dividend to their shareholders. In exchange for this, the BDC's taxes are a lot lower which is perfect because then that leaves more money to be paid out as a dividend to us. This does mean however that BDC dividends are not preferred dividends. BDCs can be high yielding cash cows often hitting double digit yields.

If a BDC has to give out 90% of their taxable income how do they grow? This is one of the things I love the most about the BDC sector. They constantly do secondary public offerings and sell more shares of stock but it is not dilution.
1: A BDC sells shares of stock. Often this is above the net asset value (NAV) of the company.
2: The BDC uses these funds to give out loans.
3: The loans generate dividends and grow the NAV as unused cash is deployed into assets, the loans.
4: Share price is pushed up as the fundamentals of the company grows.
5: Sell shares of stock at at higher price.
Rinse and repeat.

Disclaimer: The investments and trades discussed are not recommendations for others. I am not a financial planner, financial advisor, accountant, or tax adviser. The financial actions I talk about are for my own portfolio and money and only suited for my own risk tolerance, strategy, and ideas. Copying another person's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.

1 comment:

  1. Fantastic summary of BDCs and the different levels of debt. I think in a large and well diversified portfolio, having a subset of BDCs kicking off high yielding returns can really provide a kick of returns. Ideally I'd like to hold a subset of 4-5 different BDCs down the road to help grow my actual dividend growth portfolio.