Wall Street received a painful reminder this year that the stock market isn’t a free-money machine. Stocks don’t always march higher, and the risk of declines, if perhaps only temporary, are very real. Dividends, however, allow you to realize consistent cash returns and avoid the need to sell at inopportune times – and few areas of the market produce higher dividends than business development companies (BDCs).
Business development companies are like private equity funds for the common man, though they have some important differences. Whereas private equity funds tend to be opaque, have long lockup periods and are restricted to high-net-worth and institutional investors, BDCs are publicly traded on the stock market and are completely transparent.
BDCs make debt and equity investments primarily in “middle market” companies that are generally a little too big for bank financing but not quite big enough to go public via an initial public offering (IPO). They invest in the proverbial Main Street … or at least, this is as close to Main Street as Wall Street gets.
Main Street suffered much more than Wall Street during the pandemic, so it’s not surprisingly that many BDCs entered 2022 below their pre-COVID prices. Their cheapness relative to the rest of the market makes them attractive, particularly given that BDCs are also some of the highest-yielding stocks you’re going to find.
Like their cousins, real estate investment trusts (REITs), BDCs were created by Congress to encourage investment in the real economy, and both benefit from preferential tax treatment, paying no income tax at the corporate level so long as they pay out at least 90% of their net income as dividends.
This is why BDCs and REITs generally have such high dividend yields. They’re legally mandated to pay out nearly every red cent, and the absence of taxes makes more cash available to pay.
Let’s look at five of the best BDCs to get our portfolios through 2022 and beyond.
Data is as of March 17. Dividend yields are calculated by annualizing the most recent payout and dividing by the share price.
- Market value: $3.0 billion
- Dividend yield: 6.2%
BDCs are the proverbial Main Street, then let’s start with Main Street Capital (MAIN, $41.80). Main Street is generally considered to be one of the best-managed BDCs in the space and a true blue-chip operator – and it’s a monthly dividend stock to boot.
Main Street provides debt and equity financing to middle market companies that are too large for a bank loan, but not quite large enough to execute an IPO. The company targets companies with annual revenues between $10 million and $150 million.
Remember: Business development companies are required to pay out at least 90% of their earnings as dividends. But BDC earnings can be cyclical. So, whenever earnings take even a short-term hit, many BDCs are put in the unfortunate position of having to choose between funding the dividend with debt or cutting it.
Well, Main Street avoids that problem by keeping its regular dividend fairly modest and topping it up with special dividends, usually twice per year. In particularly good years, the “bonus” special dividends might be a little fatter than usual, and in bad years they might get trimmed back.
At current prices, Main Street yields more than 6% based on its regular monthly dividend. A modest special dividend in December added about 0.2% to the yield, but that figure could be higher in the years ahead.
- Market value: $9.8 billion
- Dividend yield: 8.2%
Ares Capital (ARCC, $20.40) is the world’s largest BDC by market capitalization, with a value of roughly $10 billion. It also happens to be one of the most conservatively allocated; 47% of its portfolio is invested in first-lien loans, with another 23% in second-lien loans. Only 21% is allocated to equity.
In other words, when push comes to shove, Ares is generally first in line to get paid, or awfully close to it.
Ares is also very well diversified by sector. Software makes up 22% of the portfolio, with healthcare and professional services making up 11% and 9%, respectively. No other sector accounts for more than 7%.
ARCC slightly lowered its quarterly dividend during the worst of the pandemic, but it has since started raising it again – and in fact, it is now back at a pre-pandemic level of 42 cents per share. Better still, the company announced four 3-cent special dividends to be distributed throughout 2022, which boosts the yield from a stated 8.2% to more like 8.8%.
That’s an excellent haul for a BDC with ARCC’s conservative profile.
- Market value: $5.7 billion
- Dividend yield: 8.5%
Relative newcomer Owl Rock Capital (ORCC, $14.52) started trading in 2019 – just in time for the pandemic to turn the world upside down. Owl Rock weathered that storm, though, and continues to deliver a steady stream of dividends to its investors that adds up to an 8%-plus current yield.
Like many of the BDCs covered today, Owl Rock follows the sensible policy of keeping its regular quarterly dividend comparatively modest and topping it up with special dividends as cash flows allow.
Also like most BDCs. Owl Rock Capital tends to focus on middle market companies, and its typical portfolio company boasts annual EBITDA from $10 million to $250 million. Over the past several quarters, its portfolio has consisted of 75% to 78% first-lien loans with most of the remainder in second-lien loans. Fully 99% of its debt investments are floating rate, meaning the company should have no issues staying safely ahead of Federal Reserve rate hikes.
The BDC is also very well diversified; its top 10 positions account for only 21% of its total portfolio. Software is its largest industry exposure, at 11% of the portfolio, following by insurance and financial services at 9% and 8%, respectively.
- Market value: $685.6 million
- Dividend yield: 11.6%
For a more specialized BDC, consider the shares of Newtek Business Services (NEWT, $28.38). Newt is a relatively small player with a market cap of less than $700 million. But it offers exposure to a collection of technology, financial services and fintech investments.
Newtek’s product offerings include business lending (which includes both SBA and traditional loans), electronic payment processing, cloud computing, technology consulting, e-commerce, accounts receivable and inventory financing, and a host of other services to small- and medium-sized business.
NEWT is very different from the rest of the BDCs reviewed, as it functions as an operating business. It’s not merely a collection of investments in third-party companies in the private equity model. This makes the risk profile a little different than the typical business development company, but it also means that adding Newtek to a BDC portfolio adds diversification.
NEWT is also one of the highest-yielding stocks in this industry, with a dividend yield of nearly 12% … at the moment. You see, the dividend is highly variable – over the past year alone, it has ranged from 65 cents per share to $1.05 – so you’ll want to keep that in mind if you require extremely stable payouts.
- Market value: $2.1 billion
- Dividend yield: 11.0%
For a different, slightly more aggressive take on the BDC sector, consider Hercules Capital (HTGC, $17.52).
As we covered earlier, BDCs can generally be thought of as publicly traded private equity companies. Hercules is different, however. It operates more like a venture capital firm.
This might sound like a distinction without a difference, and the two terms often get lumped together, but private equity and venture capital are very different asset classes. Private equity covers primarily established companies with relative long track records. Venture capital tends to be the domain of startups.
Of course, focusing on newer companies is potentially a lot more exciting (and lucrative). But it’s also generally going to be risker than private equity.
Hercules Capital is the largest BDC in the world that is focused primarily on venture lending. And as you might expect in this space, its biggest focuses are in technology, healthcare, software as a service and renewable energy.
About 91% of HTGC’s portfolio is invested in debt investments, and 94% of the debt investments are floating-rate instruments. This should insulate Hercules from rising interest rates as the Fed continues to tighten. This might help to explain why Hercules’ share price has remained as stable as it has in early 2022 despite soaring bond yields and falling stock prices.
Like some of the other BDCs reviewed today, Hercules keeps its quarterly dividend relatively conservative and tops it up with supplemental dividends as cash flows allows. As an example, the March 2022 payout will consist of a 33-cent regular dividend and a 15-cent supplemental dividend. That translates into a massive 11% yield at current prices.
Source: kiplinger.com