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All Contents © 2019The Kiplinger Washington Editors
By Will Ashworth, Contributing Writer
| August 26, 2019
The market for business development companies (BDCs) just got a little more institutional.
For those of you unfamiliar with BDCs, here’s a quick primer. Business development companies provide firms with debt and equity capital, or a combination of the two, to help them grow. They first came to be in 1980 when Congress passed an amendment to the Investment Act of 1940 that created a new category of closed-end investment company: BDCs.
For tax purposes, BDCs must pay out 90% or more of their taxable income in the form of dividends so they can retain the tax benefits of regulated investment companies.
BDCs have become popular with retail investors over the past decade because of the significant income they generate. These companies often yield more than 8% on their distributions.
Consider this: BDC Owl Rock Capital Corporation (ORCC) sold 10 million shares to investors during its initial public offering on July 18, 2019. This IPO is important because Owl Rock Capital Partners, who operate the BDC, founded it in 2016 with the sole purpose of meeting the needs of institutional investors. Since its founding three years ago, Owl Rock has raised more than $5.5 billion from pension funds, university endowments, family offices and other high-net-worth investment vehicles. And when institutional-caliber investors get involved, it’s time to take notice.
Here are 10 BDCs to consider for your investment portfolio. Just remember: Their uber-high yields come with some measure of risk. Many use debt leverage to generate their strong returns, which is risky in the first place and adds interest-rate risk into the picture. Also, the companies they invest in typically have a higher chance of default than larger corporations. But for those willing to take the risks, these 10 BDCs yield between 5.7% and 10.9%.
Data is as of Aug. 25. Dividend yields are calculated by annualizing the most recent monthly payout and dividing by the share price.
Market value: $7.9 billion
Current Yield: 8.6%
One of the trickier aspects of investing in BDCs is digesting the sheer number of loans that each company has outstanding. That’s especially true of Ares Capital Corporation (ARCC, $18.57), the largest BDC in the U.S. by both net assets and market value. Its website currently dedicates 18 pages to its portfolio of investments.
Ares was created as a specialty finance company in 2004, and went public that same year. Ares acquired American Capital in January 2017 for $3.4 billion in cash and stock, solidifying its hold on the middle-market direct lending industry in the U.S.
The company focuses on middle-market companies with EBITDA (earnings before interest, tax, depreciation and amortization) of between $10 million and $250 million. It invests between $30 million to $500 million in an individual company. In addition to its first-lien senior secured debt, it also makes second-lien senior secured and mezzanine loans. The terms of its loans run from three years to 10 years. It also does equity investments – typically non-controlling positions of $20 million or less.
One thing to pay attention to when evaluating BDCs is costs. The company is externally managed by Ares Capital Management, which is a subsidiary of Ares Management (ARES). It receives an annual investment management fee of 1.5%, as well as 20% of the investment income above an annual hurdle rate of 7% and 20% of any realized capital gains in a given year. In fiscal 2018, Ares Capital paid out $180 million in base management fees and $202 million in income and capital gains incentive fees.
Still, if you’re looking for a diversified portfolio of loans, Ares – and its 8%-plus yield – is a good bet.
Market value: $6.1 billion
Current Yield: 7.8%
Owl Rock Capital Corporation (ORCC, $15.85), which we mentioned above, sold 10 million shares of its stock July 18, raising as much as $163 million in net proceeds from its initial public offering.
Owl Rock Capital began its investment activities in April 2016. Since then, it has originated $12.7 billion in loans and equity investments to U.S. middle-market companies. The company defines the middle market as businesses with $10 million to $250 million in EBITDA and annual revenue of $50 million to $2.5 billion. Its current portfolio has weighted average annual revenue of $444 million with $79 million of EBITDA.
Owl Rock’s portfolio invests in a total of 27 industries, with professional services and internet software and services accounting for 10% each. The company has 90 portfolio companies totaling $7.2 billion in debt and equity investments, and the portfolio’s weighted average yield is 9.1%.
An example of a current client is Blackhawk Network Holdings, a company that was once owned by grocery chain Safeway but now is owned by Silver Lake, a California tech investor with more than $43 billion in assets under management. Owl Rock’s second-lien senior secured loan has a fair value of $104.4 million, it matures in June 2026, and it charges an annual interest rate of the Libor benchmark rate + 7.0%.
Market value: $2.7 billion
Current Yield: 5.7%
Main Street Capital Corporation (MAIN, $43.33) is the fifth-largest BDC by assets and the fourth-largest by market value. It was formed in March 2007, then went public in October of that same year for $15 per share. It is an internally managed BDC, which means it doesn’t pay any advisory fees. The tradeoff? It does incur the operating expenses of employing investment professionals to do investment analysis, research and other duties.
Main Street focuses on lower middle-market companies with revenues between $10 million and $150 million. It invests $5 million to $50 million per company. It also invests indirectly in middle-market companies with revenues of $150 million to $1.5 billion, investing between $3 million to $20 million in those companies on average.
MAIN estimates that there are more than 175,000 lower middle-market businesses in the U.S., and says they’re inefficiently priced. The typical company has an enterprise value that’s 4.5-6.5 times EBITDA with leverage of 2.0-4.0 times EBITDA.
Now’s a good time to mention that while BDCs may raise their dividends in boom times, it’s not uncommon for some to cut their payouts depending on the business environment. Main Street has never decreased its monthly dividend; instead, it relies on a low regular payout that it supplements throughout the year as its business allows. MAIN started paying periodic supplemental dividends in January 2013. In July 2013, it switched to semi-annual supplemental dividends. Since its IPO in 2007, it has paid out $22.485 a share in regular dividends and $3.80 in supplemental dividends.
If you’re looking for consistent income, Main Street is a BDC worth considering.
Market value: $1.2 billion
Current Yield: 10.1%
New Mountain Finance Corporation (NMFC, $13.45) was incorporated on June 2010. It went public in May 2011, selling 7.3 million shares at $13.75 for gross proceeds of $100 million. It used the proceeds for loans to middle-market companies.
New Mountain Finance looks for companies with EBITDA of $10 million to $200 million. It prefers businesses with high free cash flow generation and barriers to entry. At the end of fiscal 2018, its top 10 investments accounted for 27% of its total assets. The three largest industries – business services, software, and healthcare services – account for more than half (56%) of total assets.
This BDC uses an external investment adviser: New Mountain Finance Advisers BDC LLC, itself a wholly owned subsidiary of New Mountain Capital LLC, an alternative asset manager based in New York City with more than $20 billion in assets under management.
New Mountain Finance finished the second quarter ended March 31, 2019, with total investments of $2.7 billion in 102 portfolio companies yielding 10.0%. It originated $183.3 million in new loans during Q2.
Since its IPO, New Mountain Finance has delivered a cumulative total return of 130.5% – higher than many of its peers, including several mentioned in this article. In the eight years since its IPO, the BDC has paid out $11.04 a share in regular dividends and another 61 cents in special dividends. Just understand that it hasn’t paid a special dividend since 2014, so it’s not a regular part of the plan like it is at Main Capital.
The thing to understand about New Mountain is that it’s very much a yield-first play. NMFC has traded in a range between $12 and $15.50 for most of its publicly traded life, and it’s in the middle of that range right now. A long way of saying: New Mountain seems unlikely to deliver much in capital appreciation. But for pure income, NMFC delivers.
Market value: $1.1 billion
Current Yield: 6.9%
Like many BDCs, Golub Capital BDC (GBDC, $18.54) is externally managed by an affiliated company. In GBDC’s case, it is managed by GC Advisors LLC, which interestingly enough uses experienced credit professionals from affiliate Golub Capital LLC to manage the BDC.
The BDC got its start in November 2009. It now has 211 portfolio companies with a fair value of $1.9 billion as of June 30, 2019. Roughly 80% of its portfolio is invested in “one-stop” loans (characteristics of both first-lien and second-lien loans) in middle-market companies. Its top three industries are “diversified/conglomerate services” at more than a third of the portfolio (34%); healthcare, education and childcare (18%); and electronics (7%).
The BDC invests in middle-market companies with EBITDA of less than $100 million. The typical investment is between $5 million and $30 million per portfolio company. Like many of the middle-market companies, it’s investing in securities that are rated below investment-grade (or aren’t rated but would be rated as such if they were). Other criteria for its loans include scalable revenues and operating cash flow, experienced management, low capital expenditures, and a North American base of operations.
GC Advisors charges a base management fee of 1.375%. Its hurdle rate for income-based incentive fees is 8%. It gets 20% of any investment income above the 2% quarterly hurdle. It also gets 20% of any realized capital gains.
That said, you’re paying for experience. Golub Capital’s 100-plus investment professionals boast more than 12 years of experience on average.
Market value: $938.5 million
Current Yield: 9.0%
In recent years, the BDC industry has seen an invasion by alternative asset managers, many of whom specialize in private equity investments. Bain Capital Specialty Finance (BCSF, $17.95) is one of those companies.
BCSF got its start in October 2016 as an externally managed, closed-end, non-diversified management investment company, then went public in November 2018, raising net proceeds of $145.4 million. The company was formed to take advantage of the opportunities presented to it by Bain Capital Credit’s senior direct lending business. Bain Capital Credit – 100% owned by Bain Capital LP – has more than $39.2 billion in assets under management.
Bain Capital Specialty Finance’s typical investment is a middle-market business with annual EBITDA between $10 million and $150 million. While it will invest in mezzanine debt, equity, distressed debt and other debt-related products, it tends to stick to senior debt with first or second liens on the collateral. BCSF also has the option of investing up to 30% of the portfolio in investments outside the U.S. or other non-qualifying investments.
This is a very diversified portfolio of 123 companies across 30 industries, as of the company’s second quarter. The current portfolio size is $2.4 billion with a weighted average gross yield of 8.0%. It’s also coming off a strong Q2 in which net investment income – an important profitability metric for BDCs – improved 8% year-over-year to 41 cents per share.
Bain Capital Specialty Finance is externally managed by BCSF Advisors, a subsidiary of Bain Capital Credit that gets a base management fee of 1.5% of the company’s gross assets. They also have an incentive fee that’s based on both income and capital gains.
Market value: $730.2 million
Current Yield: 7.3%
Investors who are familiar with Oaktree Capital Group (OAK) – the alternative asset manager co-founded by famed distressed-debt investor Howard Marks – ought to be interested in Oaktree Specialty Lending Corporation (OCSL, $5.18), which Oaktree Capital externally manages.
Oaktree got into the BDC business in July 2017 when it paid $320 million to become the investment adviser for two closed-end funds formerly managed by Fifth Street Asset Management. Fifth Street was forced to sell the management contracts after several run-ins with the SEC, as well as several bad investments. Oaktree Specialty Lending previously was known as Fifth Street Finance Corp.
To make the BDC more attractive to investors, Oaktree lowered the base investment management fee from 1.75% annually to 1.5%. Also, it decreased its portion of the income and capital gains incentive fees to 17.5% from 20.0%. The current hurdle rate on income earned is 7.3%.
The business itself? Oaktree Specialty Lending focuses on middle-market companies with enterprise values of between $100 million and $750 million. More than half the portfolio (54%) was invested in first-lien loans as of the end of its June quarter. Another 26% is invested in second-lien loans, with another 11% in unsecured loans and equity, and the remaining 9% tied up in joint ventures. Oaktree’s 105 portfolio companies boast qualities such as resilient business models, strong underlying fundamentals and seasoned management teams.
A promising piece of news: Brookfield Asset Management (BAM) one of the finest alternative asset managers anywhere in the world, announced in March that it would by 62% of Oaktree Capital. If any of Brookfield’s quality bleeds down into OCSL, all the better.
Market value: $407.7 million
Current Yield: 8.8%
Many of the largest BDCs available to investors today provide equity and debt financing to middle-market companies, a considerable number of which operate industrial businesses with stable cash flows.
TriplePoint Venture Growth BDC (TPVG, $16.40) – which went public in March 2014 and used the proceeds of its IPO to pay down the bridge loan it took out to buy its initial portfolio of investments – is a bit more aggressive.
TPVG specializes in debt and equity investments for technology, life sciences and other high-growth industries. The typical company it lends to is backed by leading venture capital investors and looking for venture growth-stage capital. It targets annual returns of 10% to 18% on its loans with equity kickers in the form of warrants, providing additional upside to mitigate against the increased risk.
TriplePoint is externally managed by TriplePoint Advisors LLC, itself a subsidiary of TriplePoint Capital LLC. The Silicon Valley lender has provided more than $5 billion in commitments to more than 500 venture capital-backed companies since its formation in 2006.
In the second quarter ended June 30, it funded $72.5 million in debt investments with an average annualized portfolio yield of 13.9% at origination. It finished the quarter with a record investment portfolio of $496.0 million, and grew net investment income by nearly 15% year-over-year.
TPVG currently yields nearly 9%, making it an excellent BDC investment for those looking to benefit from the venture capital industry in a more income-oriented manner.
Market value: $391.8 million
Current Yield: 7.2%
Most BDCs are designed to generate income for its shareholders rather than capital gains. Capital Southwest Corporation (CSWC, $22.14) hasn’t always been geared that way.
Although it got its start in 1961, Capital Southwest didn’t elect to be a BDC until 1988 – a full 10 years after going public. It is an internally managed BDC that only recently changed course (in 2015) to deliver greater shareholder value through income.
Capital Southwest had a large concentration of its assets in just two industrial companies. The unrealized capital gains from those two equity investments were significant. The solution was to spin off its industrial assets into a separate, independent publicly traded company – CSW Industrials (CSWI) – so CSWC could focus on income-generating assets.
Before the Oct. 1, 2015, spinoff, CSWC’s income-earning assets accounted for 1% of the company’s portfolio. After the spinoff, 92% of its portfolio earned income. Except for one remaining legacy investment, the CSWC pre-spinoff is non-existent.
The transformation involves two strategies. The first is to make loans of up to $25 million to lower middle-market companies with EBITDA of $3 million to $15 million. Alongside its loans, CSWC often will make equity co-investments. The second strategy is to invest in syndicated loans to upper middle-market companies with EBITDA over $50 million. It manages the second strategy – I-45 Senior Loan Fund – in partnership with Main Street Capital, which we discussed earlier.
Interestingly enough, despite the change in strategy, CSWC has been growing like a weed. For the fiscal year ended March 31, 2019, Capital Southwest generated a total return for shareholders of 37%; 24 percentage points of that was from capital appreciation.
Market value: $266.7 million
Current Yield: 10.9%
As is the case with many BDCs, WhiteHorse Finance (WHF, $12.98) has external management. In this case, it’s H.I.G. Capital – a global alternative asset manager with more than $34 billion under management. It specializes in smaller companies.
WhiteHorse, which specializes in smaller companies, commenced operations on Jan. 1, 2012. It received initial funding of $176.3 million, provided by three investment funds affiliated with H.I.G. Capital. WhiteHorse priced its IPO on Dec. 4, selling 6.7 million of its shares at $15 each, then started trading the next day.
Since its IPO, WhiteHorse has invested $1.4 billion in capital in approximately 109 investments. Its average investment across its current 47 portfolio companies is $8 million, with an average effective yield of 11.3% as of the end of 2019’s second quarter. In terms of the type of loans, 85% of its investments are first-lien secured loans, 12% are second-lien secured loans, and the remaining 3% is in the form of equity and warrants.
WHF tends to focus on the lower middle market and companies with enterprise values between $50 million and $350 million looking to borrow between $5 million and $25 million. It favors companies that don’t rely on technology and possess competitive advantages or other barriers to entry.
Something else to like: A November 2018 investor presentation showed that of the 3,983 opportunities reviewed by WhiteHorse professionals between 2014 and Sept. 30, 2018, only 306 resulted in term sheets being offered, and just 57 actually closed. This indicates that the BDC is very particular about which companies get financing.