BDCs are a public play on private credit. They raise capital from investors and lend to small and midsize businesses.
Illustration by Benedetto Cristofani
In a low interest-rate world, the promise of a 7%-plus dividend yield sounds too good to be true, and with most stocks it usually is. But there’s a corner of the market where rich dividends are attractive and arguably underpromoted. Welcome to the world of business development companies.
BDCs are a public play on private credit. Created by Congress in 1980 to spur investment in small and midsize private businesses, BDCs raise capital from investors to purchase portfolios of debt and equity in companies generally valued at less than $250 million. Like real estate investment trusts, BDCs distribute at least 90% of their income to shareholders and don’t pay corporate income taxes.
Annual dividend yields of 7% to 10% are typical. In comparison, a benchmark of high-yield bonds, the ICE BofA U.S. High Yield Index, sports an annual yield of about 5.5%, and the
S&P 500
index yields 1.4%. Even with bond yields set to rise as the Federal Reserve begins lifting interest rates, BDCs offer attractive yields, with the possibility of growth.
They have no shortage of targets. A flood of capital into private-equity funds has meant more leveraged buyouts to finance, just as traditional banks have shied away from riskier lending in the post-global-financial-crisis era.
Private credit assets under management topped $1.2 trillion at the end of 2021, according to data provider Preqin Global, after a decade of 13.5% annual growth. Preqin expects the total to reach $2.7 trillion by 2026.
Loans extended by BDCs tend to have floating interest rates, meaning that interest income should rise as benchmark rates go up. On the other side, BDCs tend to borrow at fixed rates, holding their costs steady.
The broad BDC category trades around one times net asset value, a slight premium to its long-term historical average closer to 0.95. Investors shouldn’t count on appreciation driven by NAV growth—total returns from BDCs come from their quarterly dividend payments.
Sources: FactSet; company filings
So what’s the catch? BDC fees are high—backers generally collect a management fee of about 1.5%, plus an incentive fee in the 10%-to-20% range. Those fees raise the bar for returns. And with illiquid holdings and portfolios that can be a bit of a black box, investors are betting on the manager of a BDC to be a good steward of their investment.
“It’s not an earnings story; it’s not a multiple expansion story,” says Chris Tessin, lead portfolio manager and managing partner at Acuitas Investments in Seattle. “It’s more about evaluating the quality of the management of the BDC and having some comfort with a diversified portfolio.”
The
VanEck BDC Income
exchange-traded fund (ticker: BIZD) has some $574 million in assets. It tracks an industry index and is the largest individual shareholder of most public BDCs. With an annual dividend yield of 8.1% and a management fee of 0.4%, the ETF is a straightforward way for investors to add diversified BDC exposure to their portfolios.
“It’s a great way to access private credit for a lot of investors that would have a difficult time accessing it otherwise,” says Brandon Rakszawski, director of ETF product development at VanEck. “A lot of those investments are limited to institutional or accredited investors, or to much less liquid vehicles.”
But the ETF is rather top-heavy. Two BDCs—the $10.6 billion
Ares Capital
(ARCC) and the $6.6 billion
FS KKR Capital
(FSK)—make up about 30% of the portfolio. The ETF’s top 10 holdings are some 70% of total assets. Investors willing to take a more active approach can balance their exposure more evenly with individual securities.
“Generally, you want to diversify across at least five BDCs not all targeting the same end market,” says Raymond James analyst Robert Dodd. “You want to diversify in reality, not in name only.”
Blackstone Secured Lending Fund
(BXSL),
Owl Rock Capital
(ORCC), and
New Mountain Finance
(NMFC) are high-quality BDCs backed by established institutions. All three invest in lower-risk first-lien debt, which is first to get paid back in the event of a default. That’s an attractive approach for a potentially volatile period ahead.
The Ares BDC, which went public in 2004, is among the most diversified across end markets and the types of loans it extends. Some BDCs, including
Prospect Capital
(PSEC) and
Main Street Capital
(MAIN), employ higher octane strategies by also investing in more junior or unsecured debt or equity portions of companies’ capital structures. That makes them more sensitive to business conditions.
Raymond James’ Dodd has about a dozen Outperform ratings in the BDC space, but only one Strong Buy:
Barings BDC
(BBDC). It has relatively low risk and a differentiated portfolio, and it just acquired another BDC, Dodd notes. It has the potential for both dividend growth and NAV appreciation. “That’s a tough combination to find in a BDC,” he says. Dodd has a $12.50 price target for Barings, some 15% above recent levels. The stock yields 8.5%.
High yields never come without risk, but diversification and a long-term focus can help tilt the risk-reward equation. In the current climate, more investors should consider BDCs.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com
