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BDC: How Dividend Seekers Are Riding the Private Credit Wave to Attractive Yields

By Yasin Ebrahim

Business development companies (BDCs) are rapidly gaining popularity among income-focused investors. These entities have earned a strong reputation for providing attractive dividend-like returns by addressing the funding gap in the middle market that traditional banks often overlook.

According to a recent report from Jefferies, the BDC sector has experienced remarkable growth, with total assets under management surging from $12 billion in 2000 to over $260 billion by 2023.

What Are Business Development Companies?

A BDC is an investment entity that typically focuses on the middle market, targeting smaller private companies that generate between $5 million and $100 million in earnings before interest, taxes, depreciation, and amortization (EBITDA). Primary funding comes through debt, often in the form of senior secured loans, although BDCs may also adopt a more diverse investment strategy.

BDC investments yield income via coupon payments on loans and various fees from borrowers, which are then distributed to investors. While debt funding is their mainstay, BDCs can also invest in equity capital. When the value of these equity investments rises, BDCs may realize additional returns. Notably, BDCs must distribute approximately 90% of their investment income to shareholders, usually as dividends.

The emergence of BDCs can be traced back to the 1980s, following a financial crisis that led to stricter lending regulations, causing banks to tighten their lending standards. As a result, middle-market companies found it increasingly difficult to secure debt capital. In response, Congress passed the Small Business Incentive Act of 1980 to encourage private equity firms to fill this void.

Private Vs. Public: Liquidity Matters

Not all BDCs are equal regarding liquidity. Publicly traded BDCs, which are listed on stock exchanges like Nasdaq, offer higher liquidity. Conversely, private BDCs resemble traditional private equity fund structures, with returns typically distributed at the end of the investment cycle, resulting in lower liquidity. Perpetual BDCs provide a middle ground, allowing investors to redeem investments during designated periods known as redemption windows.

Investing in publicly traded BDCs allows shareholders to partake in both the underlying assets and the income generated from those assets. As Kyle Brown, the CEO of Trinity Capital, explains, purchasing shares means acquiring a small portion of all the loans across the portfolio, leading to monthly or quarterly income distributions in the form of dividends.

High Returns from Addressing the Middle-Market Funding Gap

The dividend yields from BDCs usually range from high single digits to mid-teens, drawing income-seeking investors. The attractive returns stem from the underlying assets of BDCs, predominantly senior secured loans.

Leverage: Most BDCs utilize leverage to amplify returns, allowing them to borrow funds at short-term rates and lend them to their portfolio companies at higher rates. Legally, they can borrow up to twice their equity base; however, many BDCs, including Trinity Capital, maintain a leverage ratio closer to one-to-one.

Fees: In addition to leverage, various fees charged to borrowers also play a significant role in generating returns. These may include upfront commitment fees, prepayment penalties, and backend fees.

Internally managed BDCs can handle investments directly instead of outsourcing, enabling them to generate additional income by managing third-party capital.

Understanding the Risks: What Every BDC Investor Should Know

Investing in debt instruments entails managing credit risk. Since BDCs may target a spectrum of companies, ranging from startups to established firms, investors must be aware of the varying risk levels involved. For example, Horizon Technology Finance invests in early-stage companies in technology and life sciences, which might have negative EBITDA due to high cash burn rates. Such investments carry higher risks but are often offset by the potential for higher returns.

Proactive management is crucial for recognizing potential issues. Horizon Technology Finance conducts monthly reviews and quarterly evaluations to stay ahead of any challenges.

For publicly traded BDCs, which must adhere to SEC reporting requirements, valuation represents a significant risk. Short-term economic shifts can impact valuations, affecting stock prices even if loan collection capabilities remain intact. However, for investors focused on income, these fluctuations may be less concerning than for those attempting to time the market.

Risk to BDCs from Lower Interest Rates or Recession?

With the Federal Reserve entering a rate-cutting phase, concerns arise about income from loans, which typically float above a benchmark rate, potentially affecting high dividends offered by BDCs. Although yields may drop, lower borrowing costs can help cushion the impact on margins.

Jefferies has noted that many base dividends for BDCs are not significantly at risk from rate cuts, thanks to accelerating originations and refinancing fees that should help maintain dividend coverage. The leveraged loan index default rate has seen a slight drop this year, suggesting stability.

The Art of Deal Origination

As the number of funds increases within BDCs, their ability to source quality investment opportunities becomes vital for maintaining a competitive edge. Effective deal sourcing not only enhances access to high-quality assets but also strengthens a BDC’s balance sheet. A seasoned management team is essential, providing the necessary market access for origination opportunities.

To BDC or Not To BDC?

Regardless of the economic or interest rate cycle, thorough due diligence remains critical when choosing which BDCs to invest in. Potential investors should closely examine the management team’s experience and understand how the BDC consistently generates income to meet dividend obligations over time.

The unique access that BDCs provide to private credit opportunities, combined with the potential to build income, suggests that this asset class remains robust. Continuous capital flow is expected, with many companies managing to maintain enterprise value by cutting costs, indicating ongoing optimism about the future of BDCs.

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