This article was coproduced with Williams Equity Research (“WER”)
Breaking Down The Basics
Business Development Companies (“BDCs”), like Real Estate Investment Trusts (“REITs”) and Master Limited Partnerships (“MLPs”), are special company structures created by legislation to solve certain problems.
REITs give the average investor access to diversified real estate at a reasonable cost and ease the capital raising process by eliminating taxation at the corporate level.
MLPs increased the ability to raise money for infrastructure (usually but not exclusively energy oriented) in a similar way. Decades later, there are trillions of dollars in assets in these more focused and efficient vehicles for owning hard assets like real estate and pipeline.
BDCs are not involved primarily in the ownership of hard assets. Instead, BDCs are required to invest at least 70% of assets in the debt and or equity of U.S. businesses. These are generally private companies that depend on BDCs for a significant portion of their lending needs.
BDCs help a company take on debt to buy out management, expand their operational footprint, or invest in a new service line. BDCs have other types of constraints as well, such as limits on leverage.
Favorable Characteristics For Mom In Today’s Market
In today’s environment, investors seek investments that solve many problems simultaneously. Principal protection going into a recession is paramount, yet without inflation protection, there may not be much principal in several years’ time.
Income generation is just as critical as before, but higher rates and inflation are squeezing balance sheets and cause inflation adjusted yields to decline. Chosen carefully, however, quality BDCs can potentially solve all these problems.
The portfolios of BDCs include majority floating rate investments less sensitive to changes in interest rates, generate average yields well above 8%, contain highly diversified loan pools, and represent a business model that has now been around for decades.
In terms of opportunity, BDCs enjoy near exclusive access to the gigantic private company economy of the United States. BDCs are limited to small and medium-sized companies for most of their asset base, but that’s still many trillions in private company market capitalization. With banks unable to lend to this segment, BDCs can generate higher returns for relatively lower risk.
This is supported by the fact top managers in the space, as we’ll soon explore, tend to have realized loan losses akin to quality corporate bonds and far superior loan performance compared to high yield bonds. That’s despite BDCs paying ~100% and ~50% greater current income than investment grade and junk bonds, respectively.
Ares Capital Corp (ARCC)
Ares Capital Corp is externally managed by Ares Management (ARES), one of the top credit managers in the world. Ares Capital Corp is a legend among BDCs in part due to its excellent lending track record and also its size.
As of August 9th, Ares Capital Corp’s market capitalization has increased to $10 billion and it remains #1 in the sector. A BDC doesn’t need to carry a $10 billion valuation to succeed, but scale certainly has its benefits.
First, the rating agencies are big fans of scale. In fact, it’s almost impossible to earn an investment grade credit rating without a portfolio with gross assets of at least $1.0 billion. That’s not the only reason Ares Capital Corp earns a BBB investment grade credit rating that was affirmed by Fitch in April of this year.
This enabled Ares Capital Corp to issue 7-year bonds back in 2021 with an interest rate of just 2.875%. Like most quality BDCs, Ares Capital Corp was smart enough to issue significant fixed-rate debt when rates were unusually low. Due to increased risk premiums and benchmark interest rates, Ares Capital Corp’s bonds maturing in 4-5 years now trade with 6-6.5% yields.
That still creates a large positive spread versus the loans it owns and Ares Capital Corp doesn’t need to refinance significant loan volumes until 2025 and later. It’s liquidity profile and financial durability is near the best it has ever been.
One differentiator between quality BDCs is portfolio construction. In the case of Ares Capital Corp, it maintains 60%, 14%, 10%, and 9% in first lien secured loans, preferred equity, second lien secured loans, and senior subordinated loans, respectively.
First lien loans are the bread and butter of all quality BDCs but Ares Capital Corp maintains significant exposure to less secure assets that also provide greater upside. Without exposure to preferred or traditional equity, it is extremely difficult for a BDC to increase its net asset value (“NAV”) over time.
Speaking of NAV, Ares Capital Corp’s recovered quickly coming out of the pandemic sell-off in early 2020 as it experienced very minimal loan losses despite all the scary headlines and panic selling associated with the stock price. In fact, all quality BDCs were mostly unfazed by the pandemic and the dramatic sell-off in 2020 was one of the best buying opportunities in any sector since the Great Recession.
I personally bought shares in over half a dozen BDCs in March and April of 2020. The main reason is big dividend yields. Ares Capital Corp increased its base dividend in 2022 by 5% to $0.42 and paid a special dividend of $0.03 in both Q1 and Q2.
At current levels around $20 per share, that’s an 8.15% base dividend yield or 9.0% using the first half of 2022’s payouts. In addition, the payout ratio over the last 5 quarters (individual quarters are too variable to be useful for accounting reasons) is a healthy 95% based on GAAP net income per share.
Although current pricing isn’t as attractive as the $17-$18 available in mid-June, anything under $20 per share is likely to be a great entry on this dividend machine for years to come. That’s a modest 7.2% premium to NAV on a BDC that normally carries a 10-15% premium.
Main Street Capital Corporation (MAIN)
Main Street Capital is one of the income stocks on Seeking Alpha, and for good reason. In addition to the investment grade credit rating and multi-billion portfolio like Ares Capital Corp has, Main Street Capital specializes in strategic and highly profitable equity investments.
Headquartered in Houston, Texas, Main Street Capital IPO’d in 2007 and is one of a handful of BDCs that have beaten the S&P 500 in total shareholder return since inception. That’s no small feat for any income stock, much less one involved in mostly loan investments. This impressive performance is in part due to Main Street Capital’s increase in its NAV from $12.85 at IPO to over $25 today.
It’s not just the NAV that has grown like clockwork over the years. Main Street Capital has grown its monthly dividend from $0.33 per share to $0.66 for Q4 of 2022. That’s exactly 100% dividend growth since inception. But do you want to know the real reason Main Street Capital is a fan favorite among dividend investors? And it’s not the fact it has never cut its distribution despite living through the Great Recession and pandemic, but good guess.
Since its IPO, the company has paid out $30.63 in regular dividends and $4.39 in supplemental dividends totaling over $35 per share. That was more than the company’s entire stock price just two months ago during the worst of the sell-off.
Internally managed Main Street Capital has best-in-class operating expenses and management owns a lot of common stock to further align interests with shareholders.
Just like Ares Capital Corp, Main Street Capital maintains an extremely diversified portfolio with the largest exposures to less cyclical industries like internet software and services (8%), machinery (8%), construction and engineering (7%), and commercial services and supplies (6%).
The weighted average yield on debt of 11.2% covers the regular dividend, but how does the company pay out such large and frequent special distributions? Main Street Capital, unlike most peers, isn’t just a lender.
This top tier BDC has average fully diluted equity ownership of its portfolio companies of 41%. It has majority control over 32% of its portfolio companies and a 25-49.9% stake on another 40%. This means Main Street Capital is truly aligned with its portfolio company management teams. Those companies know Main Street Capital’s plan isn’t to bleed them dry with interest expense and fees – they are equity owners too.
Despite the recent rise in benchmark interest rates, investment grade rated Main Street Capital’s debt still trades for 2.481% to 5.864% depending on the term. It doesn’t have any material refinancing risk near-term, but even if it did, the credit markets would loan money on economic terms.
Main Street Capital currently has a base yield of 5.75% (don’t forget those supplemental dividends) and trades at a 75% premium to NAV. Outside of market crises, Main Street Capital’s historic range is a 35% to 90% premium to NAV. That puts the current valuation on the high side but far from the standard peak. We suggest waiting to pick up shares of MAIN closer to $40 per share.
Owl Rock Capital Corp (ORCC)
Owl Rock Capital is a currently ranked the third largest BDC despite being one of the newer members of the club. Like Ares Capital Corp and Main Street Capital, Owl Rock Capital maintains conservative leverage around 1.20x debt-to-equity, sports an investment grade credit rating from multiple agencies, and has an excellent track record of minimal loan losses.
In fact, Owl Rock Capital has experienced only a 13-basis point annual loss rate since inception. For context, 13 basis points is 0.0013 or $13 per $10,000 invested. That compares to a weighted average yield of 8.6% or $860 in interest income from that same $10,000 in loan investments.
Owl Rock Capital is known for its conservatively structured loan portfolio of 73% first lien and 15% second lien secured loans. Only 10% of gross assets are comprised of the risker categories of preferred equity, common equity, unsecured debt. That’s less than half of Ares Capital Corp or Main Street Capital’s portfolio.
There’s a trade-off as you might expect. Owl Rock Capital’s income generation is among the most consistent in the sector but the company doesn’t have as many levers to pull to increase NAV over time. Investors should look at Owl Rock Capital as a very secure 9.25% yield with minimal opportunity to benefit from a gain in NAV.
That said, in our opinion there is another important tailwind for Owl Rock Capital investors. This tier one BDC, an elite group we composed of only the top ~25% companies, trades at a 7% discount to NAV.
In my opinion as an experienced due diligence officer at multiple $100+ billion financial services institutions, the stock should trade at a 5-15% premium based on its fundamentals relative to peers. Instead, we can obtain an even higher yield than the portfolio generates by buying at a discount to its intrinsic value.
Even if it only returns to historical norms, we can reliably obtain a ~10% capital gain as the NAV eventually settles at the average of a 0-5% premium.
Just like the other two BDCs we’ve covered thus far, Owl Rock Capital has experienced near zero loans on non-accrual and finished last quarter with only 0.1% of the portfolio by fair value in that category.
In addition to the 88% senior secured portfolio statistic, 99% is composed of floating rate debt investments. This means Owl Rock Capital is anticipated to systematically increase earnings as rates rise. Ares Capital Corp and Main Street Capital expect to do the same with their majority floating rate investments, but their percentage can’t touch Owl Rock Capital’s.
We think Owl Rock Capital is an excellent buy at current levels and is positioned to generate safe and consistent low double-digit returns for the foreseeable future.
Generating adequate and safe income for retirees, like many of our mothers, is no easy task. Quality BDC stock prices are typically very stable until they are not. With a sound understanding of their plusses and minuses, disciplined investors can capitalize on distressed pricing with confidence.
Even if BDCs are only acquired at “good” rather than “great” prices, which is where most fall today, the long-term return potential, particularly in terms of income, offers among the best risk-adjusted return profiles of any sector we cover.
These 3 BDCs are especially compelling for retirees and loved ones that need dependable and high levels of income. All three of today’s picks are part of our elite tier one classification, earn multiple investment grade credit ratings, never cut their distribution in 2020, deploy conservative leverage, and maintain payout ratios under 100% despite their near double-digit dividend yields.
In today’s environment, the fact BDCs have proven resilient in most recessions and are composed of majority floating rate investments are icing on the (Mother’s Day) cake.
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Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.