How to Invest in Business Development Companies (BDCs)

How to Choose Quality BDCs

Every industry has its key metrics to watch and with BDCs there are four that every potential or current BDC investor needs to know: weighted average portfolio yield, NAV/share, the non-accrual ratio, and the NII payout ratio.

Portfolio yield is just the weighted average yield on the BDCs loans and other assets (which can include equity stakes in the companies they finance). The weighted average portfolio yield can tell you two important things about a BDC.

First, the yield can be a good proxy for how risky the BDC’s portfolio of loans is. Remember these are all subprime loans, so generally a lower yield is better because it means that the loan book is probably more heavily weighted towards first lien (i.e. more senior) debt.

In the event of a default, that allows the BDC to recoup at least some of its investment. From Main Street Capital Corporation (NYSE:MAIN)’s most recent quarterly results below, we can see two important facts.

First, the loan book remains highly conservative by the standards of the industry, where average portfolio yields can often be 13% to 15% (Main Street Capital’s yield is 10.4%).

Second, and perhaps more importantly, we can see that the portfolio yield is above the dividend yield of 8.5% (which includes its biannual $0.275 special dividend). This tells us that Main Street’s conservative portfolio can easily support both the monthly regular dividend and the two special dividends, assuming interest payments continue to be made.

Now the second thing we want to check with any BDC, and arguably the most important (over the long-term) is the trend in NAV/share. Remember that financial companies like BDCs and banks have an intrinsic value, which is the total value of all tangible assets minus liabilities.

But because BDCs have rising share counts, thanks to a constant influx of new equity capital, we need to make sure that NAV or shareholder value per share is rising over time. This is the best way of telling whether a BDC is helmed by a skilled management team that can be trusted with your capital.

As you can see, the growth in NAV/share for even high quality blue chip BDCs such as Ares Capital aren’t that big. However, the fact that they are positive is one of the better filters for excluding those BDCs whose management teams have proven incapable of creating long-term shareholder value, such as Prospect Capital and Full Circle Capital.

Source: Ycharts

Another reason that NAV/share is such an important metric is because the premium or discount a BDC trades at is another great proxy for the quality of the management team. Here is a list of BDCs with each stock’s price-to-NAV.

BDC Price/NAV Oct 29th, 2016
Source: BDC Buzz

This is for two reasons. First, a BDC that can’t invest accretively, either due to a poor management team, too high cost structure, or both, will destroy shareholder value by decreasing NAV/share over time. The market thus tends to price the highest quality, most time tested (i.e. most successful) BDCs at a premium to NAV/Share.

While that may seem counter intuitive, to invest in BDCs that are trading at or above NAV/share, it is actually the conservative and smart approach to this high risk industry in most cases. For example, look at Full Circle Capital Corp (NASDAQ:FULL), which has, over the last six years, destroyed 60% of NAV/share (i.e. shareholder value). From 2011 through 2015, FULL’s stock returned negative 11.9% per year while the market gained 12.4% annually!

Recently the market was offering Full Circle Capital Corp (NASDAQ:FULL) at a steep 25% discount to its intrinsic value. But if you had done your homework and seen that Full Circle had a history of growing through excessive shareholder dilution, resulting in a collapsing NAV/share, a 52% reduction in the dividend since 2011, and a -37% total return over that time, well you would hopefully think twice about investing in this toxic BDC.

On the flip side Main Street Capital, trading at a 61% premium to NAV/share is pricing in the best management team in the industry, one of the least risky loan books, one of the most secure dividends, and the absolute best payout growth rate. In fact, over the past six years, Main Street has grown its dividend by 120% and produced a 260% total return compared to the market’s 119%.

While past success is no guarantee of future excellence, in the high risk BDC industry, it is the best portent one has. In addition, a premium valuation is also an actual competitive advantage to a BDC and can actually help “winners keep winning.”

Remember that BDCs are constantly selling equity to grow their assets, because they are legally limited to a debt/equity ratio of 1:1. If a BDC is trading below its NAV/share then every share sold is literally further destroying shareholder value because, as in the case of Full Circle Capital, it’s selling $1 in assets for $.75.

On the other hand, Main Street’s premier “brand” in the BDC industry allows it to sell new shares to raise growth capital at the rate of $0.62 in assets per share for each $1 in additional equity raised. That extra $0.38 per share? That benefits existing investors because is accretive to NAV/share.

Said another way, Main Street’s unbeatable track record as the best managed BDC in America helps it to secure low costs of equity capital and keep growing its asset base, NII/share, and the dividend.

That in turn leads to more earnings and a more secure, growing dividend, which in the long-term causes the share price to appreciate. Here’s a look at the recent cost of equity capital for BDCs, courtesy of BDC Buzz.

BDC Cost of Equity
Source: BDC Buzz

The next metric that’s important for BDC investors to keep track of is the non-accruing loan ratio, which tells you how much of a company’s loans are in default.

For the second quarter of 2016, Main Street had eight loans in nonaccrual status representing 3.7% of its invested capital, up from 3.1% in Q2 of 2015. The increase, while troubling isn’t yet high enough to put the current dividend at risk.

However, it’s certainly worth watching, if only because a rising nonaccrual ratio tells us that the credit market may be turning, a potential prelude to a recession, and trouble for the industry as a whole.

Finally, and most importantly for all dividend investors, is the Net Investment Income (NII), which funds the dividend. For Main Street last quarter, NII came in at $0.58 per share. That’s compared to $0.555 per share in dividend, or a 95.7% payout ratio. While that may appear alarmingly high, remember that BDCs are legally required to payout almost all income as dividends, so any payout ratio under 100% can represent a sustainable payout.

More importantly than the payout ratio in any given quarter is the trend over time, (Main Street’s 2015 payout ratio was 90.9% and its TTM ratio is 92.9%) because a payout ratio above 100% for several quarters in a row is likely a sign of distress at the BDC and a potential prelude to a dividend cut.