A Business Development Company (BDC) is a finance company operating under special pass-through laws and rules. Pass-through business structures allow companies to not pay corporate income taxes as long as the majority of net income is “passed through” to investors as common stock dividends.
Real estate investment trusts (REITs) are another well-known type of pass-through business structure. Like REITs, investors buy BDC shares because of attractive dividend yields.
The BDC laws were enacted to allow companies to use a tax-advantaged business type with the goal of providing financing options to small to mid-sized corporations. This is a portion of the business community that is too small to access the public debt and equity markets and too risky to get business loans from commercial banks.
So specifically, BDCs provide debt and or equity capital to small corporations. Most BDCs focus on making loans, to earn interest. According to the BDC rules, at least 90% of net investment income must be paid out as dividends. Shares of the companies in the sector are typically priced to carry between high single-digit to low double-digit yields.
Unfortunately, there is a range of problems and dangers of investing in BDCs. While there are a few outstanding BDCs, the business structure and how it is implemented makes investing in this group often dangerous to investor wealth. Here are some of the problems with the BDC sector.
- These companies make loans to high-risk companies. BDC clients overall are more susceptible to an economic downturn.
- BDC rules don’t allow these companies to set aside loan loss reserves. Since the sector is designed to serve a riskier slice of the business world, loan losses are inevitable, and a BDC’s book value will inevitably experience erosions. Management of a BDC must devise business strategies to offset the ongoing portfolio declines.
- BDC rules limit the amount of leverage a company in the sector can use. To grow the business and offset portfolio losses, a BDC will regularly issue new common stock shares to raise capital. For this to benefit shareholders, the shares should be trading at a premium to book/net asset value (NAV). A BDC trading at a discount to NAV is not a good deal.
- Most BDCs are externally managed by financial services or investment management companies. The management fees for an externally managed BDC are much higher than management fees of the few internally managed BDCs. Also, since management fees are based on the assets under management, the external managers may be more focused on growing the asset base versus generating significant returns for investors.
Because of these reasons, there are just a few BDCs out of the three dozen or so publicly traded companies that I would recommend to my newsletter subscribers. Today I want to highlight three BDCs to sell if you happen to own shares. These BDC stocks are dangerous to your portfolio value.
FS KKR Capital Corp (FSK) is a $3 billion market cap BDC that currently yields over 13%.
The problem is that the share price has been dropping and lost 40% of its value over the last two years. That is a good sign of an eroding NAV. The shares trade at a 27% discount to NAV.
In June the company announced it would merge in four non-traded BDCs. That will close in the 2019 fourth quarter.
I would sell this stock and revisit next year to see if anything has improved.
Prospect Capital Corp. (PSEC) is a $2.4 billion market cap BDC with a 10.9% yield. The stock share NAV has been in a slow, but steady decline since 2014.
With PSEC trading at a 27% discount to NAV, that decline is likely to continue, and the company cannot raise capital with new equity issuance.
This BDC is popular among the high-yield seeking investing crowd, but shareowners are likely to face another dividend cut soon. The payout was last reduced in 2017. Sell PSEC.
Apollo Investment Corp. (AINV) is a $1.1 billion market value BDC with a current 11.9% yield. The AINV share price is currently trading at a 14% discount to NAV.
This company’s portfolio is 35% invested in the far riskier Second Lien debt. Another danger is having 20% of the portfolio invested in just one company, called Merx Aviation Finance.
As of the 2019 first quarter, AINV had 3% of its portfolio on non-accrual status. It’s those inevitable loan losses that result in NAV erosion and eventual dividend cuts. Sell AINV.