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All Contents © 2018The Kiplinger Washington Editors
By Lisa Springer, Contributing Writer
| June 4, 2018
Business development companies (BDCs), with dividend yields averaging between 8% and 11%, already are well worth considering as income investments. Now, thanks to a recent regulatory change, BDCs have even more appeal.
BDCs make loans like banks but serve a different lending niche, consisting of middle-market companies in a high growth mode. Unlike banks, BDCs invest in both debt and equity of companies and provide managerial oversight and advice to clients.
Business development companies yield more than banks because they pay no corporate taxes. As a trade-off, however, BDCs are required to distribute at least 90% of income to shareholders. But because they must rely on debt or equity financing to grow, growth rates can be erratic and BDCs sometimes must cut dividends.
However, BDCs have recently gotten a huge helping hand from Washington. A little-known provision of the $1.3 trillion omnibus spending bill may jump-start BDC growth by freeing these companies from a major constraint. Traditionally, BDCs were required to hold one dollar of equity for every dollar loaned. Under the new rule, BDCs need only hold one dollar of equity for every two dollars loaned, thus enabling their lending operations to grow.
Smaller BDCs may leverage loan growth to increase net interest income (an important earnings metric for BDCs) and dividends. Larger BDCs may opt to improve portfolio quality by increasing the percentage of low-risk loans. In this scenario, while NII doesn’t necessarily rise because of lower yields on new loans, the BDC earns a higher valuation multiple as a result of improved portfolio quality.
Here are 10 BDCs that already provide high yields, and now have a chance through this rule change to bolster their dividends and share prices.
Data is as of June 1, 2018. Dividend yields are calculated by annualizing the most recent quarterly payout and dividing by the share price.
Market value: $864.7 million
Dividend yield: 9.8%
TCP Capital (TCPC, $14.47) is a middle-market lender with a great track record for generating NII (net interest income) that consistently exceeds dividends. Since its IPO six years ago, TCP has covered dividends 24 quarters in a row. Special dividends have been paid three times and have totaled 25 cents. NII exceeded dividends by 15 cents last year, setting the stage for another special dividend in 2018.
TCP’s $1.5 million loan portfolio yielded 11% last year. Senior secured debt represented 93% of the portfolio, indicating high-quality holdings.
More than 89% of the portfolio is floating-rate debt, which enables TCP to benefit from rising interest rates. In addition, yields on most investments are tied to three-month LIBOR rates, which also are rising. The company estimates that a 100-basis-point increase in interest rates would add 31 cents per share in NII.
TCP recently reduced borrowing costs by replacing a credit facility priced at LIBOR plus 2.5%, with a new line at a lower LIBOR rate.
This BDC has paid a $1.44 annual dividend four years in a row and recently approved a $50 million share repurchase program. Shares will be repurchased when the share price drops below $14.80 – currently the case. Meanwhile, the company’s net asset value was precisely $14.80 per share for the quarter ended Dec. 31, 2017, and it rose to $14.90 for the most recent quarter. Translation: TCPC is trading for a discount.
Market value: $7.2 billion
Dividend yield: 9.0%
Ares Capital (ARCC, $16.93) is the largest BDC in the middle-market lending niche. Ares holds a $12.2 billion investment portfolio spread across 360 client companies. The portfolio, which yielded 9.7% last year, is of mid-tier quality, consisting of 42% first lien debt (the least risky debt), 30% second lien debt and 28% other debt and equity.
Last year, Ares acquired a $2.5 billion portfolio from American Capital at a price below net asset value. The BDC has since sold $1 billion from this portfolio; in the process, it has earned sizable gains on loan sales and reinvested the proceeds in higher-yielding assets.
NII improved each quarter last year thanks to rising yields. Ares targets additional gains in 2018 from increased lending, portfolio rotation and rising interest rates. Like TCP, Ares has a large percentage (81%) of floating-rate debt.
Ares has paid a $1.52 annual dividend five years in a row and has also distributed a 5-cent special dividend each year. Excess NII totaling 81 cents per share has accumulated that could be paid as special dividends.
ARES also is well-liked by the analyst community, with 10 of the 14 following the stock rating it “Strong Buy” or “Buy.” The rest see it as a “Hold.”
Market value: $1.1 billion
Dividend yield: 8.2%
TCG BDC (CGBD, $18.10) is a wholly owned subsidiary of Carlyle Group (CG), a global money manager with $170 billion of assets under management across 140 client companies. The value of the BDC’s investment portfolio rises from $1.9 billion to $2.8 billion if joint venture investments are included. Last year, TCG generated an 8.9% yield on its core portfolio and a 6.9% yield on the combined portfolio.
TCG invests primarily in manufacturers, followed by health care, high-tech and business services companies. The portfolio is high-quality, consisting of 77% first lien debt in the core portfolio and well more than 90% first lien debt in the combined portfolio. This BDC is also nicely positioned to benefit from higher interest rates; floating rate represents 99% of debt.
In the past three years, quarterly dividends have ranged from 37 to 42 cents. The BDC also paid three special dividends totaling 37 cents. Last year, TCG paid a $1.52 annual dividend and a 12-cent special dividend.
Four analysts follow TCG and rate the stock either “Buy” or “Strong Buy.”
Market value: $1.9 billion
Dividend Yield: 10.6%
FS Investment (FSIC, $7.80) relies on its relationship with FS/KKR to source deals not made available to the broader market. FS/KRR acts as an investment adviser for six BDCs, with $18 billion in assets under management.
FS has a large portfolio valued at $4.1 billion and investments in 94 companies. Last year, the BDC improved the portfolio by increasing the percentage of first lien debt from 52% to 64%.
FSIC has more fixed-rate debt (and thus more interest-rate risk) than some other BDCs. Its portfolio is 18% fixed-rate and 69% variable-rate debt – but again, that also means it has upside if rates climb.
The company last year made $1.28 billion in loans and sold or redeemed $1.13 billion of investments, resulting in net portfolio growth of $149.3 million. Portfolio yield improved to 9.6% from 9.1% a year earlier. At present, FS has more than $261 million of borrowing capacity available on an existing line of credit.
Quarterly dividends grew from an initial rate of 18.7 cents in 2009 to 22 cents in 2015, but were trimmed to 19 cents at the end of 2017. But the new payment is much more manageable, and over the past few months, the market seems to be forgiving and forgetting.
Dividend yield: 10.0%
Hercules Capital (HTGC, $12.40) is a tech-focused BDC that lends to venture capital-backed companies, primarily in the tech, life sciences and renewable sectors. Hercules was an early investor in companies like Facebook (FB), DocuSign (DOCU) and Trulia. The BDC’s $1.4 billion debt portfolio spans 85 companies and yielded an impressive 14.2% last year.
Hercules has delivered steady growth in investment income, which has helped fuel a 16% CAGR in NII since 2011. Return on equity has also averaged nearly 300 basis points higher than industry peers.
Hercules entered the commercial lending space this year by acquiring Gibraltar Business Capital, which has made more than $325 million of loans since 2010. The BDC expects this acquisition to be accretive to 2018 NII per share.
Despite its focus on tech companies, Hercules has good asset quality, with more than 85% first lien debt in its portfolio. Loan maturities are short, generally ranging from 36 to 42 months, which further mitigates risk.
The debt portfolio is 96% floating rate, positioning Hercules to profit from Fed rate hikes. Every quarter-point rise in interest rates is expected to add 4 cents to NII per share. Rising NII will improve dividend coverage and potentially enable Hercules to increase its payout this year.
The BDC has paid 50 consecutive quarterly dividends since its 2005 IPO. The quarterly rate has held steady at 31 cents for four years in a row.
Market value: $1.2 billion
Dividend yield: 10.5%
Apollo Investment (AINV, $5.74) is mainly a corporate lender, but it also operates in the aircraft leasing, lender financing, real estate and asset-based lending spaces. A high percentage of Apollo’s investments are in the business services and aviation transport sectors, which together represent 36% of the portfolio, but the BDC is also diversified across healthcare, tech, energy and other sectors.
Apollo holds investments in 86 portfolio companies and a $2.4 billion portfolio that yielded 10.5% last year. The portfolio is mid-tier in quality, consisting of 50% first lien debt, 32% second lien debt and 18% unsecured debt and equity.
A major appeal of this BDC is its recent efforts to increase first lien and floating-rate debt. In the past six quarters, first lien has increased from 40% to 50% of the debt portfolio, and the floating-rate component has grown from 77% to 92%.
Apollo is managed by Apollo Global Management (APO), one of the world’s largest money managers with more than $249 billion of assets under management. The BDC’s ability to co-invest with other Apollo businesses gives it access to bigger deals. In the past six quarters, Apollo has deployed $511 million, or 40% of total deployed capital, through co-investing arrangements.
Quarterly dividends were trimmed from 20 cents to 15 cents in mid-2016 but have held steady for seven quarters in a row. Dividend coverage is improving, too; NII per share has matched or exceeded the dividend for the past six quarters.
This February, Wells Fargo analyst Fin O’Shea upgraded his rating on Apollo from “Market Perform” to “Outperform,” citing “prudent balance sheet management,” share repurchases and an attractive valuation, among other things.
Market value: $1.1 billon
Dividend yield: 6.9%
Golub Capital BDC (GBDC, $18.55) taps loan-origination channels that have been developed by a related entity, $25 billion-in-assets Golub Capital, and also partners with private-equity firms to source deals.
Golub’s $1.8 billion portfolio represents investments in 189 client companies. The BDC is strongly focused on the healthcare, education and childcare sectors, which account for 20% of the portfolio, but also invests in 11 other industries.
One-stop loans are 77% of the portfolio and consist of senior secured loans that allow borrowers to pay off the loan by making a single lump sum payment at the end of the term. The other major component of the portfolio is first lien debt. Golub has no second lien or subordinated debt and only 1% of equity investments.
With floating-rate debt at 99.6% of the portfolio, Golub is better-positioned than most BDCs to profit from rising interest rates.
Investment yields have held steady and even trended slightly up in recent quarters, enabling Golub to grow its asset base. Expanding assets and yields indicate a BDC that may soon be able to grow the dividend.
Golub has paid a 32-cent dividend for several years and delivered an 8-cent special dividend in the first quarter of 2018. NII per share plus realized gains on sales has more than covered the dividend.
Market value: $526.5 million
Dividend yield: 8.4%
PennantPark Floating Rate Capital (PFLT, $13.58) is managed by PennantPark Investment Advisors, which has funded more than $7 billion of investments. PennantPark is an efficiency leader in the BDC space, with expense ratios well below industry peers, and takes a value-based approach to investing that emphasizes preservation of capital.
The BDC’s $834 million investment portfolio is spread across 86 companies. The debt portfolio yielded 8.3% last year. The BDC invests in 24 different industries, but has concentrations in tech, consumer goods and business services, which together represent 37% of the portfolio.
This BDC enjoys rising interest rates due to a portfolio that is 99% floating rate debt. The portfolio is also high-quality, consisting of 91% first lien debt, 4% second lien debt and 5% subordinated debt and equity.
PennantPark has modest leverage and plenty of capacity for portfolio growth. Its sources of capital include a $300 million loan fund joint venture with Kemper Corporation, $228 million in proceeds from recent debt and equity offerings and a credit facility recently upsized to $405 million attractively priced at LIBOR plus 2.0%.
PennantPark is a monthly dividend payer and has paid a 9.5-cent dividend for 24 consecutive months. NII per share totaling $1.11 last year was slightly less than the $1.14 dividend, indicating asset growth is needed to maintain the dividend rate.
Keefe Bruyette & Woods analyst Ryan Lynch rates shares a “Buy” and notes that PennantPark has one of the best credit records in the BDC sector.
Market value: $379.5 million
Dividend yield: 8.3%
Newtek Business Services (NEWT, $20.18) is the largest non-bank Small Business Administration lender and the sixth largest SBA lender overall. (Payment on SBA loans is guaranteed by the U.S. government.) Newtek’s $187,000 average loan size is much smaller than other BDCs, and its portfolio is well-diversified across more than 1,500 different investments.
Newtek’s volume of loan funding rose 25% last year to $385.9 million, and Newtek anticipates funding at least $465 million of SBA loans in 2018.
Newtek is unusual among BDCs in generating most of its income from gains on loan sales. The BDC typically sells the 75% guaranteed portion of each SBA loan and retain the 25% unguaranteed portion for its portfolio. Premiums earned on loan sales have average around 12% per year.
Another unusual feature is Newtek’s wholly owned businesses, which cross-sell electronic payment processing, technology consulting and other business services to loan customers. These businesses pay dividends to the parent company that help smooth earnings and minimize interest-rate risk.
Newtek grew its dividend 7% last year to $1.64 and expects to pay a $1.70 annual dividend this year. Adjusted NII rose 11% last year to $1.77 per share and more than covered the dividend.
Market value: $221.5 million
Dividend yield: 11.5%
TriplePoint Venture Growth (TPVG, $12.54) funds companies that are backed by prominent venture capital firms. Its investments are primarily in tech, life sciences and other high-growth sectors.
TriplePoint targets 10% to 18% returns on its venture growth portfolio. Loans are short-term (maturities of just three to four years), conservatively underwritten (25% ratio of loan-to-enterprise value) and de-risked by equity support from VC sponsors. Since its 2014 IPO, TriplePoint has originated more than $1.4 billion of investments.
During 2017, the BDC added 16 companies to its portfolio, grew funded investments by 49% and increased NII per share by 13%. TriplePoint is benefiting from robust demand for venture growth debt financing this year, as well as Amazon’s (AMZN) recent purchase of loan customer Ring, which should generate a nice payout for the BDC.
TriplePoint’s $401.3 million portfolio (a record high) consists of debt, warrants and equity from 21 portfolio companies. The portfolio is 95% debt, 65% floating rate debt and yielded 16.4% last year. NII growth will come from increased loan yields and profit-sharing “equity kickers” attached to warrants. In addition to debt, TriplePoint holds 32 warrants and 14 equity investments valued at $20 million.
TriplePoint has paid a 36-cent dividend for 14 quarters in a row. NII of $1.61 more than covered the $1.44 dividend last year.
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