A Quick Survey of Business Development Companies (BDCs)

A so far unremarked misadventure of my own the last few years has been making several investment mistakes in mortgage real estate investment trusts (MREITs). Perhaps 10 years ago a friend of mine mentioned that he had invested in Annaly Capital Management Inc (NLY). At that time, I was leery of investing in high-yield financial securities, having observed several equity REITs with high yields crash about a dozen years before. The basic idea of an MREIT is simple enough. The problem I worried about was the conflict of interest management has with shareholders, and the intense competition among companies in the same industry trying to outdo each other in leveraging up their assets. The other problem is that I've never found interest rates to be predictable over the short term, and over the long term the error is more likely to be in holding long-dated bonds as interest rates rise.

Sure enough, my experiments in that sector resulted in mostly setbacks. At the moment I'm not convinced that I have the expertise to pick winners in the MREIT industry, and so I am currently avoiding it.

Still, MREITs are not the only high-yield sector. Another category in the Business Development Company sector. Last week I spent some time exploring it, and I liked what I found much, much more than MREITs. This article will report on my findings.

BDC Structure and Legal Background

The BDC structure originates in a 1980 amendment to the Investment Company Act of 1940. Taxation is pass-through, like a REIT or MREIT. The BDC Wikipedia article and Investopedia have good explanations, so I will say nothing more here. I found the external links section of the Wikipedia article to be a great resource.

Use as a VC-Style Investment

Suppose you've had some success at investing in publicly-traded equities, have watched Shark Tank, and want to go further and get closer to the founding and running of new enterprises? You could start your own business, be an angel investor in friends and acquaintances' businesses, or take other risks like bungee jumping with frayed cords. BDCs offer a way to get the flavor of this style of investing, with smaller initial outlays, liquidity, and diversification. You can choose to pay little attention and just collect dividends, or inspect the portfolios to see the small businesses who are clients. In my short investigation of one BDC's portfolio I found arborists, a cosmetics company, an HVAC services company, several small manufacturers, and a construction company.

Function 

The purpose of BDCs is to provide increased borrowing options for small and medium-sized businesses. The public supplies the capital, a management team (typically fairly small with respect to the investments, of course) supplies concentrated business expertise at judging the riskiness of the client firms, and small business gets credit and expansion opportunities they might not have had otherwise. In my quick view of the business I saw multiple important functions addressed for all parties. The usual business risks are present, as they always are, but there is a fundamental purpose that is quite valuable.

The BDC purpose is not flawed like MREITs. MREITs exist to provide capital to the housing market. Unfortunately, this purpose accidentally provides all of the benefits to the public and real estate brokers. Since mortgage funds then become a commodity, mortgage rates are driven to levels that are unprofitable for the lender, and which also then drive risky behavior by management, who scramble for survival. (Or at least are scrambling for the survival of the enterprise's book value.) Though I have not yet written enough for a full article on the topic of U.S. housing finance, I think there is some reason to believe that the tax-advantaged nature of mortgage debt makes the U.S. housing market inherently unstable, and that instability is reflected in the volatile and generally poor results of the MREITs. 

Selections and Rationale

Closed End Fund Advisors maintains an outstanding database of BDC data. They maintain an extensive database and provide reports on most (all?) closed-end funds. It is well worth your time to go to their excellent, well-presented site and review what they have to offer. (No, I am not affiliated with them and this is not a paid advertisement. I doubt they even know that Vorpal Trade exists.)

I reviewed all 49 BDCs in the database, noting NAV growth especially. My method of sorting for quality using the data was to weight annualized NAV rate of return most highly, and to discount NAV ROR for length of tenure. I was also less interested in BDCs trading at a large premium to their NAV. With those criteria in mind, I found these nine BDCs worth investment: ARCC, CSWC, FDUS, GAIN, NEWT, PNNT, PSEC, SAR, TSLX.

This year's turbulence has driven down prices of most BDCs, so although some have recovered in price over the month of July, you are getting better prices than were available in 2021. Also keep the premium or discount to NAV in mind. The market clearly favors BDCs that generate above average NAV gains, so you might have to pay a premium to get quality.

The vast majority of BDCs are debt-focused, making secured loans. Many will still have some equity or warrants in their portfolio. I saw only two equity-focused BDCs, though I may have missed some others. The past performance of the equity-focused BDCs was not impressive, so none are in my list of nine.