U.S. Dividend Stock Investing for Canadian. High Yield Income from Business Development Companies

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1 U.S. Dividend Stock Investing for Canadian Investors High Yield Income from Business Development Companies 1

2 High Yield Income from Business Development Companies The list of publicly traded business development companies (BDCs) is a small, unique sector of the stock market. BDCs are attractive to investors because when they operate well the shares provide steady dividends with attractive yields. Typical yields in the group range from high single digits to low double digits. A lot of investors like the idea and want 8%, 9%, even 10% cash flow yields flowing into their portfolios. Business development companies operate under the Small Business Investment Incentive Act of 1980, which was an amendment to the Investment Company Act of The 1940 Act is the primary law governing investment products such as mutual funds, closedend funds and exchange traded funds. The 1980 Act provided some exceptions to Investment Company Act rules. The purpose was to open a new source of financing for small to medium size businesses that do not have access to the public debt and equity markets. In structure, a BDC is closely related to a closed-end fund. A BDC operates under a strict set of rules. First, a BDC can only make loans or equity investments in small to medium sized corporations that meet the criteria in the law. The next rule is that a BDC can only have debt equal to the equity capital of the company. For example, a new BDC sells stock and has $500 million from the sale. The company can then borrow another $500 million, bringing the company s total investment capital to $1 billion. By law, a BDC cannot over leverage itself. Finally, a BDC must pay out at least 90% of net income as dividends to investors. If a BDC pays out 95%, it gets an additional tax break. BDCs are pass-through companies, which means if they pay out the 90% of income, they don t pay corporate income tax. The rules under which BDCs operate produce companies that have certain features. The companies in the sector are primarily in the lending business. They make high rate loans to companies that cannot qualify for traditional bank loans. 1

3 The interest income is passed through as dividends to share owners. A BDC may also take equity positions in the client companies. These positions can be actual ownership or equity warrants that pay off if a client is bought out or goes public with an IPO. A BDC also provides management advice to portfolio companies. The typical BDC will have hundreds of portfolio investments, which produces a wealth of information concerning good business management practices. A BDC will be either internally managed or have an external management agreement. The companies in the sector are about evenly split between the two management structures. Internal management is self-explanatory. The people that operate the BDC are employees of the BDC. With external management, the BDC has a contract with an outside asset manager to handle the investments and administration of the company. The external manager will earn a base fee of about 2% of assets and incentive fees when the portfolio exceeds a preset return, typically above 8% annually. In general, an externally managed BDC will suck off significantly more money for management expenses as a percentage of assets than the expenses of an internally managed one. Business Development Company Challenges The way the BDC rules are structured leads to several hurdles which can prevent a BDC from providing long-term positive investment results to investors. Risky Business. By law, a BDC provides debt and equity capital to small to mid-sized corporations. These are companies that cannot get bank financing due to the riskiness of their business operations. They are too small to tap into the public debt and equity markets. The core business of every BDC is to make high rate loans to companies that likely cannot get business financing from any other source. A BDC will experience some level of loan losses. In a good economy the losses will be smaller. If the economy has problems, the BDC could experience significant losses in its loan portfolio. This is a serious problem for a company operating as a BDC. Remember that by law, a BDC must payout 90% of its net earnings. This rule prevents a BDC from setting aside loan loss provisions, as regular banks do. For a BDC, loan losses will lead to an inevitable drawdown of the company s portfolio value and the equity capital in the company. 2

4 A BDC can only have debt to a maximum of one times the equity, loan losses can force the BDC to find some way to reduce its debt load not an easy task for a company that is shrinking in size. As a result, each BDC must have a plan to offset the inevitable loan losses. The most common strategy employed by management teams in the sector is to grow their way out of declining portfolio values. This is done by issuing new shares of common stock, which allows a BDC to take on debt equal to the capital raised from the stock offering. This new capital is put to work making new loans, and the growth covers up loan losses. With this strategy, a BDC must make regular offerings of new stock shares, and issue new debt to support the current dividend rate. Often, a BDC will also take equity positions in client companies. These ownership stakes can pay off with higher returns which will offset some of the loan losses and support a BDC s book value. The bottom line is that a BDC management team needs to peddle fast just to stay even with its ability to generate interest income and support the current dividend rate. Management vs. Investor Conflicts. As I noted above, the majority of BDCs are operated by an external money management company. The management fees charged by external management contracts are almost always higher as a percentage of assets compared to BDCs with internal management. External management fees can top 3% of assets per year, while a well-run internally managed company will have expenses below 2%. Since most of the external management fee is based on the amount of assets in the BDC, an external manager grows its income by growing the asset base. This growth may not result in better results for common stock shareholders. You saw from the previous section, that a BDC must grow its assets just to stand still as far as its ability to pay dividends. Share Price vs. Book Value. Investors like to find opportunities where a security is trading at a discount to its net asset or book value. For a BDC, having the share price trade for less than the book value is a very big danger signal. First, if the stock is trading for less than book, a BDC cannot issue shares without an approval vote from shareholders. 3

5 As noted on the previous page, BDCs need to issue shares to grow, and selling shares at a discount dilutes the book value. When a BDC is trading at a discount it is on the wrong side of the grow or die equation. If the BDC share price is at a premium to book value, that is a powerful benefit for investors. Each time a company with a strong share price issues shares, it is accretive to book value. The share price to book value is a very important metric when evaluating a BDC for investment. My rule is to never buy or own shares of a BDC trading at a discount to its book value. Conclusions The business development company sector is attractive to investors because of the high yields and the apparent safety of rules that limit the amount of debt leverage one of these companies can use. However, the restrictions that keep a BDC from having loan loss reserves is, in practice, a big detriment for one of these companies to operate as a steady and dependable dividend paying stock. The BDC sector is littered with companies that got behind the loan losses and low share price to book value curves and were forced to slash dividends. As an income investor you want to dig out those BDCs with business operations that produce stable to growing dividend payments. You want to own shares in the companies that trade at a premium to their book values. Currently only two business development companies meet my criteria to be Dividend Hunter recommended stocks. 4

6 Main Street Capital Corp. (NYSE: MAIN), is quite different from the rest of the BDC crowd. Since its 2007 IPO, MAIN has tripled the total return average of its BDC peers. Here is a list of some of the reasons why this company stands apart from its peers in the industry: MAIN is internally managed with insiders owning over 2.8 million shares. Co-founder, Chairman, and CEO Vince Foster is the single largest individual shareholder. Main Street is the most conservatively managed BDC in the industry and holds an investment grade BBB credit rating. Investment grade is rare among the BDC crowd and allows Main Street to borrow at a much lower cost of capital compared to most other BDCs. Operating, admin, and management costs are 1.4% of assets compared to 3.4% for the average BDC and 2.7% for commercial banks. Net debt is just 0.61 times company equity, well below the 1.0 times maximum set by law. The share price is about 1.5 times the book or NAV value. MAIN uses a two-tier approach to its portfolio. This unique strategy allows Main Street to generate a high level of interest income and capital gains from equity investments. In the middle market, MAIN provides debt financing to companies with stable finances and low risk of default. Currently, Main Street has 68 middle market clients with an average loan amount of $9.3 million. The loans total over $600 million or about 28% of MAIN's total portfolio. Middle market loans are floating rate and match with MAIN's floating rate debt facility. The average 8.7% yield on this group of loans is 5.35% higher than Main Street's debt used to fund the loans to clients. The 5.35% interest margin is almost pure cash flow that can be used to help pay dividends on MAIN's stock shares. In the lower middle market, the company takes equity stakes along with providing debt financing. The equity provides a significant boost to the total returns generated. Lower middle market companies are smaller than the typical BDC client and have annual revenues between $10 and $150 million. 5

7 There are over 175,000 companies in this revenue bracket in the U.S., and MAIN has 71 lower middle market clients with loans and equity investments worth $938 million. The loans to the companies in this part of the portfolio have an average yield of 11.9%. The equity position gives an average 38% ownership of the client companies. The equity stakes are what have allowed the MAIN net asset value (NAV) to increase by almost 80% since the 2007 IPO. The equity investments are what set MAIN apart from most other BDCs. The rules under which these companies operate prevent them from setting aside loan loss reserves. Because a BDC makes higher risk loans, there will be loan losses. These losses have a direct negative effect on a BDC's book or net asset value. That is why most BDCs struggle to maintain their book values compared to the growing value built by Main Street Capital. In recent years, Main Street has been growing what it calls its Private Loan Portfolio. These are loans originated through strategic relationships with other investment funds on a collaborative basis and are often referred to in the debt markets as club deals. The private loan portfolio makes up 22% (56 loans for $486 million) of the overall MAIN portfolio and carries and average yield of 9.3%. The loans have floating interest rates and benefit from lower overhead costs. Core Income Holding Investment The lower middle market client, middle market client, and private loans mix provides a combination of net interest income to support MAIN's very excellent history of dividend payments. The result has been a BDC that has generated both regular dividend growth for investors and special dividends to pay out capital gains. As an additional bonus, MAIN pays monthly dividends, smoothing out the cash flow into your brokerage account. In August 2017, the monthly dividend was increased by 1/2 cent to $0.19. This dividend rate is 5.5% higher than a year ago. At $38.50 per share, MAIN currently yields 5.9%. Also, the company has been paying a special dividend twice a year to pay out some of the profits from the lower middle market equity investments. Over the last year, the two payments have totaled $0.55 per share, bringing the total yield to 7.3%. MAIN generates a significant cash flow cushion to cover the dividends to be paid. 6

8 This is a very important factor when considering which stocks to add to the portfolio. As of the 2017 third quarter, the distributable cash run rate was $2.49 per share. This is interest income only, no capital gains, and provides 112% coverage for the monthly dividend. The high share price to book value ratio (about 1.5 times) for Main Street allows the company to sell shares and generate an immediate positive result for investors. This capital can then be put to work to generate a growing cash flow stream to support future dividend increases. 7

9 Hercules Capital Has Carved Its Own Niche Hercules Capital Inc. (Nasdaq: HTGC) is one of the oldest BDCs, founded in 2003 and into the market with a 2005 IPO. The company is internally managed with a $1.15 billion market cap. In the BDC world, $1.0 billion, with a $1.6 billion enterprise value (market cap plus debt) is one of the larger companies. What sets HTGC apart from its peers is its client focus. Hercules works with venture capital and private equity firms to provide funding for companies that are pre-ipo or being groomed for merger or acquisition. The BDC lives up to its name, providing funding primarily to various types of technology related companies. To assist its client companies and their venture capital backers, HTGC makes only senior debt loans with maturities of 3 to 3 1/2 years. About 90% of Hercules' assets are loan with 10% as equity positions that can pay off very well when a client goes public or is acquired. The loans made by HTGC carry an average "core" yield of 13% to 14%. The typical loan has a 10.5% coupon rate, and the core yield is bumped up by commitment and origination fees. Equity profits and early termination fees have increased Hercules average effective returns to above 16%. The company's relationships with over 500 venture capital type firms has allowed HTGC to steadily grow its book of business, and steadily increase its annual dividend. Since 2010, the annual dividend has increased from $0.80 per share to $1.24 paid in The dividend has been flat for the last three years, but now the company is again in a position to grow the per share payout. 8

10 Investment Potential The HTGC share price dropped sharply in April 2017 when the founder proposed to take the company s management to an external structure. Investors rebelled, and the external manager proposition was shelved permanently. At this point the HTGC share price remains below its early 2017 peak of $ As a result, the stock yields a very attractive 10%. At the recent share price, the stock trades at 1.25 times the book value, so still at an acceptable premium. Net investment income per share is growing, which points to dividend increases soon. Land, Fly or Die, Tim Plaehn Editor The Dividend Hunter INSIDERS 2018 Investors Alley Corp. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Investors Alley Corp., 8560 Sunset Blvd, Suite 400, Los Angeles, CA or For complete terms and conditions governing the use of this publication please visit 9