Stocks to Watch: Business Development Companies

By Markets Fool.com

The business development company industry makes its money by making debt and equity investments in smaller, private businesses. Many of its investments are made alongside private equity sponsors, who use large amounts of debt to buy whole companies.

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But the BDC industry can also be a great source of yield. By law, BDCs must distribute virtually all of their earnings as a dividend in order to avoid all forms of corporate taxation. The result is an industry that frequently pays double-digit yields to investors. Here are two business development companies to keep on your watch list.

1. A new big fish
Where most BDCs start off small before growing big, FS Investment Corp. came onto the market and immediately staked its claim as one of the biggest in the industry. The company is currently the fourth-largest BDC in the industry by assets despite having raised no new equity capital since its IPO in 2014.

There are a few things that make FS Investment Corp. appealing. The most important is its relationship with its subadvisor GSO/Blackstone, arguably the best combination of credit and private equity investors in the world.

The benefits of this star manager go beyond pure capital allocation. FS Investment's portfolio companies can take part in Blackstone's group purchasing organization. The group purchasing organization combines the purchasing power of Blackstone's portfolio companies to negotiate with suppliers on everything from printer ink to toilet paper.

At its most recent Investor Day, FS Investment Corp. broke out some examples showing how the GPO saved its portfolio companies money. Its qualifying portfolio companies have created average savings equal to 5.4% of their annual earnings before interest, taxes, depreciation, and amortization.

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Driving down a portfolio company's cost structure at the margin is a powerful advantage, as it allows for better debt service coverage while creating more earnings, and thus higher valuations, for its portfolio companies.

In an industry where too many participants claim to provide managerial and operational support to their portfolio companies, FS Investment actually does. And I think its relationship with GSO/Blackstone also gives it access to much better deal flow than its competitors. All else equal, the capacity to be more selective about the deals you take part in should result in better returns.

2. A new face with a long history
It may be new as a publicly traded BDC, but Capitala Finance Corp. is no stranger to the world of private finance. Capitala's manager has run SBIC funds for more than a decade, investing in the smallest of private companies, also known as "lower middle market" companies.

I generally think the lower middle market is better than the "true" middle market made up of larger companies. Smaller companies simply sell for lower prices relative to earnings, boosting long-run returns for BDCs that make equity investments in their portfolio companies.

Capitala's investment record also reveals some excellent long-term winners. The company crushed it with a 2011 investment in Boot Barn prior to its public listing, generating an internal rate of return of 78% and 6.1 times its initial cash investment.

In addition, other winners include the likes of apparel chain City Gear and sales training company Corporate Visions, both of which are held at significant multiples of Capitala's original investment.

The company is monetizing some of its older equity investments at a gain, affording it the ability to pay out special dividends to its investors. In all, its equity portfolio is currently held at a 74% premium to its cost. The winners have more than covered its occasional losers.

Capitala will stay on my watch list for now. It doesn't have the investor-friendly cost structure that other lower-middle market BDCs have, being an externally managed company with a less-than-stellar fee agreement. In addition, it has a significant stake in energy investments, which made up 12% of its investment portfolio last quarter.

Offsetting some of these disadvantages is its small size, which should enable it to be more selective in making new investments, and the fact that management is heavily invested in its stock, holding more than 7% of its shares outstanding.

These two BDCs are very different, and only time will tell whether their business models can drive big returns for shareholders. But their records suggest they're worth watching.If they can perform half as well in a downturn as they have in the post-financial-crisis recovery years, these two stocks could be great candidates for your income portfolio.

The article Stocks to Watch: Business Development Companies originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.