Do BDCs Have Sustainable Business Models?

Business development companies, or BDCs, are popular among income-seeking investors for their high dividend yields. However, whenever companies pay such high dividends, the question of sustainability comes up.

We asked two of our analysts about the sustainability of the BDC business model, and here is what they had to say.

Matt FrankelWhile no stock that pays a dividend of more than 10% is without a substantial level of risk, business development companies are a pretty good idea in principle.

Basically, these companies finance the debt of small- to medium-sized businesses that don't have a high enough credit quality to get competitive financing elsewhere. Due to the risk that comes with investing in this type of company, the BDC earns a relatively high rate of return on its investment. Then, to boost returns, the BDC borrows money against its assets to lend out and pockets the spread between the two rates.

And while each individual company is rather risky, when a BDC has over 100 investments in its portfolio, it mitigates that risk through diversification. For instance, if one holding defaults on its debt, it's not that big of a deal to a BDC's investors if that company only represents a small part of the portfolio.

In theory, so long as these companies earn more than they pay out, the dividends should be sustainable. For example, Ares Capital Corporation currently pays out $1.52 per year, which represents an 8.8% annual yield. And the company is projected to earn $1.58 per share for the 2015 fiscal year, so it should have no problems covering the dividend.

However, while this sounds good in principle, it doesn't always work out that way in practice. My colleague, Jordan Wathen, has written several articles on the questionable actions of some major BDCs recently, so I'll let him delve into some of the inherent problems with BDC investing.

Jordan WathenI'm a big believer in the idea that incentives matter, particularly when it comes to how a company is managed. The BDC industry suffers from an inherent conflict of interest between management and shareholders. Managers want to grow their asset base, because more assets mean more pay. Shareholders are primarily concerned with the return on assets, not necessarily the number of assets.

While I think BDCs and their underlying investments can be great for achieving high yields in a low-yield world, I do think investors should pay close attention to whether a management team has shareholder interests in mind.

One of the best ways to test for alignment is to see how and when BDCs grow. Because BDCs grow primarily by issuing new shares to the public, shareholders should invest only in BDCs that have a record of selling shares at the highest possible price. Recently, many have sold shares at prices below book value, essentially making shareholders poorer while making managers richer. As a category, BDCs that routinely issue shares at or near their last-reported book value will likely underperform those that only issue new shares at a sufficient premium -- call it 10%-20% over book value. This basic smell test is one of the best indicators of alignment between managers and shareholders.

Tread carefullyIf you do choose to invest in business development companies, use caution. Make sure the company you invest in has shareholders' interests in mind and earns enough money to sustain the dividend. And, as we mentioned, no high-yielding investment is without risk, so make sure you do your homework before jumping in.

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the_motley_fool has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. Matthew Frankel 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.

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