Main Street Capital(NYSE: MAIN) and Triangle Capital(NYSE: TCAP) are known as frugal operators in the business development company (BDC) industry. They hold their operating expenses to a fraction of the average BDC, helped by their internal management structures.
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The advantage is tremendous. An advantage in operating expenses allows these financiers to make more underwriting errors and still generate superior returns. Investors are happy to pay a premium for their shares as a result.
Main Street shares trade at a 70% premium to book, while Triangle Capital's stock sells for a 17% premium. By contrast, the median BDC trades at a 5% discount.
But there may be better options
In their simplest form, BDCs have a lot of similarities with fixed-income closed-end funds(CEFs). They both make their money investing primarily in debt investments and use leverage to amplify their returns. In many cases, shares of BDCs and CEFs are more liquid than their underlying portfolios, too.
Traditionally, BDCs invest in private companies, and CEFs invest publicly traded companies. But some CEFs really blur the lines and act more like BDCs.
Take the Barings Participation Investors fund as an example. It invests primarily in privately held companies through debt investments, many of which yield 10%, if not more. Other than the roughly 30% of its portfolio invested in traditional high-yield bonds, its portfolio is very BDC-like.
In fact, it shares some investments with some well-known BDCs. Its investments in Dunn Paper, Del Real, ERG Holding, and Money Mailer can be found on BDCs' balance sheets, too.
But while Barings Participation Investors may have a BDC-like portfolio, it doesn't have BDC-like fees. Total expenses, excluding interest expense, tallied about 1.2% of assets last year. By comparison, most BDCs charge fees that start at 1.5% of assets, plus 20% of returns, resulting in total fees that top 3% of assets, more than twice what some CEFs charge.
Before taking aim at a BDC stock, consider CEFs, which have comparable yields from similar investment portfolios. Image source: Getty Images.
A curious valuation
BDCs with lower costs can theoretically generate more income per dollar of equity capital, possibly justifying an above-average valuation.
Compared with similar CEFs, though, Main Street and Triangle aren't especially frugal. They aren't very cheap, either, given their high price-to-book multiples. Both trade at a substantial premium to CEFs that hold private debt and equity investments.
Data sources: SEC filings, Morningstar. Expenses calculated by dividing all expenses net of interest expense by total year-end assets for 2016.
Why do CEFs trade differently from BDCs?
There are a few obvious reasons that may explain some, but not all, of the valuation differences. BDC-like CEFs tend to be less liquid because of their relatively smaller size. In addition, CEFs' investments in easy-to-access asset classes such as traditional corporate bonds (which make up 30% of Barings' portfolio) aren't deserving of a multiple on book value.
Some argue that BDCs have some optionality value. Main Street Capital and Triangle Capital have the capacity to grow their book value on a per-share basis by issuing new stock, something many CEFs do rarely or not at all. (I think the logic tenuous, as it assumes that a BDC has a higher intrinsic value just by virtue of being more expensive.)
Ultimately, valuation differences are probably just something of an inefficiency, given that both CEFs and BDCs can rapidly overshoot to wide premiums or discounts to their underlying value. After all, Barings' fund once traded at a substantial premium. The Pimco High Income CEFhas famously traded at a persistent premium to book value, averaging 36% over the past six months, according to Morningstar. The fund traded at a discount before the financial crisis, before investors started chasing yield as never before.
Before you pay up for a BDC, you might want to explore the world of CEFs, many of which offer high yields from similar investments, but without the operating costs and premiums to book value.
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