There’s never a dull moment when we’re seeking out dividends. It’s a fascinating world of corporate finance, unique business models, consistent cash flows, and lucrative opportunities. There’s more than one way to financial freedom but they all lead back to one core concept – return on investment.
In my previous article, I decided to cherry pick investments that offered monthly dividends. Dividends, as you already know, is the primary focus of this blog. It’s a hard cash return on investment that we value above all else. Many of our readers rely on these dividends to pay their household bills and meet living expenses. Since these expenses are usually monthly, it makes sense that dividends match up to that schedule.
Nevertheless, annual and quarterly dividends are the most popular schedules on Wall Street. If you hold a dividend-paying stock, chances are high that the cash flows in once a year rather than every month. There are, however, some stocks that pay on a monthly basis. In my previous article I listed 35 of them. Nearly 9 out of those 35 companies were specialized firms called Business Development Companies or BDCs.
Considering 25% of monthly dividend stocks are BDCs, it’s worth taking a closer look at these niche businesses to figure out how they generate stable cash flows and offer lucrative dividends to investors. Here’s an overview of BDCs for income seeking investors:
Creating a business is notoriously difficult. Ask any entrepreneur what they’ve had to go through to get a business started and they’ll tell you about the sleepless nights and panic attacks they’ve suffered over the years.
A jaw-dropping 40% of all new businesses fail within the first five years. A colossal 96% fail within the first ten years. There’s a lot of reasons businesses don’t continue, but a lack of funding or adequate cash flow ranks high on the list of threats.
Sustaining a business requires capital, which comes from a number of places. Most people self-fund with their own savings or ask friends and family. But when a business gets too big for such methods, and a bank loan isn’t an option, entrepreneurs will turn to venture capital (VC) or private equity (PE) firms.
Almost everyone knows what a VC or PE firm does. They buy equity or lend money to a business and expect a return within a certain amount of time. What most people don’t know is that the money is sourced from wealthy individuals, professional investors, or institutional buyers. Only qualified or accredited investors can pour money into a VC or PE firm. According to the SEC, a person needs annual income of at least $200,000 in each of the past two years ($300,000 for joint income) or a net worth of at least $1 million to qualify.
This means the best new opportunities and young, new private firms are off-limits to the average investor.
In 1980, Congress decided to change this with amendments to the Investment Company Act of 1940. These amendments allowed for the formation of a new type of business. One solely focused on offering capital to small and medium-sized firms and generating income for average investors. They’re known as a Business Development Companies.
How BDCs work
BDCs work much the same way VC or PE firms do. They raise funds from investors and offer loans or investment to private companies. They hold on and offer support to the business till they get a viable return on their investment. The money is returned to the original investors.
The key difference is the fact that BDCs are publicly listed on stock exchanges. They can be accessed by any income seeking investor. Regulations ensure that a BDC pays out most of its profit in the form of dividends. Many of these BDCs choose to pay dividends on a monthly basis. These monthly dividends tend to be rather high if the BDC is performing well.
At the moment, the average BDC monthly dividend yield is 9.7%. Compare that to the 2.5% offered by the S&P 500 and you can see why these investments are so attractive.
BDCs are not just great for income seeking investors. They’re also good for the companies. Unlike VC or PE firms, BDCs can take deeper stakes and hold on for longer. This creates liquidity and long-term capital for private businesses across the country.
The typical BDC tends to target gaps in the capital market left out by big VCs, PEs, institutional investors, and banks. They tend to go for riskier loans to smaller companies that are generally not listed. The investment methods include senior secured debt, unitranche term loans, junior secured term loans, subordinated debt investments and minority equity co-investments. Typically, these funds go to companies that earn between $10 to $500 million annually.
No Free Lunch
BDCs promise investors the promised land of riches. Not only do they offer hefty monthly dividends but they also offer retail investors a slice of the private market where returns are expected to be higher. They act as the private equity firm for the little guy. And PE firms have done rather well when compared to the public market:
However, you’ll hear a lot of folk on Wall Street claim there’s never a free lunch. BDCs offer sky high dividends, but those dividends come with inherent risk. These firms lack transparency and the companies they invest in lack liquidity.
BDCs usually invest with considerable leverage. These leveraged bets are in small or medium-sized private companies that can’t be studied by public records. The loans extended to these companies are often on complex and indecipherable terms.
In short, BDCs are taking on a lot of risk but there’s no way to judge or accurately measure the risk from outside. Loans are being extended and companies are being bought, but the value and covenants are being written by an army of lawyers and analysts. It’s all a little overwhelming for the average investor.
Valuations in the private equity business are subjective. Which means a certain business or asset could be marked down drastically without warning.
This is the price retail investors are expected to pay for a high-yield monthly dividend BDC listed on the market. Right now, there are over 88 BDCs active in the US, with net assets of more than $52bn. Between 2005 and 2015, the size of the industry increased ten-fold.
The rules prohibit excess leverage. A BDC can only take leverage to the ratio of 1:1. That means there is a dollar of debt for every dollar of equity. However, there are no limits on the leverage these firms can take for leveraged buyouts or other risky financial engineering.
Activist investors have been arguing that the performance fees and management salaries at these firms often chew into the overall return to investors. Most BDCs trade on the stock market below their net asset value, which seems to indicate investors are well-aware of this inefficiency.
Some of the Best
Getting the right BDC is a balance between high yield and low risk. You need a firm that has a history of high monthly dividend payments, an attractive portfolio, and excellent cash management.
Here are some of the best BDCs as per their monthly dividend yield and the dividend coverage ratio.
PennantPark Floating Rate Capital Ltd (NASDAQ:PFLT)
Gladstone Capital Corporation (NASDAQ:GLAD)
Business development companies fill an important gap in our economy. Despite record-low interest rates across the world, banks are still under tight regulation. This means banks will not easily lend to risky businesses that don’t fit their strict criteria.
Entrepreneurs can reach out to friends and family, but when the business gets to a certain size a better solution is needed. Most entrepreneurs will reach out to venture capital firms or private equity companies for their funding needs.
However, these VCs and PEs are out of reach of the common investor. BDCs are a better alternative. The bypass corporate taxes by paying most of their income back to investors. This results in higher monthly dividends.
Nevertheless, these securities are risky. Management fees could be too high or the loans given out could be too risky. The only way to tell is to look closely at the company’s track record and portfolio.
For income seeking investors who need monthly dividends and don’t mind a bit of added risk, BDCs could be an excellent opportunity.