What Are BDC Stocks and Should You Buy Them?
The past few months have been difficult for stock market investors. Many once-popular stocks have gotten slammed and even formerly-invincible names like Amazon and Meta Platforms are down about 40%. When the market is crashing like this, investors tend to recalibrate their expectations. Instead of buying into stocks that are going “to the moon,” they’re just trying to not lose money. Suddenly, a nice, consistent return on their money doesn’t sound too bad. This is just one reason why lots of investors are taking a second look at BDC stocks.
What are BDC Stocks?
Business development companies (BDCs) are sort of a combination between stocks and private equity investments. They are a publicly-traded company that invests in PE and VC-style investments. This essentially gives retail investors access to the private markets. BDC companies typically invest in mid-sized companies. This means that they go after companies that are too big for bank financing but not big enough to go public yet. Most BDCs offer both debt and equity investments.
Another key aspect of BDC stocks is that they need to pay out 90% of their income to investors. Doing this allows them to remain exempt from federal taxes. If this structure sounds familiar, it’s because it’s the same structure used by Real Estate Investment Trusts (REITs). In this sense, you can think of BDCs as similar to a REIT but for private debt/equity investments.
With that said, let’s examine some of the pros and cons of buying BDC stocks.
Benefits of BDC Stocks
Investing in BDC stocks can give you exposure to private equities. Usually, unless you are an accredited investor, investing in private equities is probably off-limits for you. To invest in private companies, you usually need to have a net worth of over $1 million. BDC stocks offer a way around this. On top of that, BDCs don’t require lockups or minimum investments. They can also be easily bought and sold on most stock exchanges.
High Dividend Yield
Just like REITs, BDCs must pay out 90% of their income. By doing this, they are exempt from paying federal tax. This structure allows BDCs to offer higher-than-average dividend yields. For example, most BDCs can offer a yield between 5-10%. But, keep in mind that this high dividend yield is never a guarantee. Let’s take a closer look at that.
Downsides of BDC Stocks
As you might’ve guessed, a higher potential yield comes with more risk. In this case, you have to put more faith in the business development company. To start, the BDC usually holds illiquid investments in private companies. There probably isn’t going to be a ton of information available about the specifics of these companies or the deals. In this sense, you are going in a little bit blind and trusting the management team’s judgment. Speaking of which…
The BDC’s investment decisions are usually controlled by a small team. There is always the risk that this team won’t always make the right decisions. Or, if the team is very successful, there is always the risk that they will leave to pursue other projects.
BDC stocks use a lot of leverage. Generally, they borrow money so that they can lend it to mid-sized companies that need it. This usually involves using a combination of fixed and floating interest rates. For this reason, BDCs are constantly at risk of interest rate fluctuations. A small increase in interest rates can impact the margin in the BDCs loans. This directly impacts its profitability and, subsequently, its dividend.
Unlike low-cost ETFs, BDCs may have a handful of fees. This includes a management fee, incentive fee, and fees associated with servicing loans. The exact fees will vary depending on the BDC. However, these fees can eat into your returns and reduce the rosiness of a high dividend yield.
Low Capital Gains
BDCs payout 90% of their income as dividends. For this reason, the price of their stock does not usually increase very much. If you are trying to grow your money over time, BDCs are not for you. But, if you want consistent dividend income then BDCs are a great choice.
What are the Best BDC Stocks to Buy?
This article is mainly meant to serve as an introduction to business development companies. Not a detailed analysis of the best BDC stocks. However, I went ahead and identified a few solid BDC stocks to get you started.
Main Street Capital Corporation (NYSE: MAIN)
Main Street Capital Corporation is a Texas corporation that has provided funding to over 200 private companies. It operates in both equity and debt capital solutions. It currently has a dividend yield of 6.98%. You can view a full list of its portfolio of companies here.
Great Elm Capital Corp. (Nasdaq: GECC)
Great Elm Capital Corp is an externally managed BCD. It seeks to generate both income and capital appreciation by investing in equity securities, particularly in specialty finance businesses. It currently has 57 total investments with the majority of them being debt investments. Great Elm has a dividend yield of 13.3%. Notably, it has also not recovered since the crash in 2020.
Ares Capital Corp (Nasdaq: ARCC)
Don’t get $ARCC confused with Cathie Wood’s ARKK. Ares Capital Corp is a market-leading BDC that delivers financial solutions to the middle market. It has a dividend yield of 8.93%. Additionally, its portfolio consists of 395 companies and has a fair value of $19.5 billion.
At the end of the day, BDC stocks can be a great choice for today’s economic climate. In addition, they are fairly safe, usually offer a great dividend, and make payments monthly. Investing money in them can help you avoid the turbulence of other stock classes.
However, BDCs also come with a few risks. Mainly, the risk that interest rates will rise, reduce the profitability of the BDC and force them to lower their dividend.
I hope you’ve found this article valuable in learning what BDC stocks are and whether they’re right for you. Please remember that I’m not a financial advisor and am just offering my own research and commentary. As usual, please base all investment decisions on your own due diligence.