Five Critical Requirements for Your BDC Investments

Pay close attention to how your BDC stock candidate does business.

Business development companies (BDCs) are a terrific way to generate large dividends for your portfolio. However, if you choose the wrong BDC, you could get burned. What’s interesting about how to choose the right BDC is that that same approach BDCs take to choosing investments are the same approaches you should take when buying a stock.

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So here’s a double lesson in due diligence: how to find the right BDC and things to remember when choosing stocks for your own portfolio.

Remember, BDCs raise capital by going public, and they put that money to use by investing in middle-market companies that the average investor doesn’t have access to. These are usually debt investments that yield 10-15%, and often higher, and BDCs often take an equity position or ask for warrants (contracts that allow them to buy more equity at a specified price).

They’ll invest in leveraged buyouts, management buyouts, re-capitalizations, growth financing and acquisition financing.

Here’s what BDCs look for in their investments, and by extension, what you should look for in BDC investments:

Experienced management with skin in the game: BDCs don’t invest in a product, and neither should you. Yes, the product is what grabs your attention, but a great product can falter under lousy management. BDCs invest in people. Just as they research management’s background and have numerous phone conversations, arrange site visits and spend time getting to know management of a company they are going to invest in, you should too. You can’t meet management, but if you read earnings transcripts, you’ll learn a lot from what is said, how transparent they are, and how direct they are.

Free cash flow: BDCs only invest in companies that are generating some kind of cash flow. It not only demonstrates that the company’s goods or services are actually selling, but they are selling in excess of what its expenses are.

Good margins and return on assets: Neither you nor BDCs should tolerate a business that doesn’t make a strong profit. Thin margins are bad, and make the company susceptible if business falters. The exception are proven restaurant concepts, where free cash flow is doing very well, and has for quite some time.

Potential market leaders with competitive advantages. BDCs don’t want start-ups. They want to invest in products that many people use every day that have the potential to take over market share, or products that lead a niche market. They also must have a clear competitive advantage. Commodities, for example, are terrible choices.

Exit alternatives: BDCs love companies that they know they can exit with a gigantic profit. We aren’t just talking about collecting 15% interest every year. We’re talking about taking an equity position at a low price, helping the company grow, then exiting having made multiples of their investment.

These are all factors to consider in a BDC, and in any company you invest in. Next time, I’ll point out three BDC stocks that I think fulfill these requirements.

Stay tuned.

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