You know what a bank is, of course. But did you know that banks have high-yield doppelgangers?
I refer to business development corporations (BDCs), financial firms that lend to small- to middle-sized private companies, generally those with annual revenue up to $400 million.
BDCs are analogous to banks in many ways: They issue equity and debt and secure revolving lines of credit. But instead of lending to you and me ̶ consumers ̶ they lend only to businesses in the form of first- and second-lien senior loans and mezzanine debt.
These loans and the debt have the added benefit of being secured by the assets of the portfolio company. You could say that BDCs secure better collateral than your local bank. Would you rather own a loan secured by cash-flow-generating equipment and buildings or your neighbor’s 2014 cash-consuming, daily-depreciating Dodge Avenger?
Additional differences slant the table even more in the BDCs’ direction from an income investor’s perspective. Unlike banks, BDCs are mandated to return cash to shareholders.
BDCs are taxed as regulated investment companies. As long as the BDC meets certain income, diversity, and distribution requirements, it pays little or no corporate income tax. To maintain this “pass-through” structure, a BDC must distribute at least 90% of its taxable income as dividends to investors.
Think about that ̶ nearly all the income flows to the shareholders. The more munificent big banks will pay up to 50% of their earnings as dividends, which is still a relative pittance compared to the dividends of the better BDCs. Just look at the parsimonious dividend yields.
|Citigroup (NYSE: C)
|Bank of America (NYSE: BAC)
|Goldman Sachs (NYSE: GS)
|JP Morgan Chase (NYSE: JPM)
Investors can choose from roughly 25 legitimate BDCs. The universe is small. For me, the universe shrinks further. I like one BDC above the rest, and this one BDC pays a dividend that yields 9.3% to boot. What’s more, this BDC maintained its high-yield dividend during the 2009 financial meltdown. Every one of the above “too-big-to-fail” banks sliced and diced their respective dividends down to nothing, or close to it.
Ares Capital Stands Out
Few BDCs have clutched the return-to-investor mantra closer to heart than $7 billion market-cap Ares Capital (NASDAQ: ARCC), the largest BDC on the market.
Since its IPO in 2004, Ares has returned $18.69 in cumulative dividends to shareholders. That’s not bad for a stock that had an IPO of $15 a share. Ares currently pays $1.52-per-share annual dividend.
Ares’ modus is lending to market-leading companies (216 of them) with a history of stable cash flows, proven competitive advantages, and experienced management teams. Company size ranges from $20 million to $200 million of annual revenue.
Ares’ loans coalesce into a diverse investment portfolio ̶ valued at $11.4 billion ̶ composed of manufacturers, restaurants, energy business services, education providers, financial services, and more. This focus-on-the-basics style of investing has proven to produce steady income and reliable dividends over time.
I expect the adjectives “steady” and “reliable” to persist into the distant future. Ares’ expansive loan portfolio is managed by a proven commodity ̶ its management.
Ares is led by a team of partners and managing directors who average15 years each of relevant operating experience. The investment committee is even more experienced, with each person averaging over 20 years of relevant experience. They know how to run the business through thick and thin.
Thick is on the way. Ares is poised to profit if interest rates rise. Ares just might be the best investment if you expect interest rates to rise.
Ares borrows long term, and most of its debt, roughly 80%, is fixed rate. Its $11.4 billion investment portfolio, on the other hand, is roughly 80% composed of floating rate loans. Most of these loans are set to LIBOR.
Here’s where it gets interesting.
Based on recent SEC filings, Ares tells us that if LIBOR ̶ a short corporate benchmark interest rate ̶ rises to one percentage point, Ares’ net interest income is projected to rise by $58 million. If LIBOR rises to three percentage points, net interest income is projected to rise by $180 million. More income earned means more dividends to shareholders.
And it’s not like Ares pays a miserly dividend as it is. It already pays a high-yield dividend in a low-interest-rate environment. Imagine the dividend it will pay in more favorable rising-interest-rate environment.