About 10 years ago, I became very popular with some big names on Wall Street. For a due diligence officer, that is.
It wasn’t because I was a good guy (although I think I am). And it wasn’t anything I necessarily did.
But I had access to something they wanted. And they were lining up…
Blackstone (BX), Apollo (APO), KKR & Co (KKR), and a firm called Blue Owl Capital (OWL) were all trying to crack the same code: How to build the perfect business development company (BDC). And then sell the heck out of it to high-net worth and institutional investors.
A business development company is a tax structure like a real estate investment trust (REIT) or master limited partnership (MLP). BDCs can be private or public, but they have to follow the same rules.
BDCs were created to provide capital to private companies based in the U.S. They’ve filled a big hole left by the banks in the wake of the Great Recession.
From the top floors of the tallest office buildings in New York City, dozens of executives and management teams would sit down with me and answer every question I had.
As a due diligence officer for some of the largest brokers and dealers in the country, Wall Street firms needed my approval to gain access to my firm’s clients and their billions in capital.
It allowed me to have an intimate understanding of this asset class, one that should be appealing to any income-minded investors.
The Growth of BDCs
BDCs typically have above-average yields (one of our latest recommendations has an estimated yield of 11.5% this year). And because they elected to be taxed as a BDC, they are required by law to pay out 90% of taxable income to investors.
Ten years ago, only a handful of mostly no-name firms were in the BDC space. I was one of the few due diligence officers covering them.
Today, Blackstone Inc (BX), BlackRock (BLK), KKR & Co (KKR), Ares Management (ARES), The Carlyle Group (CG), and Golub (GBDC) all manage multi-billion-dollar BDCs. These firms aren’t just on Wall Street. They are Wall Street’s elite. In total, there are 139 BDCs with over $312 billion in assets under management, with more on the way.
You might think this is “too good to be true” thanks to their near double-digit annual yields. Here at Wide Moat, we invest using facts, not hearsay.
That’s why we built a proprietary system to evaluate BDCs. Most investment-grade-rated BDCs (about half of the sector) receive a top rating. So do some “under the radar” BDCs that few other analysts cover.
All of our top-ranked BDCs held the line on their dividend during the pandemic. Many even increased it. The next time you hear that BDCs are “too risky,” remember these facts.
And unlike Wall Street, individual investors like us can’t buy interest rate derivatives or use other tricks to hedge volatile Federal Reserve policy. BDCs generally have floating-rate loan investments, which means income goes up, not down, when rates rise.
That’s why many BDCs are near 52-week highs today while interest rate-sensitive sectors, like real estate, struggle. But it gets better.
According to Raymond James and Putnam, BDC dividends are likely to hold strong even if interest rates fall dramatically. We agree. That’s because they structured their loan investments to win no matter what interest rates do. That’s an advantage that is hard to find anywhere else.
So, how does an investor find the best, highest-yielding BDCs?
Look for These Qualities
Before we ever recommend a BDC to our readers, there’s a few qualities we always look for. First and foremost, we want to know the quality of the debt held on the company’s books. A chart like the one below is always the most important piece of homework when evaluating a BDC.
What it shows is the risk rating of the debt held by a BDC that we recently recommended. First-lien debt is the lowest-risk debt a company can hold. And as you’ll see, this particularly BDC has consistently held 94-95% of its portfolio with this high-quality debt. That’s precisely what we want to see.
Another important metric is industry exposure. As investors, we want to see a low percentage tied to cyclical sectors like real estate and oil and gas. Some exposure is fine because the extra reward may be worth the risk.
But as a general rule, we want to avoid BDCs that have high exposure to industries that may experience a downturn and thus struggle to pay back their loans.
We also want to know that a BDC has diversification with its borrowers. After all, we don’t want the fate of our investment to be tied to just one or a handful of firms. If that company were to struggle to repay its debt, it would negatively impact the BDC and, thus, our investment.
In the course of my analysis, I like to see a BDC with average exposure to each borrower at or below 1%. When it comes to BDCs, diversification is king.
Our Eyes Are on BDCs
Now you understand why BDCs are a pillar in our High-Yield Advisor service. We’ve already exited two BDC trades for an average profit of over 30%. All our other BDC positions are in the black and racking up more dividends as we wait for profit targets to be reached.
We have a promising start with the returns we have already locked in from BDCs. And we’re not done yet.
As great as they are, we aren’t limited to BDCs. We also scour the $20 trillion U.S. credit market for the best deals on discounted corporate bonds and preferred stock. We’ve paid as low as 72 cents on the dollar on top-quality bonds.
My goal is to help find investments that will pay out time and time again. And that’s exactly what we’re doing at Wide Moat Research.
I look forward to sharing more research with you in the weeks and months ahead.
Regards,
Stephen Hester
Analyst, Intelligent Income Daily