How Dividend Seekers Are Riding the Wave of Private Credit to Earn Attractive Yields By Investing.com

By Yasin Ebrahim

Investing.com – Business development companies (BDCs) have taken the investment world by storm as income-seeking investors flock to this asset class that has earned a reputation for generate attractive dividend-like returns by covering the mid-market funding gap. left by traditional banks.

The BDC sector has seen significant growth, according to a recent Jefferies report, with total assets under management increasing from $12 billion in 2000 to more than $260 billion in 2023.

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A BDC is an investment firm that typically invests in the middle-market industry, focusing on smaller private companies, or those generating between $5 million and $100 million in earnings before interest, taxes, depreciation, and amortization (EBITDA). BDCs primarily provide debt financing in the form of senior secured loans, but their investment strategy can be more diverse.

BDCs receive coupon payments on debt or loans made and various fees from borrowers, which are then distributed to investors. While debt financing is their primary objective, BDCs can also invest in equity capital. When shares of these equity investments appreciate, BDCs can sell them to earn additional returns. BDCs must distribute around 90% of their investment income to investors, typically in the form of dividends.

The origin story of BDCs dates back to the 1980s, a period that followed the financial crisis of the late 1970s that led to increased regulation and compliance, forcing banks to tighten lending standards. and left middle-market companies struggling to access debt capital.

Congress was forced to act and created the Small Business Incentives Act of 1980 to “encourage private equity firms to provide that debt capital to these middle-market companies,” Dan Trolio, CFO of Horizon technology Finance (NASDAQ:). .com's Yasin Ebrahim in a recent interview.

In addition to a decline in bank lending, smaller companies stay private longer and tend to rely on debt capital to finance their growth.

Private vs. Public: Liquidity matters

Not all BDCs are created equal; some are more liquid than others.

Publicly traded BDCs, which trade on public stock exchanges like Nasdaq, are at the top of the liquidity scale. In contrast, private BDCs reflect typical private equity fund structures with returns distributed at the end of an investment cycle and tend to be less liquid. Perpetual BDCs fall somewhere between public and private BDCs and offer investors the opportunity to redeem investments during specific periods known as redemption windows.

Purchasing shares of a publicly traded BDC allows investors to gain exposure to the underlying assets and receive income generated by those assets.

“When you buy our shares, you get a very small part of each of those loans distributed in the portfolio, and then you receive monthly or quarterly distributions of our income in the form of a dividend,” the Trinity Capital boss said. executive Kyle Brown told Investing.com.

High connection performance The Middle Market Financing Gap

The distributions or dividend yields generated typically range from high single-digit income to 10- to 10-year income, so it is not surprising that investors are turning to BDCs to lock in their income.

The returns generated from the BDCs' underlying assets, primarily senior secured loans, “for some BDCs, range from high single-digit to mid-single-digit gross returns,” Brown said.

But how can BDCs generate these attractive returns?

Leverage: Most BDCs leverage their equity capital or pool of raised capital. This amplifies the return they can offer investors by borrowing at a lower interest rate and then lending at a higher rate to their portfolio companies.

BDCs are legally allowed to borrow up to twice their equity base; For every dollar of capital, they can borrow up to two dollars. However, Brown added that for most BDCs, including Trinidad Capital Inc. (NASDAQ:), leverage is one to one.

“That leveraged yield is why the yields are a little bit higher,” Brown added.

Fee: While leverage provides a decisive boost to profitability, the fees charged to borrowers also contribute significantly.

Fees charged to the borrower may vary by BDC and may include initial commitment fees at the beginning of a loan, prepayment fees if a borrower pays off a loan early, or final fees charged at the end of a loan or in certain cases. event.

“We (Horizon technology Finance) have a unique and specific product where we receive a current payment coupon,” Trolio said. “We receive an upfront commitment fee and fees afterward. In total, we are typically within a band of around 11% to 14% of revenue if a business were to make all payments from day one to month 60.”

Internally managed BDCs have resources to manage investments directly rather than outsourcing them. This allows them to generate additional income by managing third-party capital.

“Our BDC and some other internally managed BDCs, including Hercules and Main Street, have additional funds under management that our investors benefit from because we are able to charge management fees and incentive fees to other equity funds,” Brown said.

While strong dividend income is attractive, experienced investors know that risk always needs to be considered before looking at any asset class.

Understanding the Risks: What Every BDC Investor Should Know

When investing in debt instruments, credit risk must be managed. Since BDCs can invest in various companies, from venture capital-backed startups to late-stage companies, investors should be aware that risk levels can vary significantly.

Horizon technology Finance invests in development stage companies in the life sciences and technology sectors, often with negative EBITDA due to high cash burn rates. While these investments carry greater risk compared to EBITDA-positive companies, the returns associated with venture debt investments are typically higher to offset this greater risk.

It also helps to take a proactive management approach to identify any potential problems, Trolio said.

“We're looking at each of our companies on a monthly basis, doing quarterly portfolio reviews and really digging into each of the companies, their cash position, their performance, the sponsors, the management team… and we really try to get ahead of that.” “he added.

For publicly traded BDCs, which are subject to SEC reporting requirements, the “biggest risk” lies in valuations, Brown said. As publicly traded BDCs must value their assets quarterly, short-term economic changes could affect valuations, impacting the stock of BDCs even “if the ability to collect on the loan has not been diminished,” he added. .

But for investors whose primary goal is to generate income, fluctuations in valuations are not as worrying compared to those looking to “time the market.”

“If you are an investor looking for yield and income,” Brown added, “this probably won't affect you as much because you will stay invested; “It will continue to collect dividends while watching valuations fluctuate.”

“But if you're trying to buy and sell stocks,” he warned, “market timing could be a problem because valuations could go down.”

Risk to BDCs from lower interest rates or recession?

As the Federal Reserve begins a cycle of rate cuts, many investors are concerned that income from borrowing (which typically floats above a benchmark rate like the SOFR) could come under pressure.

This raises concerns about the high dividends offered by BDCs.

While the yield on these debt investments managed by BDCs may decline with falling rates, borrowing costs also decline, helping to cushion the impact on margins.

“Most BDC core dividends are not at significant risk from Fed rate cuts,” Jefferies said in a recent note. There are several mitigating factors, including acceleration of originations and refinancing fees, and improving credit performance, Jefferies noted, that should help BDCs maintain dividend coverage.

In anticipation of further rate cuts, the leveraged loan index default rate saw a modest decline this year, S&P Global said, and could remain near 1.50% through June 2025, from 1.55% in June. of 2024.

While lower interest rates should not “dramatically affect BDCs,” Brown emphasized that it is “important for investors to look at individual BDCs” and understand their underlying assets along with performance during different economic and interest cycles, including the zero interest rate period.

The art of creating agreements

As the number of funds within BDCs grows, their ability to generate quality investment opportunities may give them an advantage over their competitors. “It's absolutely critical,” Trolio said of pursuing deals, emphasizing the importance of BDCs “putting high-quality assets on the balance sheet.”

“Supply agreements allow us not only access but also improve our competitive advantage,” he added. A long-standing management team is a crucial composition of a successful BDC because it provides “market access” to origination opportunities.

To BDC or not to BDC?

Whatever the economic or interest rate cycle, due diligence remains essential for investors to consider which BDC to invest in.

For investors looking at BDCs, “what you really want to focus on is the management team,” Trolio said, and ask “how long have they been in the industry and do they understand the market?”

When evaluating the dividend yield of a BDC, Trolio believes it is critical for retail investors to understand how a BDC has been able to generate income to cover that dividend over time, what the strength of their portfolio is to continue to cover that dividend, and How did they grow over the years?

The access that BDCs provide to private credit opportunities and income-generating opportunities suggests that this asset class is not likely to lose steam anytime soon.

“I think the outlook going forward is that capital will continue to flow,” Trolio said, boasting continued optimism about the future of BDCs. “We will see more activity and companies that have been able to reduce their costs and maintain high enterprise value.” .”