Juicy Returns in the Offing for BDCs

 | May 30, 2014 | 4:00 PM EDT
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Over the years I have become a big fan of business-development companies (BDCs), which spit out very high dividends and generally grow along with the economy and the markets. The typical BDC makes loans to middle-market and smaller businesses, most of which are not public. Sometimes they also take equity in the form of warrants and common stocks.

At this point, these specialty closed-end funds are poised to become major players in the lending market. After all, it is no secret that banks have become increasingly risk-averse in the wake of the credit crisis -- they simply are not making many types of loans due to restrictions in their lending practices. This, in turn, opens the gateway for such specialty lenders as the BDCs. While the U.S. economy is hardly robust, it is doing well enough that there is demand for capital among middle-market companies.

So, as the economy continues to grind toward a real recovery, I believe BDCs are poised for solid long-term returns -- and all this could be a huge opportunity for investors to invest in BDCs, collect some huge dividends and see long-term capital appreciation. Even in the event of a slowdown, these names should continue to provide decent returns to long-term investors, given their high dividend payouts and flexibility in structuring loans.

I see BDCs as being very similar to private-equity funds, and I approach them with the same long-time frame as I would do an investment in an illiquid private-equity fund. In fact, a carefully constructed portfolio of these companies should provide for the kind of high long-term returns that private-equity-fund investors have enjoyed for decades.

Moving on to my specific recommendations, my favorite BDC is Apollo Investment (AINV). The firm has a relationship with leading private-equity firm Apollo Global Management (APO), and it uses that expertise to find solid investment opportunities.

Currently, Apollo Investment has a $3.5 billion portfolio comprising 111 companies. It has been repositioning the portfolio toward senior secured debt, and more than half of the outstanding loans are senior securities. It has also taken steps to protect itself from the potential of rising interest rates in U.S. Treasuries, and 42% of the portfolio is in floating-rate debt. Beyond this, Apollo has been moving into the energy area: It recently opened an office in Houston in order to seek out opportunities to make secured loans to midstream oil-and-gas outfits.

Apollo Investment shares are cheap right now, trading at a little less than net asset value, and the company's dividend yield of 9.57% should certainly appeal to income-seeking investors. Moreover, its relationship with Apollo Global gives it access to opportunities that most other BDCs simply will not see. All in all, I think this stock will provide private-equity-like rates of return to long-term investors.

I also like Gladstone Investment (GAIN), a BDC that functions more like a buyout shop than most of its competitors do. Gladstone currently has $314 million invested in 29 companies across 14 states and 14 industries. The buyout approach appears to be working nicely: Net income has grown from $0.48 a share in 2010 to $0.73 this year, and the dividend has meanwhile risen from $0.48 to $0.71.

Gladstone likes its targets' execs to be invested, as well, and 88% of the portfolio companies have insider ownership of 10% or more. The firm is also positioned to benefit if Treasury rates rise over the next few years, as 82.5% of its outstanding loans have variable interest rates. 52% of the portfolio is in senior debt, and 23.5% is in preferred or common equity in portfolio companies. Gladstone stock is trading at 90% of net asset value, and it currently yields at 9.3%.

Fifth Street Finance (FSC) is another BDC that I believe is well-positioned to provide solid long-term returns. It makes loans to mid-market companies, usually in connection with a private-equity investment by one of the leading PE firms. Fifth Street currently has loans to 124 companies with a weighted average yield of 10.8%, and more than 80% of the loans are senior debt. More than 70% of the portfolio consists of floating-rate loans, so a rise in interest rates over the next few years would be beneficial to Fifth Street and its investors. The shares trade at 95% of net asset value, and they yield 10.7% at the current price.

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