Get to Know Your BDCs

 | Oct 16, 2012 | 1:00 PM EDT
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The search for income remains one of the most important concerns for investors in today's confusing financial markets. Yields on bonds, CDs and other traditional income investments are at historic lows and cannot provide the payout investors seek. For the past few years, money in search of yield has been pushed into equity markets and dividend-paying stocks. It has been a hugely successful strategy so far, as blue-chip, high-yielding stocks have performed admirably since the depths of the credit crisis in 2008. Like everything else in the markets, it has worked so well that it has attracted attention and heavy promotion of the strategy has raised valuations and eliminated many opportunities. Now we face the possibility of tax increases on dividends. This is probably not the best time to put new money to work in the traditional sources of equity income.

For investors who have to get the cash to work and the dividends flowing, it is probably best to look at unconventional sources of yield that are not taxed as ordinary dividends. Such concerns would include real estate investment trusts and business development companies (BDC). These companies pay not qualified dividends, are already taxed at regular tax rates, and they are not subject to a readjustment if tax rates increase. Looking for situations that are not subject to the tax cliff and are attractive values can reward income investors, even in today's uncertain market.

One of my favorite areas for unconventional yield investing is BDCs, which invest in other companies, usually in the middle markets, and favor private over public investments. They function very much like private equity firms and provide capital in the form of subordinated loans, mezzanine financing and equity in some cases. With banks and Wall Street pulling back on lending in the middle market there is an opportunity for BDCs to fill the void and become an important source of capital. As banks have pulled back, BDCs have been stepping up over the past several years. Since 2008, BDC total assets have grown by more than 50% annually.

I am a big fan of buying these at a discount from net asset value and holding for a long period. I have owned shares of companies like Prospect Capital (PSEC) and Solar Capital (SLRC) for some time and I have no intention of selling anytime soon. One of my current favorites is Apollo Investment (AINV). The shares trade at a slight discount to the announced net asset value of $8.30 and yield a generous 10.1%. The BDC is an affiliate of private equity giant Apollo Global Management (APO) and benefits from their decades of middle market lending and investing.

Apollo Investment has a widely diversified portfolio. It has deals with large public companies such as Chesapeake Energy (CHK) in the form of subordinated debt. It has everything from workplace uniform and linen providers and security guards to kidney dialysis and pharmaceutical companies in the portfolio. In all Apollo has $2.8 billion of equity invested in 64 companies, with an average yield a little over 12%.

Apollo has been reducing overall portfolio leverage to reduce risk in the current environment. It is also moving to reduce exposure to subordinated lending. To take advantage of the sector I believe has the most long-term return potential, Apollo recently opened an energy specialty office in Houston. The energy team will look for lending and investment opportunities in natural gas and oil, an area that is undervalued, with enormous long-term upside potential.

Insiders apparently like the long-term potential of BDCs. Officers and directors have been buying shares in the open market in the past six months near the current quote. Collectively, insiders own almost a third of the outstanding shares. They obviously share my belief that not only does Apollo offer an attractive yield, there is potential for dividend increases and capital gains as the economy improves over the next several years.

One of my most tightly held beliefs about investing is that you cannot do well doing what everyone else does. Business development companies like Apollo Investment and other unconventional yield investments allow us to apply that philosophy to income investing.

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