This article was originally posted on BDCReporter.com
Financial experts have lauded business development companies (BDCs) for being “a terrific way to generate large dividends for your portfolio.” But how do you choose the right option? As you weigh your options, ask yourself these five questions to help you make the best decision for your investment goals.
1. Do I Understand What BDCs Are?
This is an important question. If you’re rushing into the investment because you read a headline somewhere about the “big yields” associated with BDCs, make sure you take a little time to get to the know this area of the investment industry. Review my primer about how BDCs stack up against traditional investments. In November 2015, I wrote an ABCs of BDCs that explains the history of BDCs and their growth in the last several years. Both articles would be a good introduction for the all-around first-time investor or if you’re building an already growing portfolio and considering BDCs for the first time.
The big thing to remember with BDCs: They are closed-end investment companies that are similar to venture capital funds in that BDCs invest shareholders’ money to generate investment income and turn a profit. BDCs, however, are different in two ways: 1) Accessibility (they’re open to the public, not just the wealthy) and 2) Transparency (BDCs disclose more information and have more open-ended dialogues with their investors).
2. Do I Understand How This BDC, In Particular, Works?
Under the Investment Company Act of 1940, nearly 60 companies have elected to be regulated as a BDC. And, to cite Saratoga Investment Corp’s research, these “companies represent $65 billion in assets under management and $25 billion in market cap.” The types of companies that a BDC invests in will vary by each BDC and its particular focus. Saratoga, for example, invests in later-stage, small- and middle-market companies ($10 million to $150 million in revenue, $2+ million in EBITDA) with strong margins and free cash flow. Other successful BDCs will have different characteristics and strategies, but will maintain discipline.
3. Am I Impressed with the Management?
The not only means the management team of the BDC itself but also the management of the company in which it’s investing. What you want, experts say, is “experienced management with skin in the game.” Though the company’s product or service might seem flashy or irresistible, keep in mind that BDCs invest in people. The BDC should have a good sense of the management personalities and business acumen of a company in which they plan to invest. Plus, that information about the management team should also be available to you (typically via earnings transcripts).
4. Am I Evaluating the Right Metrics?
First, don’t solely choose a BDC based on yield. “Yield is an inaccurate metric and doesn’t tell you anything about the underlying business. Yield should be based on return on equity as opposed to the percentage of yield of the stock,” explains Saratoga’s analysis on choosing BDCs as an investment.
But here are metrics that we at Saratoga recommend:
“A company’s record of building Net Asset Value (NAV) with high quality assets is important to consider. Saratoga’s NAV, for example, is up 76% since 2010, which is a CAGR of 8%. Assets under management are up 202% since 2010, a CAGR of 21%, and more than 98% of our loan investments have the highest credit rating. This indicates that management is concerned with the health of the BDC and is not pushing heedlessly for growth. And then ROE and total return are also very important.”
5. Is There a Clear Competitive Advantage?
The ideal BDC investments are “products that many people use every day that have the potential to take over market share, or products that lead a niche market,” explained financial expert Lawrence Meyers in a recent blog.
However, always go back to BDC earnings. The biggest things that you should look at are, again, the net asset value but also the non-accrual rates, what the portfolio looks like, and the diversification of the portfolio. At Saratoga, we look to diversify by industry and geography, so if one region of the country goes into recession, it will not harm the overall portfolio. But when you’re choosing a BDC, the type of industry and its location are not necessarily as important as disciplined investing and diversification.