We started off yesterday with our look at Bryan Perry’s teased Business Development Companies for his Cash Machine newsletter … and, as is perhaps expected, his headlines were reserved for the pick he teased most fully and touted most aggressively, the Big Daddy of BDCs, Ares Capital (ARCC).
But he also hinted at three others, and I promised to unmask those for you as well (assuming the Mighty, Mighty Thinkolator is up to the job) … so let’s just jump right in, shall we?
“You don’t need a few million bucks to join this Silicon Valley venture group — all it takes is one share of stock. This team of 13 directors — with 274 years experience between them — specializes in tech and life science financing, where this economy’s real growth is. Current yield: 8.5%.”
There are now a few BDCs that focus on high tech and venture capital-type companies, including Horizon Technology Finance (HRZN for the stock, HTF for their listed debt) and TICC Capital (TICC), but this time he appears to be teasing the oldest of these targeted BDCs, Hercules Technology Growth Capital (HTGC for the stock, HTGZ for the listed debt). HTGC, which is what you would want for that higher and possibly growing BDC income (HTGZ is a senior note with a 7% coupon, matures 2019), pitches itself as providing “venture debt” to help startups balance their financing when they’re in the early stages of relying on “venture capital” before they go public or get taken over or otherwise stop being “ventures” or “startups.”
You can see the portfolio of companies that Hercules has invested in/lent to over the years here, some you’ll have heard of, and many no one has heard of that are either very early stage projects or never grew enough to get attention. I haven’t taken a look at this one in quite a long while, but it was teased during the financial collapse by Carla Pasternak, so she gets credit for a pretty decent pick — at the time she suggested the stock it was around $8 and carried a near-20% yield, but the dividend has been cut a couple times over the last three or four years and the stock has risen, so the current yield is indeed about 8.5%, right in line with Ares, but HTGC, with their focus on venture stage companies, definitely conjures up a riskier image.
Is that fair? Well, not necessarily — they did cut the dividend a few years ago, but investors didn’t give up en masse because there’s still plenty of hope for outsize returns from their portfolio investments, since equity in a startup tech or biotech company always offers up that little bit of potential for a dramatic profit to juice returns, and they do seem to get in on pretty decent deals … but more interestingly, you can get an idea of just how tied together these stocks are by checking out a five year chart — ARCC has done a bit better than HTGC over five years (up a few percent vs. down about 5% over that time — not including the dividends), but they clearly move up and down on the same waves.
“This new addition to our Cash Machine buy list is flying under Wall Street’s radar right now — followed by only two analysts — and that often creates huge opportunity. Its three-pronged business strategy is clicking on all cylinders — as evidenced by its recent 33% dividend hike. Current yield: 12.1%.”
This one, sez the Mighty Thinkolator is almost certainly (OK, 90% sure) KCAP Financial (KCAP). It does indeed currently carry a 12.1% yield, and they did just raise the dividend by 33% in the second quarter of this year (though, to be fair, we will also note that this just gets the dividend back to where it was in late 2009 — in the middle of a couple years of slashing the dividend as their world was falling apart.
KCAP is attached to one of the more storied names in private equity, Kohlberg (as in Kohlberg Kravis Roberts, KKR, stars of the “Barbarians at the Gate” leveraged buyout of RJR Nabisco in the 1980s .. though it’s actually Kohlberg who’s behind KCAP and he left KKR just before the Nabisco takeover), and I suppose that you can say it does have a “three pronged” business strategy. They have a traditional BDC business, the middle market mezzanine debt, secured debt and equity that most BDCs specialize in, and they also have two asset management businesses that generate fees and sometimes investment gains (Trimaran and Katonah Debt Advisors).
This is one of the smaller BDCs, with a market cap of just over $200 million, and they are not all that levered (debt of $80 million — the basic limit for BDCs is that debt has to be less than equity, so they could conceivably borrow quite a bit more if they wanted to). They have done well lately, with some analyst upgrades to go along with that nice dividend raise, and you can really see with this one the impact that the dividend has on the share price — they were doing worse than the average BDC for the early part of the year, and trading at a bit of a discount to net asset value as they bottomed out under $6 back in June, and then they raised that dividend and the shares have jumped sharply in the last few months and handily outpaced the average, and now trade at about 1.1X book value. KCAP was one of the worst BDCs during the financial crisis, with a stock price that collapsed, albeit very briefly, from the low teens to just over a dollar as they were in dispute with their bank … but they still paid a dividend even as the stock cratered, albeit a smaller one, in part because they had a diversified enough asset base to keep some cash flowing.
I do like the asset management business as a bit of ballast for the typical BDC lending portfolio, and it was the addition of another asset manager (Trimaran) that gave them the wherewithal to raise that dividend, so that’s positive and may make this firm more stable than the relatively small market cap would imply (I haven’t looked at them all that closely, to be clear, think of me as the guy on the next barstool doodling on a napkin for you). Like many BDCs, KCAP hasn’t actually booked earnings lately — they have a loss over the past year — so it always looks like they’re paying out big dividends without actually making any money. That’s a bit misleading, since the earnings number is impacted heavily by non-cash charges like writedowns of their equity investments, but, as you might imagine, even if it’s OK for a BDC to report losses for a while while still paying good dividends, they can’t keep that up forever — accounting rules and writedowns aren’t always particularly sensible or clear, but eventually losses do catch up with you if portfolio values don’t recover or loans don’t perform over time.
“A more aggressive play in this sector really pays off big — a whopping 14.9% current yield! This is a leveraged play on government-mandated high yields — backed by one of the most-experienced names on Wall Street. Check out the details in your online copy of Government-Mandated High Yields — free when you join me at Cash Machine now.”
This one, I think, is a fund — it’s possible that he’s teasing one of the riskier little BDC’s, because there are actually a couple that have yields in that neighborhood, approaching 15%, but I think that with the “backed by one of the most-experienced names” bit he’s hinting at the backing for an exchange traded note, and the “leveraged play” — since BDCs are somewhat limited in their leverage — indicates to me that it’s the leveraged ETN he means.
There isn’t an indexed ETF for BDCs that I’m aware of, but there are two ETNs — ETNs are Exchange Traded Notes, which means they’re debt instruments (like bonds) that are an obligation of the issuer, but they’re designed (and the issuer promises) to track the performance of an index through both capital gains (or losses) and dividends … so the “backing” of an ETN is substantially more important than the backing of an ETF, since ETFs actually hold the underlying stocks and can be broken up and assets returned to shareholders if necessary but ETNs are essentially “black boxes” backed by a promise from the issuer. They’re both UBS ETRACS ETNs that track the Wells Fargo BDC Index, so they’re obligations of UBS, which is indeed one of the most-experienced names on Wall Street, and there’s both a “regular” and a “high octane” version — “regular” means it tracks the index, “high octane” meaning it tries to deliver twice the return of the index, and twice the dividend yield. The index-tracking ETN is BDCS, the “twice the index” leveraged tracker is BDCL.
So the guess — and that’s what this one is, a guess — is that Perry is pitching the 2X levered ETN, ticker BDCL, which aims to have twice the dividend of the index and twice the amplitude on the stock chart (ie, if the index falls 25% it’s supposed to fall 50%, if the index goes up 8% it’s supposed to rise 16%). Right now the trailing yield of BDCL is around 13.9%, but if you annualize the most recent distribution (ie, assume that the next four dividends are the same as the last one) it would get you to an expected annual yield of 14.8%. Which is a bit less than twice the yield of the average big BDC, but pretty close. Both of these exchange traded notes are built on the Wells Fargo index, which itself was just invented a bit over a year ago — the index is market cap and liquidity weighted, but it’s also capped so the three biggest BDCs, Ares Capital, American Capital (ACAS), and Apollo Investment (AINV), each make up for about 10% of the index even though ARCC and ACAS are twice as big as AINV… and it also includes several BDCs that don’t currently pay a dividend, including notably ACAS, so that makes the yield slightly lower than you might expect (BDCS has a current yield of about 7.5% if you annualize the last distribution).
That 14%+ yield for the leveraged ETN is about as good as it gets in dividend land when you’re talking about ETFs or ETNs — the other high yielders tend to be also leveraged, like the ETF that aims to return 2X the performance of the Alerian MLP index (MLPL), but in the “high yielding” list you’ll also see the ETF for the mortgage REITs (REM) … no surprise, given the fact that this perpetually frightening and cash-spewing sector has many huge yielders, even the biggest company in that group has a massive yield at 13% (that would be Annaly, NLY — we’ve written about them many times, too).
So those are a few more options — I’m not crazy about ETNs in general, given their lack of transparency and the counterparty risk, but for smaller investors who can’t build a portfolio of three or four BDCs on their own it makes a lot of sense to use a nice, diversified tool like this to get that same kind of exposure. For those who don’t want to dabble with an ETN, the picks Perry outlines might lead to a strategy of starting with the big guy (Ares Capital) as a relatively stable foundation for your BDC portfolio and dabbling in some of the smaller, higher-yielding names like KCAP or the many others to add some spice and raise your income a bit.
Just do remember that BDCs are, on average, pretty much flat over the last five years, and therefore as a group could have provided you a pretty nice average return of 8-10% a year during what have been five extremely turbulent years, which sounds really nice in the abstract … but during that period you would have had to sit through share prices that in many cases fell 50-75% or more during the financial crisis before their long recovery. And even the big ones can fall hard and splat instead of bounce — even if we except Allied Capital, which lost investors a lot of money in their last few years, the example of caution is right at the top of the index: American Capital (ACAS) (which was not teased by Perry in this ad, to be clear), is almost as big as Ares and has been a leading BDC for almost as long as BDCs have existed, but they fell much harder than the average BDC in the crisis and are one of the few that hasn’t recovered from that fall … thanks largely to the fact that they’ve not paid a dividend since 2008. And the third biggest BDC, Apollo, has also done substantially worse than ARCC and the “average” BDC. BDCs can be a great way to get above-average income that tends to be levered to the performance of the underlying economy, and you do get that “government mandate” that they have to pay out their earnings as dividends … but there is, unfortunately, no government mandate that they have to have earnings. And any pundit or advisor telling you to jump into BDCs in the several years before the market crash would very likely have urged you to start with Allied Capital and American Capital, the two dominant and seemingly most stable firms at the time … which wouldn’t have made your portfolio very happy.
And since I went off on that tangent about ACAS for a moment, I should close by clarifying: ACAS is still in the new BDC index and still grouped together with the rest of the large players in this mezzanine lending/middle market financing industry, but they’re not actually a BDC right now — they changed over to be treated as a regular corporation in 2008 or 2009 so that they could take advantage of their massive pile of tax losses (you can’t write off a tax loss unless you’re a taxable entity, I suppose). And they probably will start paying a substantial dividend again at some point — the stock was so beaten down, and remains so beaten down, that it trades at a substantial discount to their net asset value, so the company has been using cash flow to buy back stock instead of restarting the dividend, with the implication that once the shares are trading more in line with their underlying value they will start paying a dividend again. And who knows, maybe when they burn through their tax losses and regain some sort of stability they’ll re-convert to a BDC.
If you want to learn more about BDCs in general, the BDC Reporter has a nice primer on them as well as a list of reasons to consider including BDCs in your portfolio and frequent articles about the companies tracked. If you want to start poring through a list of the available BDCs, the Dividend Detective has my favorite listing but you could also just peruse the composition of the Wells Fargo index for ideas.