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Long/Short Investments in L/S Equity: Valuation and Ideas,

High-Yield Biz Development Companies – Worth The Risk?

Business development companies attract the attention of investors given their high dividend yields. When a stock is offering a 7%+ yield, it’s psychologically attractive in the sense that if the stock trades sideways or even a slight bit down, you’re still making money. If it goes up, then you’re doing really well relative to long-run returns expectations.

The issue is that the higher the dividend, the less the earnings will contribute to capital appreciation. So if earnings appreciate 7% year to year on a stock paying a 7% dividend, one can expect the stock to trade flat as all residual equity payout would go to the dividend rather than to market capitalization.

So in reality, it truly doesn’t make any difference whether a stock pays out a dividend or not.

Why do BDCs typically have such yields?

Given the BDCs must comply with certain income and distribution standards to be considered regulated investment companies (RICs) – like REITs – they must pay out 90% of their earnings to shareholders in exchange for the benefits of paying little to no corporate income taxes.

What are they?

Business development companies (BDCs) are riskier than average given they specialize in lending to smaller, less stable businesses. In other words, they lend at high rates and naturally have a high rate of default with respect to companies within their portfolios. Investors typically demand higher rates of return for BDCs to compensate for this risk.

They are similar to venture capital and private equity firms and can in some form democratize the landscape when it comes to investment into illiquid companies, as anyone can invest in a BDC, whereas VC and PE are largely closed off to the general public.

Drivers of BDC appreciation include a steep yield curve (as it’s a “borrow short, lend long” type of model), good economy, strong pace of business formation, and favorable regulatory environment with respect to lending standards.

Investing in BDCs

Unless one wants to invest in individual BDCs by doing the research, there is always the option of going the route of an exchange-traded fund (ETF). An ETF accumulates several names and will help cut down on volatility given the various securities contained in them.

Whether one should invest or not is up to each individual. The one potential benefit of BDCs is through the lens of its diversification benefits. Most industries in the economy correlate heavily with the broader market. Buying a tech- or healthcare-specific ETF provides little diversification benefit as these correlate with the market at around 80% to 90% and are mostly done to make sector-related bets.

However, with industries such as REITs, utilities, MLPs, and BDCs, the regulatory idiosyncrasies render the correlation low enough such that risk can be pulled from the portfolio. (A more thorough explanation of the benefits of diversifying can be found here.)

All of these industries correlate with the broader market by about only 45%-60% provided a long enough timeframe is used and have low correlation among each other as well.

If one already has a well enough diversified portfolio, investing in a BDC-related ETF probably won’t provide much marginal benefit. For those invested in little outside of a standard equity fund, BDCs can provide value in this respect. A two-asset portfolio with +0.50 correlation will reduce risk by about 13% relative to the one-asset portfolio.

The downside to BDC ETFs is that they are expensive. Even the unleveraged variety cost 85 bps (e.g., $85 for every $10,000 invested), which is very high relative to other garden-variety sector ETFs, which price around 10 bps depending.

The BDC sector is small and therefore the holdings in the two most prominent ETFs (BDCS and BDCZ) are only in the 20-25 range.

BDCS’s holdings can be found below: