Business Development Companies (BDCs) are a popular stock sector with yield focused investors. These are companies that provide financing to small and medium sized corporations. BDCs are pass-through businesses, which means they pay no corporate income taxes if 90% or more of net income is paid out as dividends to shareholders.
There are some great BDC stocks, but you need to be aware of the danger signals that point to a dividend cut.
BDCs have many features in common with closed-end funds (CEFs). However, there is one major difference when evaluating CEFs and BDCs for investment potential. With a closed-end fund, having the market share price is trading at a discount to net asset value (NAV), can be viewed as a positive investment opportunity. The discount allows you to buy the CEF’s assets at a discount to their actual value. Everybody likes a deal, and a CEF trading at a discount is a good deal.
In contrast, with a BDC, a share price trading at a discount to book value/NAV is a danger signal. Many investors see a discount and think they are getting a good deal. This is not the case. As noted above, a BDC makes loans to small and midsized corporations. These are companies that cannot get loans from commercial banks or access the public bond markets. The result of taking on riskier clients is a BDC will experience a certain level of loan losses. These losses will cause an erosion in the book value, unless the BDC management has a strategy to offset loan losses.
If a BDC’s stock trades at a premium, the company can easily build book value and net income by issuing shares. For example, a BDC trades at a 20% premium to book. The company sells $100 worth of stock and receives $120, which can be used to make $120 of new investments to generate interest income. Selling shares at a premium to book value allows a BDC to grow its portfolio and sustain its dividend.