Investing in business development companies (BDCs) can yield high income due to their tax structure and dividend distribution requirements. They raise funds through equity sales and competitively priced debt to invest in business debt and preferred equity. BDCs can secure favorable investment terms by providing substantial capital to businesses that lack access to traditional financing. With diversification and effective underwriting, BDCs can offer attractive investment opportunities.
BDCs can be excellent investment options for those seeking high returns, particularly when acquired at favorable valuations and supported by strong financials and proficient management. By investing in the following BDCs, investors can secure high yields on cost and enjoy appealing total return potential at present prices.
In this article, we will cover three high-yield BDCs that could offer attractive total returns.
Fidus Investment Corporation (FDUS)
Fidus Investment Corporation (NASDAQ:FDUS) is an externally managed BDC that offers customized debt and equity financing solutions to lower middle-market companies. It targets cash-flow-positive businesses with annual revenues between $10 million and $150 million and strong market positions. Based in Evanston, Illinois, Fidus Investments generates approximately $95 million in total investment income annually.
Fidus’ dividend is generally reliable, with high payout levels and growth since the temporary 2020 cut. The company has a well-diversified portfolio, including defensive industries and technology, which may yield above-average returns. Its first and second lien debt structures prioritize repayments in case of bankruptcy. However, a prolonged recession could lead to weaker results and potential net asset value (NAV) per share losses. Fidus does not have a significant competitive advantage, except for its ability to maintain low financing costs.
Fidus has maintained stable net investment income levels over the past decade due to a consistent yield spread between its investment yield and cost of debt. While the company has paid special dividends with extra equity gains, dividends have sometimes exceeded total gains, occasionally leading to reduced NAV per share YOY. However, equity gains not reported in net investment income have contributed to NAV per share growth, increasing from $14.46 in 2011 to $19.43 in the latest quarter. Fidus cut its dividend in 2020 but has since restored it to an annualized rate of $1.62. Rising rates benefit the company, but no growth in net investment income (NII) per share is expected in the near future due to potential mid-term headwinds.
Despite no expected growth over the next half decade, with an expected 2% annualized valuation multiple expansion and a very attractive 8.7% current dividend yield, FDUS has a real possibility of generating double-digit annualized total returns over the next half decade.
Owl Rock Capital Corporation (ORCC)
Owl Rock Capital Corporation (NYSE:ORCC) was formed in October 2015. It focuses on investing and lending to U.S. middle-market companies with annual EBITDA between $10 million and $250 million or revenues of $50 million to $2.5 billion. Based in New York, the company generates around $1.2 billion in gross investment income annually and the third-largest market cap of publicly traded BDCs at the moment.
ORCC’s current base distribution rate of 33 cents will likely remain covered given its history of special distributions and sufficient current earnings coverage. However, a future cut cannot be ruled out due to potential pressures on results. As a BDC, the company has some key advantages: its large relative market capitalization, investment grade credit ratings from major credit agencies, and the use of CLOs with low default rates. These factors contribute to its reputation, ability to secure low-cost capital, and resilience in generating results.
The company’s NII per share depends on the investment yield spreads between its cost of funds and the yield of its investments. At the end of the last quarter, the weighted average total yield of its debt and income-producing securities was up 130 bps sequentially due to rising rates. The three-month LIBOR also expanded by 100 basis points, but the weighted average spread over London Interbank Offered Rate (LIBOR) increased to 6.8%, up 10 bps sequentially. Rising rates can benefit the company if it controls its funding cost. No further NII per share growth is expected from the FY 2023 elevated base due to possible changing interest rate and macroeconomic dynamics.
With no growth expected over the next half decade, ORCC will rely on its dividend and valuation multiple to generate total returns. Fortunately for shareholders, ORCC has a very attractive current dividend yield of 10.3% and an expected valuation multiple expansion of 2.5% per year over the next half decade. As a result, it looks like a compelling high-yield buy at the moment.
New Mountain Finance Corp (NMFC)
New Mountain Finance Corp (NASDAQ:NMFC) BDC focused on financing middle-stage businesses with defensive growth characteristics. These businesses typically generate $10 million and $200 million in EBITDA. NMFC provides senior secured debt, including 1st lien, 2nd lien and uni-tranche loans.
Its portfolio consists of 108 investments, with the top 15 accounting for 38.6% of investments or $1.25 billion in equity stake. Key industry exposures include enterprise software (26.7%), business services (17.7%) and healthcare (16.3%). To align management’s interests with shareholders, employees own around 9% of the company’s shares, indicating strong insider confidence. In the last year, NMFC generated nearly $295 million in gross investment income.
New Mountain’s dividend safety has weakened due to poorer credit conditions in its counterparties. Despite this, its well-diversified portfolio, with strong software and healthcare sectors, is expected to maintain medium-term stability. In FY 2020, the company experienced a slight increase in net investment income. NMFC’s high cost of equity is its main risk. To fund investments, New Mountain has been issuing stock, but given the high cost of equity at the moment, management may favor additional debt issuance over shares. This could result in increased leverage and additional credit risk over time.
New Mountain Finance focuses on “defensive growth” industries, investing in companies with resilient cash flows. In recent years, low interest rates have led to cheaper financing, especially for defensive industries, causing NMFC’s investment spreads to decrease. The company’s portfolio yield fell from 10.3% in Q3 2018 to 8.8% in Q1 2022, leading to declining returns and small dividend cuts. However, with rising interest rates, NMFC’s portfolio yield jumped to 11.7% in Q4 2022. It is expected that there will be no growth in IIS or dividends moving forward, as they are already starting off at a higher level.
While it has a very weak growth outlook over the next half decade, NMFC’s high current dividend yield of 10.2% augmented by its 1.1% expected annualized tailwind to total returns from valuation multiple expansion make it a viable candidate to generate double-digit annualized total returns over the next half decade.
On the date of publication, Bob Ciura did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.