BDCs were established by Congress as part of the Small Business Incentive Act of 1980. Created specifically to finance privately held companies in the U.S., BDCs were set up as tax pass-through entities. While there is no double taxation on dividends, at least 90% of gross annual income must be distributed to shareholders. And at least 90% of gross annual income must come from dividends, interest and realized capital gains from the BDC's investment portfolio. That investment portfolio must also be diversified.
Despite all of these restrictions, or perhaps because of them, BDCs were devastated by the Great Recession.
The most egregious case was that of Allied Capital, which came under attack from hedge-fund manager David Einhorn. His book, Fooling Some of the People All the Time, details his campaign to alert the investing public to the dubious business practices of Allied Capital, especially in its accounting shop. The stock price of Allied Capital plunged, and it was sold to Ares Capital Management for $5 a share in 2010.
Since BDCs finance smaller entities, adverse economic conditions hit them hard; larger firms are more resilient because of their access to more resources. A BDC will never be a lender that is "too big to fail." Allied Capital was the oldest and, at times, the biggest BDC -- and it still went down. (Rightfully so, thanks to the efforts of Einhorn, who profited handsomely from his short position on the stock.) The entire sector was dragged down during the Great Recession.
Today, BDCs have recovered strongly and should continue to prosper if the American economic recovery endures.
The investment community is bullish. Over the last year, Prospect Capital is up more than 20%. Over the same time period, Ares Capital has risen over 14%. Medley Capital has jumped more than 13% over the past 52 weeks.
What creates a substantial total return for these BDCs is a high dividend income stream that is protected by law.
Prospect Capital pays a dividend at the rate of 12.91%. For Medley Capital, the dividend yield is 10.61%. The dividend yield for Ares Capital is 8.62%. Compare that with the average dividend for a member of the Standard & Poor's 500 Index, at just 1.9%.
So how can investors seek high dividends but still avoid the next Allied Capital?
The trouble is, BDCs don't release as much data as larger firms do. Their investments are in private companies, which don't have the level of disclosure required of publicly traded companies. However, the level of debt for a BDC -- along with its dividend payout ratio, which is the percentage of earnings paid out as a dividend -- are useful indicators. When economic conditions sour, it is always better to have less debt and more cash flow available for operations.
With a debt-to-equity ratio of 0.63 and a payout ratio of almost 120%, Prospect Capital has strong cash flow. Ares Capital has a payout ratio of 73% and a debt-to-equity ratio of 0.71. For Medley Capital, the debt-to-equity ratio is 0.57 and the payout ratio is over 113%.
BDCs can reward patient investors. For investors who like a great comeback story, there is American Capital (ACAS).
During the Great Recession, American Capital went from almost $50 a share in May 2007 to less than $2 a share in February 2009. To capitalize on losses, management changed the corporate structure so that American Capital is no longer a BDC. As such, it doesn't pay a dividend.
But it is a favorite of Steve Kuhn of Pine River Capital Management. He touted the stock at the "Invest for Kids" conference in October. Kuhn expects American Capital will become a BDC again, which will result in a dividend. Kuhn predicts American Capital will rise from its current price of around $15 a share to over $26.
Even without a dividend, the past year has been good to the shareholders of American Capital. The stock is up nearly 30%. The management seems to have learned its lesson about risk from the Great Recession. The company's debt-to-equity ratio is a paltry 0.15, with no long-term debt.
At the time of publication, the author had no position in any of the stocks mentioned.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.