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Editor's note: This column was submitted by Stockpickr member Arnab Dasgupta.

The broad dislocation of credit and capital markets has resulted in a correction in every group of financial stocks -- banks, specialty finance companies as well as a club of investment vehicles called business development companies.

BDCs invest in middle-market private companies using strategies that generate a steady source of cash flow that is returned to investors in the form of

dividends. These vehicles grow more attractive in market environments where liquidity is a concern thanks to the stocks' double-digit dividend yields.

However, the underlying reason for holding these investments in your portfolio is that they have a conservative capital structure relative to peers in the financials space.

As per the Registered Investment Advisor Act of 1940, BDCs are not allowed to carry more than 1:1 leverage. Several financial stocks now face liquidity risk because their collateral is subject to constant repricing leading to margin calls by investment banks. BDCs have secured lines of credit, all of which are non-recourse.

Fundamentally, in this environment they can take advantage of widening credit spreads and invest in higher-yielding assets possessing better risk-adjusted returns, thus improving operating return on equity (ROE) and dividend growth.

Due to the onset of an economic slowdown, credit risk continues to be a potential issue in such companies, and therefore I recommend only those that are invested higher up in the capital structure. For example, the portfolio breakdown should reflect a higher proportion of senior debt compared to subordinated debt.

Also, the names I discuss have above average debt/equity ratios that give them room to raise debt. We can all agree that it is almost impossible to raise equity in a non-dilutive manner in such market conditions.


Apollo Investment Group

(AINV) - Get Free Report

is considered by Wall Street to be the most conservatively managed of its peer group. Apollo recently reported fiscal first-quarter net operating income (NOI) of 53 cents a share, 9 cents above consensus. More significantly, no non-accruing loans were reported during the quarter, an improvement from the 1% reported in the previous quarter.

The company continues to originate investments ahead of consensus estimates, leading analysts to attribute its outperformance to its relationship with erstwhile

private-equity manager

Apollo Group


. Relevant metrics include a debt-to-equity ratio of 0.4, price-to-book of 1.1 times and a dividend yield of 9.3%.

Second, there's

BlackRock Kelso Capital

(BKCC) - Get Free Report

, which made its public debut in a June 27 initial public offering. This new entrant in the BDC space remains misunderstood. It recently reported second-quarter NOI of 42 cents a share, 3 cents higher than the consensus estimate.

The company is attractive due to its conservative portfolio mix (68% senior secured debt) and support from two strong investment platforms:


(BLK) - Get Free Report

and Kelso & Co. Relevant metrics are a debt/equity ratio of 0.57, price/book of 0.8 times (misunderstood!) and a dividend yield of 11.6%.


Ares Capital

(ARCC) - Get Free Report

recently reported in-line second-quarter results. At the end of the quarter, none of its investments were past due or on a non-accrual basis. Ares has lowered its risk profile considerably in the last few years by adding a higher proportion of secured loans and thus moving its investment portfolio up the capital structure. Its metrics include a debt/equity ratio of 0.5, price/book of 1.0 times, and a dividend yield of 10.2%.

It is worth mentioning that the two names in the space that I do not recommend but that, judging by their premium-to-book value valuations, continue to be investor favorites are

Allied Capital



American Capital Strategies


. The market is focused on their dividend coverage, which is currently secure through 2008, but only by realized gain on sale of investments which unlike NOI, is not sustainable.

Their leverage is also the highest in the group, and their financials reveal that their asset quality is inferior evidenced by non-accruals of 6.7% and 4.1% for Allied and American Capital, respectively.

At the time of publication, Dasgupta had no positions in stocks mentioned, but the hedge fund for which he works -- Zephyr Unicorn Partners LP -- is long Apollo Investment Group and BlackRock Kelso Capital. Positions may change at any time.

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