I’ve been recommending a small sector of private equity called business development companies (BDCs) for many years. These are small-time lenders and specialty-finance companies such as Ares Capital, Apollo Investment Group, Prospect Capital and Main Street Capital that finance small- and middle-sized private companies that want to expand. They get paid interest and fees on their loans and often take equity positions in these private companies. When they go public or are bought out, the BDC profits handsomely.
BDCs tend to pay generous dividends, anywhere from 6-8% a year, thus attracting many investors.
In the past couple of years, they have been popular and beaten the market, as investors searched for higher yields in a low-interest-rate environment. They get knocked down from time to time when they issue new shares or get overvalued.
But now there is a new threat. The Securities & Exchange Commission (SEC) recently issued new accounting rules and reporting requirements to make sure publicly traded investment companies don't underreport expenses related to their investments. Because of this bizarre change of rules, business development companies are being removed from the major indexes, such as Standard and Poor’s (S&P) and the Russell 2000. The S&P removed BDCs in March and the Russell group is expected to drop them onJune 27.
As a result, many institutions and index funds (such as Vanguard) are selling their BDCs, putting pressure on prices.
Meanwhile, the fundamentals of these BDCs look fabulous, with high profit margins, growing revenues and dividends. My favorite, Main Street Capital (MAIN), is a Houston-based BDC that finances family businesses. MAIN has profit margins exceeding 80% and has raised its dividend five times in the past year. What’s not to like? But the stock is down 5% this year due to a new secondary issue and the index problem.
I still think MAIN is a solid long-term investment and should be purchased anytime the stock sells off. While you wait for the stock to move back up, you will benefit from its rich dividend policy. J. Paul Getty said it best in his classic book “How to Be Rich,” “The seasoned investor buys his stocks when they are priced low, holds them for the long-pull rise and takes in-between dips and slumps in his stride.”