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Due to the surge of inflation to a 40-year high this year, income-oriented investors are struggling to protect the real value of their portfolios from eroding. Business Development Companies, commonly known as BDCs, offer above-average dividend yields and thus they are great candidates for the portfolios of income-oriented investors. These companies make debt or equity investments in other companies, which cannot borrow funds via traditional banking channels. As a result, BDCs try to earn high yields from their investments, which they can pass on to their shareholders. However, due to the inherent risk in investing in companies that cannot borrow funds from banks or bond markets, investors should perform their due diligence before buying a BDC. In this article, we will discuss the prospects of three BDCs that appear attractive right now.
 

Main Street Capital Corporation (MAIN)

Headquartered in Houston, Main Street Capital Corporation is a BDC that provides long-term debt and equity capital to lower-middle-market companies and debt capital to middle-market companies. Lower middle market companies have annual revenues between $10 million and $150 million. The investments of Main Street usually support acquisitions, recapitalizations, growth financing, and refinancing. The BDC currently has an interest in 75 lower middle market companies (valued at $1.9 billion), 33 middle market companies ($354 million), and 87 private loan investments ($1.5 billion).

Despite the inherent risk in its business, Main Street has exhibited a consistent growth record. During the last decade, the company has grown its net investment income (NII) per share almost every year, at a 3.1% average annual rate. A low growth rate should be expected, as BDCs are obliged by law to distribute at least 90% of their taxable income to their shareholders and thus minimum amounts are left for investing in growth projects. The key characteristic of Main Street is its consistency, which renders it a high-quality BDC.

It is also remarkable that Main Street has proved resilient throughout the coronavirus crisis. While many companies saw their earnings plunge in 2020 due to the fierce recession caused by the pandemic, Main Street posted just a 16% decrease in its NII per share. Even better, the company recovered swiftly, with a record NII per share in 2021.

Main Street has raised its dividend for 7 consecutive years and offers its dividends on a monthly basis. The stock is currently trading at a 10-year low price-to-earnings ratio of 12.0 and is offering a 7.0% dividend, with a payout ratio of 86%. While its payout ratio is high under normal standards, it is reasonable for a BDC, as this group of companies is obliged to distribute at least 90% of their taxable income to their shareholders.

Overall, it is nearly impossible to identify a BDC with a safe dividend due to the nature of BDCs. On the other hand, the 7.0% dividend of Main Street combined with its cheap valuation and its consistent growth record render this BDC attractive right now.
 

Capital Southwest Corporation (CSWC)

Based in Dallas, Capital Southwest Corporation is an internally managed investment company that has elected to be regulated as a BDC. It specializes in providing debt and equity financing to lower-middle-market companies and debt capital to upper-middle-market companies located primarily in the U.S.

The credit portfolio of Capital Southwest currently consists of 78 lower and upper-middle-market companies. The investment portfolio of the company is well-diversified and exposed to nearly 25 industries. Media, Marketing & Entertainment, Business Services, and Consumer Products & Retail account for 11%, 11%, and 9% of the total holdings, respectively.

Since the spin-off of CSW Industrials, in late 2015, Capital Southwest has managed to grow its NII per share every single year, at a fast clip, from $0.61 in 2017 to an expected $1.90 in 2022. The stock is also offering an exceptionally high dividend yield of 11.5%. The payout ratio is elevated, at 101%, but it is not extreme for a BDC, as mentioned above. In addition, the payout ratio does not take into account the realized gains that are in the form of non-investment income.

It is also important to note that Capital Southwest has proved resilient to the pandemic, as it has grown its NII per share in each of the last six years. Given also its 8-year low price-to-earnings ratio of 9.3, the stock is highly attractive right now.
 

TriplePoint Venture Growth (TPVG)

TriplePoint Venture Growth is a BDC that specializes in providing capital to companies during their private growth stage before they eventually perform their IPO in the public markets. TriplePoint offers debt financing to venture growth companies, proposing a less dilutive way to raise capital than raising additional equity, while it also helps companies in their expansion plans. Its investment portfolio mainly consists of debt provision in 59 companies (89%), warrants in 95 companies (10.9%), and a few equity investments. It is well-diversified amongst 20+ industries, with the majority of its funds allocated to the tech sector.

TriplePoint has exhibited a decent performance record throughout its 9-year history but its record has been more volatile than the record of the above two BDCs. Nevertheless, TriplePoint has grown its NII per share by 3.8% per year on average since 2014.

Moreover, the stock is currently trading at a nearly 8-year low price-to-earnings ratio of 7.4 and is offering an eye-opening dividend yield of 11.3%. Given the decent payout ratio (for a BDC) of 85%, the dividend has a meaningful margin of safety in the short run. Moreover, the company has never cut its dividend throughout its short history, though it froze its dividend for seven consecutive years and raised it by 3% in 2022. Overall, investors should not expect meaningful dividend growth going forward. On the other hand, the exceptionally high dividend yield and the cheap valuation of TriplePoint render it attractive right now.
 

Final Thoughts

BDCs offer above-average dividend yields but they carry elevated amounts of risk due to the nature of their business and their obligation to distribute more than 90% of their NII in dividends, which leaves a thin margin of safety in reference to the dividends. The above three stocks are offering attractive yields and are trading at remarkably cheap valuation levels. Given also their superior performance record when compared to most BDCs, they are likely to reward the investors who purchase them around their current stock price.

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