In 2025, Emulate Private Equity Investments for Annual Returns of 12.3%
Trump 2.0 will include Wall Street-favored figure Scott Bessent in the role of Treasury secretary. Bessent will push for financial deregulation and increased lending, leading to simpler and quicker monetary transactions. This will be advantageous for private equity (PE) firms and business development companies (BDCs).
Today, we'll discuss seven BDCs that provide yields between 11.1% and 14.2%. These BDCs operate similarly to PE shops, both benefiting from a favorable deal-making environment.
For income investing purposes, we prefer BDCs due to their ease of purchase. It is straightforward to invest in BDCs as we would with any stock. Additionally, BDCs can evade federal tax liability by distributing at least 90% of their taxable earnings to shareholders as dividends annually. These dividends often exceed what is offered by real estate investment trusts (REITs) or other high-yield stocks.
For instance, a $1 million retirement fund would generate $123,000 in annual income. Even if half of that amount was available to invest ($500,000), the annual income would still total $61,500.
However, not all high yields are secure, so it is essential to scrutinize the underlying businesses of these BDCs. Let's delve deeper into these BDCs.
OBDC Was Once a Prominent BDC—Until Now
Blue Owl Capital Corp. (OBDC, 11.1% yield) was rebranded approximately 1.5 years ago (from Owl Rock Capital Corporation). Blue Owl specializes in creating, executing, and managing debt and equity investments in American middle-market companies, typically with annual EBITDA of between $10 million and $250 million, and/or annual revenue of $50 million to $2.5 billion at the time of investment.
Blue Owl's portfolio of 219 companies predominantly consists of non-cyclical companies, with deals typically situated higher up the capital structure. 81% of its loans are senior secured, 76% are first lien, and the portfolio is mainly floating-rate. Constructed for a rising-rate environment, OBDC's composition has recently become a concern as Wall Street anticipates and experiences Fed rate cuts:
This well-managed BDC still enjoys a strong competitive position, excellent credit quality, and positive cash flow. It has boosted its regular dividend (which makes up 9.6% of the yield) multiple times over the past few years and supplements the payout with additional dividends (an additional 1.5% yield throughout the previous 12 months) in nine consecutive quarters.
However, its variable-rate portfolio, coupled with the looming merger with sister entity Blue Owl Capital Corporation III (OBDE), expected to close in Q1 2025, may discourage some potential buyers.
Given that OBDC is trading at a mere 1% premium to NAV at present, potential buyers can afford to wait.
CWSC Has Fallen Behind Other Leading Shares
Capital Southwest Corp. (CSWC, 11.1% yield) provides a similar yield and blend of regular dividends (10.2% worth of yield) and supplementals (0.9% TTM). Since the beginning of 2022, the aggressive hike in regular payouts has occurred six times.
CSWC serves companies with EBITDA between $3 million and $25 million. Its current portfolio comprises 118 firms, with approximately 89% of its deals being first-lien loans, 9% being equity, and the remainder being sprinkled with second-lien and subordinated debt. Virtually all of CSWC's debt investments are floating-rate, resulting in a similar trajectory to OBDC's.
On the positive side, CSWC has substantial room to bolster its leverage and accelerate growth. However, credit quality is lacking—it has six investments on non-accrual valuation at 3.5%, which is a significant increase from 1.9% a quarter prior. With a whopping 38% premium to NAV, anything less than perfect credit quality seems unforgivable.
New Mountain Finance Corp. (NMFC, 11.5% yield) invests in a diverse range of American middle-market businesses (EBITDA between $10 million and $200 million). It focuses on companies that are recession-resistant, have high barriers to entry, collect recurring revenues, and produce strong free cash flow. Its 128 portfolio companies are scattered across various industries and financing types. First lien is the primary deal type, accounting for 63%, but they also have second lien, subordinated, preferred, common equity, and net lease deals.
NMFC endured a rough fourth quarter, which included a 60-basis-point decline in portfolio yield. Supplementals have not only decreased, but they have dropped from 4 cents per share in Q1 to just a penny in the fourth quarter. Dividend coverage is not yet a concern, as the company has pledged to waive some incentive fees to cover the base. Moreover, New Mountain's leverage position is nearly opposite that of Capital Southwest—its leverage is quite high, so it has limited capacity to expand its portfolio.
Despite this, shares have only inched up in 2023 despite its double-digit dividend. Therefore, a 6% discount to NAV might not be an attractive offer, considering NMFC's weaker state currently.
GAIN Continues to Be Mainly a Debt Dealer, Yet Its Equity Stake is Significant
Gladstone Investment Corporation (GAIN, 12.0% yield) is part of the Gladstone group of businesses, which also includes Gladstone Commercial (GOOD), Gladstone Capital Corporation (GLAD) and Gladstone Land Corporation (LAND). The focus of its target portfolio company is to generate a yearly EBITDA of $4 million to $15 million, have a solid business model, consistent cash flows, and minimal market or technology risk.
However, what sets GAIN apart is its inclination towards equity investments. As demonstrated in the chart below, a remarkable 33% of its portfolio is invested in equities. This is essential for GAIN's "buyout" strategy, where it typically supplies most (and often all) of the debt capital, along with a significant portion of the equity capital. This approach helps maintain a high dividend payout while also offering variable supplemental payouts upon realizing gains from equity investments. It's worth noting that the regular monthly dividend accounts for only 7% of the yield, while a substantial 70-cent dividend paid in October boosts the yield by an additional 5% in the TTM.
As previously mentioned, GAIN is a well-run Business Development Company (BDC). However, we must be realistic about the dividend, which is lower than the industry standard. The regular dividend is paid monthly, but the supplemental dividends, although unpredictable, have the potential to cover the entire gap. An 11% premium to NAV isn't desirable, though.
Golub Capital BDC’s (GBDC, 12.8% yield) possesses an extensive portfolio of 381 companies, with a median annual EBITDA of $63.7 million and representation across numerous industries. The majority of its deals involve first lien senior secured debt (92%), while it also has exposure to equity financing (7%) and insignificant amounts of junior debt.
GBDC's emphasis on senior debt has generally resulted in an exceptionally high portfolio quality. With only 11 portfolio companies on non-accrual, their collective fair value amounts to only 1.1% of the portfolio. GBDC also boasts remarkably low operating expenses and fees, which have often impeded the financial performance of other BDCs.
The reduction in fees was facilitated by GBDC's merger with GBDC III, which closed in June. This merger also made GBDC the undisputed ruler of special dividends for 2024. GBDC has paid not only a high regular dividend (10.3%) but also supplemental dividends (1.5% TTM), in addition to announcing a series of merger-linked specials (1.0% TTM) set to be paid in December.
However, investors continue to wait for a catalyst to trigger a rally for GBDC shares. I’ve suggested in the past that a regular dividend increase, a fresh supplemental-dividend program, and another fee reduction could potentially serve as such catalysts. Unfortunately, shares have only managed to match the industry's performance since then. The highly patient can buy in at a meager 1% discount to NAV.
Trinity Capital (TRIN, 14.2% yield) operates in a distinct niche as a venture-debt firm that primarily supports growth-stage companies. Its portfolio is primarily composed of 75% loans, 18% equipment financing, and 7% equity.
The nature of Trinity's business offers a more robust growth profile than most other BDCs, even if it has generally performed in line with the industry over the past few years. We could blame a substantial price-to-NAV, which currently stands at an 9% premium, though this is relatively "affordable" compared to other prominent internally managed BDCs, including Capital Southwest (38% premium) and Hercules Capital (HTGC, 72%).
Additionally, unlike the other entities on this list, Trinity's high yield is entirely derived from its regular dividend. Trinity has paid supplemental dividends in the past but not recently, so an uptick in yields could indeed occur during peak periods. However, Trinity's quarterly dividend coverage is tighter, at 105%, necessitating some growth to prevent concerns about an income reduction.
FSK: Two Rallies Since 2023 Discussion
In 2023, I made the following remarks about FS KKR Capital Corp. (FSK, 13.5% yield):
"FSK hasn’t provided investors with much reason to celebrate, but there are several appealing facets. A double-digit yield, clearly, but also a dependable, well-covered payout, a streak of bottom-line beats, and an absurdly deep 21% discount to NAV."
Since then, the stock has experienced two rallies.
FS KKR Capital currently offers financing to 217 private middle-market companies in more than two dozen industries, including double-digit exposure to software and services, commercial and professional services, capital goods, and health care equipment and services.
Primarily, FSK focuses on investing in senior secured debt (around 60%), supplemented by substantial contributions in asset-based finance (approximately 12%) and second lien senior secured loans (approximately 8%). Nearly 10% of its exposure is towards Credit Opportunities Partners JV, a joint venture with South Carolina Retirement Systems Group Trust, which invests in a variety of opportunities.
Much like other Business Development Companies (BDCs), the majority of its loans are floating-rate. However, it holds around 10% in fixed-rate loans, which could provide some respite for FSK in an environment of declining rates.
Although FSK might not be as appealing as it was a year ago, there are still compelling reasons to consider it. Its dividend coverage remains satisfactory; the regular dividend contributes to 11.9% of the yield, while special dividends account for the remaining 1.6% over the past 12 months. A contraction in the base-rate next year might cause unease among shareholders. During the year, FSK worked on reducing its non-accruals, which now stand at a decent 1.7% at current market value. The discount to NAV for FSK has considerably narrowed, although it remains quite substantial at 10%.
Brett Owens serves as Chief Investment Strategist for Contrarian Outlook. To discover more prosperous income ideas, obtain your complimentary copy of his latest special report: Your Ultimate Retirement Portfolio: Generous Dividends—Every Month—Forever*.
Disclosure: None
Given the context, here are two sentences that contain the given words and follow from the text:
Scott Bessent, Trump 2.0's proposed Treasury secretary, may advocate for policies that could benefit business development companies (BDCs) and high yield stocks, as he pushes for financial deregulation and increased lending.
Blue Owl Capital Corp. (OBDC), a BDC with a 11.1% yield, has boosted its regular dividend multiple times over the past few years and supplements the payout with additional dividends, making it an attractive option for dividend investors seeking higher yields compared to real estate investment trusts (REITs) or other high-yield stocks.
