In this age of record low interest rates, yield-hungry investors have a vast array of high-yield industries to choose from, including Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), YieldCos, and Business Development Corporations (BDCs).
While these sectors have business models that make for naturally high-yields, they come with their own inherent risks and challenges.
In other words, it can be challenging to know which particular stocks to own for safe, dependable, and growing income (see 28 of the best high dividend stocks here).
Let’s take a look at Main Street Capital (MAIN), which is arguably the gold standard of BDCs, to see if this could be an appropriate investment for conservative income investors.
All BDCs are basically middle market lenders, which means they lend or take equity stakes in the 200,000 or so subprime businesses that generate about 33% of the US economy.
Essentially, BDCs serve a market of small companies that regular banks don’t want to touch to help those companies fund acquisitions, leveraged buyouts, growth projects, and restructurings.
Main Street is a medium-sized BDC with $3.5 billion in assets under management ($2.4 billion of its own capital and $1.1 billion that Main Street manages as a third-party asset manager).
The firm deals mostly with lower middle market companies with annual revenue of $10 million to $150 million and $3 million to $20 million in EBITDA.
Main Street’s portfolio consists of loans and equity stakes in approximately 200 companies, diversified both by industry and geography.
With its average loan only $9 million in size, Main Street is relatively well protected against a failure of any one of its clients. In fact, its single largest loan represents just 2.8% of its portfolio and generates 4.2% of its total interest income.
However, what makes Main Street such a standout BDC isn’t its size or its precise business model, but rather its world-class management team, which has one of the best track records in its industry.
Main Street has had a fantastic last few years, with portfolio growth, as well as growth in investment income and distributable net investment income (what funds the dividend), rising sharply.
However, you have to remember that the last decade has been unique in that the Federal Reserve has both kept interest rates at their lowest levels in history, greatly expanded the money supply (by $3.5 trillion) and limiting the amount of risky loans that major banks were allowed to make.
In other words, the BDC industry as a whole has been living in a golden age of relatively little competition from big banks, very cheap borrowing rates, and a world awash with cash and investors desperate for anything with a generous and growing dividend (which made it very easy to raise equity capital).
That being said, what makes Main Street different from its increasing number of rivals (there are around 115 BDCs in the U.S.) is that the firm’s management is far more disciplined and skilled at which investments it makes on behalf of shareholders.
That’s largely due to the fact that Main Street is one of the few internally managed BDCs, providing a meaningful cost advantage compared to its rivals.
Unlike BDCs that are managed by a third party, which collects fees based on the size of the overall portfolio, Main Street’s management team actually works for and owns a large percentage of Main Street itself (over 3.1 million shares worth about $120 million, or nearly 6% of the company).
This results in much lower operating costs and higher profitability for the company.
In fact, Main Street Capital is one of the most profitable BDCs in America, generating impressive margins and returns on shareholder capital (especially compared to its peers).
|BDC||Operating Margin||Net Margin||Return On Assets||Return On Equity||Return On Invested Capital|
|Main Street Capital||64.9%||77.9%||7.0%||12.2%||10.0%|
Source: Morningstar, Simply Safe Dividends
Better yet, those operating cost advantages result in substantially higher distributable net investment income (DNII) per share, which makes for more secure and faster-growing dividends in the short-term.
Over the long-term, Main Street’s higher profitability compounds into far better returns on shareholder capital, which ultimately results in strong growth in net asset value (NAV), or book value per share.
That’s an important point because the BDC industry is essentially a subprime banking industry, meaning that share prices track changes in book value per share over time.
As you can see, while Main Street’s NAV per share has seen periodic volatility, during recessions and recently during the oil crash (which decreased the value of its energy related investments), in general the book value of the company (dark green line) has been rising steadily.
This is in contrast to most other BDCs, which have external management structures that provide incentives for management teams to grow their portfolios’ size even if it requires funding this growth through excessively diluting their shareholders with equity offerings.
Since BDCs have to pay out 90% of taxable income as dividends by law (to avoid paying taxes at the corporate level), they can’t retain much cash flow to fund growth. Therefore, they rely on external debt and equity markets to supply growth capital.
However, by law the maximum amount of leverage BDCs can have is 1:1, meaning that they can only borrow $1 in debt for each $1 in assets.
As a result, BDCs are frequently selling new shares to raise growth capital and make new loans.
The problem with this is that each new share is like a perpetual bond, raising the cost of the dividend and making it harder to secure and grow the existing dividend over time.
That’s partially what makes the BDC industry such a challenging one to do well in over time.
Investors need to be very selective, trusting their hard-earned money only to management teams that don’t have incentives to grow the BDC (and their management fees) at the expense of shareholders.
One way investors can identify such firms is to carefully watch the long-term trend in NAV per share (i.e. a rough estimate of the intrinsic value of the BDC’s shares), which should rise over time if the company is being disciplined in the loans it chooses to make.
Not only does Main Street’s track record show that management has its interests aligned with that of regular investors (as does the steadily growing dividend over time), but Main Street is famous for taking a long-term approach to running its business in several other ways.
First, Main Street has always had a conservative approach to debt.
For example at the