How Business Development Companies Generate Their Sky-High Dividends

Have you ever heard the saying "if something seems too good to be true, it probably is?" The older (and therefore wiser) you are, the more likely you are to agree with the ancient adage. It's true within the investing arena as well; if a stock's suggested upside doesn't seem realistic, you're probably going to steer clear of it.

However, there are instances where something seemingly unlikely is not only true, but actually reasonable once you understand the rest of the story -- and the risk.

Case in point: Business development companies like Ares Capital (NASDAQ: ARCC), Prospect Capital (NASDAQ: PSEC), and Main Street Capital (NYSE: MAIN) offer shockingly high dividend yields, often in excess of 10%. It makes sense, however, when you fully understand these organizations' underlying business model.

But first things first.

What's a business development company?

Just as the name suggests, business development companies help up-and-coming corporations grow. These outfits tend to be mid-sized organizations with capital needs larger than most local banks can meet, but not quite big enough to go public. The easiest source of funding is business development companies built for this very purpose, like the aforementioned Main Street Capital, which focuses on companies doing between $10 million and $500 million worth of annual business.

This funding isn't free, of course. When the U.S. Congress passed the Small Business Investment Incentive Act of 1980, which gave favorable tax treatment to these organizations, business development companies -- or BDCs -- often exchanged their capital for an equity stake in the borrower, and almost as frequently, in exchange for a degree of control in the day-to-day management of that business. And this option still exists, to be sure.

More and more, though, BDCs provide capital in the form of loans with interest rates often well above market norms. Ares Capital's weighted average interest rates on its loan portfolio as of the end of Q1, for instance, stood at 10.3%, matching Main Street Capital's, reflecting the above-average risk of lending to corporations of this tricky size. Since the majority of a business development income must be passed along to shareholders in order to maintain its tax-free status, this effective average interest rate is a pretty good indication of that company's dividend yield.

As for picking them, investors usually choose a particular BDC because they believe the business lender's experienced management team knows which mid-sized businesses to work with and which to avoid. And to be fair, most of them do know which businesses are actually in a position to make payments on a high-interest-rate loan.

The rest of the story

Sounds great, right? Just bear in mind that business development companies face the same lending risks as other business lenders. Namely, should the borrower default on a loan, the BDC is left holding the bag, so to speak. And regardless of how savvy business development companies' decision-makers may be, none of them can perfectly predict the future -- at least some borrowers will be unable to make their payments at some point.

It's happening right now, in fact, albeit to a modest degree. Remember all the chatter in March of this year about the limitation on investor withdrawals that Ares Management (NYSE: ARES) (part of the Ares family, but a distinctly different investment from ARCC) and Apollo Global (NYSE: APO) put in place? Although this spike in liquidations was more rooted in fear than in actual defaults, the private credit market did see a slight uptick in loan defaults then, ultimately stemming from cyclical headwinds.

Arguably, the bigger risk to business development companies in challenging economic times is that smaller companies become defensive when they sense headwinds, curtailing their interest in borrowing on any terms. Althgough BDCs can still convert existing interest-bearing loan payments into dividend payments, such a backdrop prevents them from expanding their portfolio of income-generating loans.

Image source: Getty Images.

It's a two-way street, of course. Even if demand for funding from BDCs remains healthy, investors -- individuals as well as institutions -- may be hesitant to put money on the table for a business development company to lend out in the first place if they're afraid that would-be borrowers will be unable to pay it back. In this vein, note that middle-market business lenders are subject to the same interest rate risks as banks. That is, if they're lending borrowed money, higher interest rates can make it more expensive and more difficult to attract borrowers.

End result? Although it's still relatively rare, a handful of business development companies including Gladstone Capital (NASDAQ: GLAD) and Goldman Sachs BDC (NYSE: GSBD) have recently lowered their per-share payouts, reflecting the challenges that most BDCs are facing in this environment. Again, it happens.

Then there's the fact that while business development companies may sport sky-high dividend yields, they offer very little in the way of capital appreciation. That, of course, is a pretty typical trade-off for investors.

They have their place (for some)

This is neither a warning to wave you off from investing in BDCs nor a call to steer you into them. It's just an explanation of them, and an acknowledgment that -- like any other investment option -- business development companies bring a combination of risks and rewards to the table. They bring more of both than bonds, and less of both than stocks.

More than anything, though, understand that BDCs are really only suited to be an income investment, yet aren't particularly well suited to be the only holdings owned by income investors who need to preserve capital as much as they need reliably consistent income. If that's what you need, start with a foundation of more predictable dividend payers before adding these riskier, higher-yielding tickers to your portfolio.

James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.