Is the Private Credit Boom a Gift or a Risk for BDC Income Investors?

Business development companies (BDCs) are specifically designed to pass income on to investors. Some have particularly large yields, as well, often in the 10% area. However, there are important risks for investors to consider when buying a BDC. One of the biggest is the basic business model of investing in the debt of non-public companies.

This puts BDCs like Main Street Capital (NYSE: MAIN) and Ares Capital (NASDAQ: ARCC) in the same space as financial giants like Blackstone (NYSE: BX). One of Blackstone's big focuses is expanding in the private credit market, which is a mixed blessing for BDCs. Here's what you need to know.

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What do BDCs do?

Business development companies are designed to provide capital to smaller companies that lack access to public markets. They are supposed to provide guidance to the companies in which they invest, helping them grow their businesses. Like a real estate investment trust (REIT), a BDC must distribute 90% of its taxable income to investors as dividends. And, in exchange, the BDC avoids corporate-level taxation.

This is a key reason why BDCs tend to have large yields. But it also helps that smaller, private companies don't have many capital options. So BDCs can charge extremely high interest rates on their loans. In the first quarter, Main Street's average interest rate on its private loans was a lofty 10.3%. Ares Capital's average loan had the same rate.

The problem is that economic downturns can strain a BDC's investment portfolio, leading to an uptick in defaults. It isn't unusual for BDCs to reduce their dividends during recessions. Ares Capital, for example, cut its dividend in each of the last two recessions. This is where the growth of private credit comes into play.

Blackstone's private-credit growth changes the nature of the game

Blackstone is a financial giant that has been expanding in the private credit space. That draws more attention to the private-credit niche, thereby increasing the legitimacy of the BDC business model. This is a net positive. Also notable, BDCs have the potential of partnering with larger players on deals, expanding their investment opportunities. And as big financial companies look for investments, more private companies may consider raising capital this way. So it isn't inherently bad for BDCs for financial giants like Blackstone to expand into the private credit space.

The problem is that financial giants like Blackstone are likely to have deeper pockets and bigger investment teams. They will probably be getting access to the biggest and best deals. And that means that smaller players like Main Street and Ares Capital will get what's left. This is not a small issue, noting that Main Street's market cap is just $5 billion compared to Blackstone's $165 billion. Ares Capital, one of the largest BDCs, has a market cap of only $14.5 billion.

The upside of being small is that Main Street and Ares Capital don't need huge deals to move the needle. The downside is that the financial strength of the companies in which they invest is a key factor in a BDC's ability to continue paying dividends during difficult economic times. So neither Main Street nor Ares Capital is likely to be shut out of the market, as bigger players are entering it, but they may end up with riskier portfolios.

Understand the risks you are taking on with BDCs

There's nothing wrong with owning a business development company. But dividend investors need to understand the risks BDCs face during periods of economic weakness. As troubled loans mount in a BDC's portfolio, paying dividends to shareholders becomes more difficult. It is that simple.

That dynamic, however, has always been at play. The issue with larger players like Blackstone aggressively entering the private credit space is that it could exacerbate the quality issues BDCs face during downturns. And investors may not see that risk until it is too late. BDCs can boost your income, but they probably shouldn't be seen as reliable dividend stocks. Using them to supplement your dividend portfolio, not as the core income producers you rely on to pay for necessary expenses, is probably the best course of action.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ares Capital and Blackstone. The Motley Fool has a disclosure policy.