2022 has been a difficult reminder for investors that the stock market doesn’t always go up. Headlines about inflation, geopolitical issues, and recessionary concerns distract from the big picture: the economy. So, what kind of companies shield investors from all the noise? Business development companies.

Business development companies are small yet highly lucrative businesses that serve as a form of private equity for the masses. Unlike typical large-cap dividend stocks (like the dividend aristocrats), BDCs usually offer investors a higher dividend yield. Often 8% or higher. As a result, income investors find BDCs very appealing. 

However, like any investment, investors need to determine if now is the right time to invest. Assessing fundamentals is key to any well-balanced portfolio.

Understanding BDCs

Congress created the term “Business Development Company” (also known as Closed-end investment companies) to encourage direct investments in the economy.  BDCs benefit from preferential tax treatment. In fact, they pay no income tax at the corporate level so long as they pay at least 90% of their net income as dividends.

BDCs make debt and equity investments in smaller or mid-size companies that lack access to conventional big-bank financing sources or IPOs. As a result, BDCs may invest in turnaround, developing, or distressed businesses.

To be classified as a BDC, the corporation must put at least 70% of its cash in privately or publicly owned enterprises with market caps of $250 million or less. BDCs profit by investing and then selling their stake when (and if bought), generating income and capital gains. BDCs run comparable commercial structures to private equity and venture capital companies in this manner.

Private equity and venture capital are usually unavailable to the general public, whereas public BDCs are available.

Why Investors Like BDCs   

Compared to ordinary stocks, BDCs provide investors with higher dividend yields (5-10%) and potential for capital growth. However, this comes with additional risk. Indeed, BDCs are higher-risk investments because of their heavy use of leverage and targeted selection of microcap, small-cap, or distressed enterprises.

BDCs stock prices can also be rather volatile compared to large-cap stocks. However, they are still touted as premier holdings in a well-diversified portfolio. They can offer income and capital growth while providing solid long-term returns, which larger public companies cannot promise.

Let’s consider real estate for example. While there’s always an element of uncertainty, many real estate investors have found extraordinary success by transforming distressed properties into cash flow-generating commercial enterprises - thanks to joining forces with BDCs.

In Focus: 2 BDC’s With Above Average Yields

Capital Southwest Corp. (CSWC)

• Market Capitalization: $539 Million
• 5-Year Revenue Growth: 643.01%
• Dividend yield: 8.1%

Capital Southwest Corporation is an internally managed company formed in 1961 and became a BDC in 1988. The Company's investments focus on early-stage financings, expansion financings, management buyouts, and recapitalizations in a broad range of industry segments.

Capital Southwest focuses on the financing and development of middle-market firms, investing from $5 million to $30 million in securities across the capital structure, including first lien, second lien, and non-control equity co-investments. As of YE2021, the company has approximately $913 million on its balance sheet.
 

Capital Southwest is enviable as it offers innovative financing solutions for the long haul as a public company with a permanent capital base.
 

Over the last 52 weeks, the company’s shares have traded in a range between $22.20 and $28.41. Today, the company’s last trading price of $22.54 which is about 21% off its highs. 
 

On April 27, 2022, the company announced a quarterly dividend of $0.48 per share, representing a 2.1% increase over the prior quarter. Additionally, the company declared a special dividend of $0.15 per share for the quarter ending June 30, 2022.

Newtek Business Services (NEWT)

• Market Capitalization: $560 Million
• 5-Year Revenue Growth: 250.31%
• Dividend yield: 10.38%.

Newtek Business Services specializes in serving small and medium-sized companies with financial and commercial services. Specifically, a substantial portion of Newtek's income comes from companies that provide a broad range of commercial services to its extensive client base. Notably, Newtek is one of the new BDCs authorized to issue SBA loans, which is also a significant source of their income.

Looking at the financials, one can quickly determine that the company is a cash machine. For example, in FY2021, net margins topped a whopping 77%. Moreover, their balance sheet is markedly improved.

Despite the financials, Newtek’s shares are trading at the low end of their 52-week range.  Investors, however, continue to receive dividends. On April 20, 2022, the company declared a second-quarter cash dividend of $0.75 per share and is set to report Q1-2022 results on May 4, 2022