Login | September 21, 2018

BDCs, including Main Street Capital

MALCOLM BERKO
Taking Stock

Published: June 14, 2018

Dear Mr. Berko: Please explain to me what a business development company is and how it works. Also, my brother, who is a certified public accountant, has recommended that I buy 1,000 shares of Main Street Capital. What do you think? -- SP, Fort Lauderdale, Fla.

Dear SP: Business development companies were initiated by Congress in 1980. The goal of BDCs is to encourage the flow of public dollars (your investible funds) to private businesses. Generally, BDCs invest at least 70 percent of their cash in private U.S. companies or in public U.S. companies with market values of less than $250 million. And these BDCs must send quarterly, as well as annual, reports to the Securities and Exchange Commission and to their shareholders. Owning a BDC (only 55 are publicly traded) allows shareholders to have their cake and eat it, too. They enjoy the liquidity of a publicly traded stock while participating in the potential profit of private companies.

A BDC must qualify as a regulated investment company under Subchapter M of the Internal Revenue Code; distribute 98 percent of its ordinary income and 98 percent of net capital gains for one year; derive at least 90 percent of gross income from dividends, interest and capital gains; have no more than 25 percent of their assets invested in the securities of one company or two or more issues that are engaged in the same or similar business activities, limit its debt-to-equity ratio to 1-to-1 or less, and revalue its private investments every quarter.

Like real estate investment trusts, BDCs are not taxed at the corporate level, as long as they pay out the required income to shareholders. This avoids double taxation and allows BDC investments to pay higher dividends than common stock. But there's a string attached, because a large percentage of a BDC's cash distribution is considered ordinary income and is taxed at the shareholder's higher tax rate (33 percent to 39.6 percent) rather than the 15 percent rate for qualified dividends. For this reason, it makes good sense to own BDC investments in an individual retirement account, where distributions are deferred, or in a Roth IRA, where they're exempt from taxation.

Your brother's a smart lad. I like his recommendation of Main Street Capital (MAIN-$38), which specializes in long-term equity and debt investments primarily in small- and lower-middle-market companies. This is a classy BDC. MAIN primarily invests in the Southern and Southwestern regions of the U.S. Management typically invests between $2 million and $75 million in equity and between $5 million and $50 million in debt with companies that have revenues between $10 million and $150 million and an EBITDA -- or earnings before interest, taxes, depreciation and amortization -- of $1 million to $20 million. Management usually requires a fixed interest rate between 12 and 14 percent. And these investments are typically in the form of secured debt and equity participation -- and oftentimes the equity participation can be a very attractive kicker. MAIN's management likes to make loans to well-established family-run businesses that need financing for founders who want to pass their companies to heirs. MAIN's loans are highly collateralized. And rising interest rates may not affect MAIN as they will other BDCs. Rather, they will increase earnings, because 72 percent of MAIN's loans have floating rates.

MAIN has a better record than most BDCs. Compared with its peer companies, it has impressive operating margins of 83.5 percent, a 5.1 percent return on capital and a 35 percent cash flow, which are nearly twice those of its competitors. Since 2010, revenues and net income have grown fourfold, and the dividend has doubled. MAIN currently pays a monthly dividend of 19 cents a share, plus a 27.5-cent semiannual dividend. Total 2017 payout was $2.83, making for a very acceptable yield of 7.5 percent. And 2018 is looking better than any year in MAIN's history, so expect a nice dividend increase. Listen to your brother.

Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at mjberko@yahoo.com. To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.


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