Which BDCs Belong in Your Portfolio?

Shares of business development companies, or BDCs, have been volatile over the past months as fears of higher interest rates scare off nervous investors. Since BDCs are highly debt leveraged, and benefit from low borrowing rates, these companies are particularly rate sensitive.

But in this liquidity-infused market, smart BDC management will continue looking for bargain-priced companies, or add-on acquisitions, that add value to current holdings. In this continued economic recovery, a BDC's leveraged structure could mean higher future dividend payouts and capital appreciation. As the underlying BDC portfolio companies continue to grow, shareholders could see higher equity value.

BDCs are publicly traded private equity firms, which means they can provide additional diversification, and give access to industry segments that traditional investments don't provide. BDCs invest in privately owned companies through debt and equity instruments, giving investors diversification of assets that they may not otherwise be able to access.

Because BDCs must pay out 90% of income as dividends, investors continue to reap high yields. Individual investors should capitalize on the recent sell-off as an entry point, and allocate an appropriate portion of their portfolios to BDCs. But which BDCs belong in your portfolio?

Successful management and a sweet tooth
With a 9% dividend yield, Apollo Investment is one of the better-known BDCs, partly due to founder Leon Black being one of the world's richest people, with a net worth of $5.2 billion. Potential investors should take comfort in the fact that Black is a self-made billionaire, which must provide some faith in Apollo's ownership.

Apollo made news in March by partnering with another private equity group to buy the snack-cake assets of Twinkie-maker Hostess for $410 million. While the Twinkie investment caused a significant amount of buzz around Apollo, the great majority of BDC investments don't create headlines.

Apollo has continued to invest heavily, and has accelerated activity in recent quarters. In fact, during Apollo's latest quarter, the company invested $788 million in 46 portfolio companies. Half of these 46 allocations were new investments, meaning that management continues to find new good deals for capital in the face of cutthroat competition from other BDCs.

The aggressive nature of Apollo's management, and a solid 9% yield, could make Apollo a great BDC to own.

Selective management with a monthly dividend
Another highly traded BDC is Prospect Capital . Like Apollo, Prospect also invests in many private companies that individual investors may not otherwise gain access to. Prospect is invested in 124 portfolio companies, with a value of $4.2 billion. These investments are made across almost all industries, but consumer finance and financial services make up more than one-quarter of the total.

On its latest quarterly conference call, Prospect's president, Grier Eliasek, noted that these financial services investments pay an 18% annualized yield, and that the company continues to look for further opportunities in this sector. Not a bad return when considering that Prospect's borrowing costs can be as low as 3% when drawing from certain lending facilities, according to its latest 10-K.

Eliasek also noted that the company evaluates thousands of new business opportunities per year, but only invests in a low single-digit percentage of these screened investments. So, Prospect's investment strategy is very conservative, which should give risk-averse investors some comfort.

Prospect pays a monthly dividend of around $0.11 per share, for a current yield of 12%. Monthly dividends can be preferable, as it allows for faster compounding of capital due to more frequent payments. Along with a solid investment strategy, the monthly dividend makes Prospect very attractive.

Pragmatic approach
One under-the-radar BDC with potential is Main Street Capital . The company invests in mainly lower- and middle-market companies with revenue of less than $150 million. What sets Main Street apart is its unique internal investment rating system for asset performance.

Contrary to other BDCs, Main Street uses an internally developed rating system to rank its portfolio companies. Shareholders should appreciate this unique approach, as it is very systematic and transparent.

Main Street constantly tracks asset performance through this system, using a scale of one through five, with one meaning that an asset is significantly outperforming the company's expectations. Currently, 33% of Main Street's portfolio companies are significant outperformers, while zero are significantly underperforming. Not bad! More on Main Street's rating system can be found in its 10-Q.

The company also pays a monthly dividend, currently $0.16 per share, amounting to an annualized yield of around 6%. Not shabby, but not up to the level of Apollo and Prospect.

Main Street's shares recently took a dive after slightly disappointing earnings. Shares are still below the pre-earnings price, so this could be a good entry point for investors who value Main Street's pragmatic approach.

Conclusion
BDCs should only make up a small portion of a well-rounded portfolio. These investments carry significant interest-rate risk, and the underlying investments of BDCs are highly illiquid. In an economic downturn, the valuations of these companies could take a hit. But, during normal times, BDCs like the ones mentioned above are a great way to add dividend income to your portfolio.

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The article Which BDCs Belong in Your Portfolio? originally appeared on Fool.com.

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