Let's face it – borrowing money is tough. Small and medium size businesses are paying more interest, and face much stricter underwriting guidelines, than at any time in the last twenty years.
There are several reasons for this reluctance to finance. According to a recent study by FrontPoint Partners, the U.S. economy has lost over $160 billion in cumulative leveraged loan capacity with the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch. This is significant reduction in the natural buyers of loans (which are traded like stocks among banks and other financial institutions). Combined with the recent economic malaise, the reduced demand for loans has made borrowing money an exercise in futility for all but the most stellar firms.
Even though the banks aren't lending as freely, there are still folks with capital to put to work. Business development companies (BDCs) are publicly traded companies that provide financing, typically through mezzanine and senior debt, to small and mid-sized businesses. Structures like REITs, BDCs are exempt from corporate income tax as long as they pass along at least 90% of their income in the form of dividends.
The handful of BDCs that currently trade boast yields of over 10%, making them an excellent addition to any portfolio. And with borrowing costs at such high levels, it isn't unusual for them to enjoy spreads as high as 12% on their loans.
One caveat about these companies is that they are required to maintain suitable equity-to-debt ratios. As a result, they must routinely issue additional shares as the debt portion of their balance sheets grow. But if the stock price exceeds the company's net asset value–which is the case for Fifth Street Finance (FSC)–secondary offering can actually be accretive to their valuation.
