More than a dozen readers recently have asked me to explain how a business development company functions and requested recommendations. Here are your answers.

Dear Readers: 

Business development companies, like venture capital funds and private equity funds, give investors the opportunity to invest in small privately held companies or public companies that need capital or management expertise. Then, at a certain point in the future, investors can participate in the sales proceeds of those investments. BDCs allow anyone to purchase their publicly traded shares, which attracts huge sums of money and gives them a very effective and flexible way to raise capital.
BDCs are taxed as regulated investment companies by the Internal Revenue Service. And like a real estate investment trust, if a BDC meets certain income, diversity and distribution requirements, it pays little or zero income tax. Most BDCs distribute 98 percent of their taxable income to avoid all corporate taxation. And because this income is not taxed at the corporate level, shareholder distributions to investors are generally taxable based on the type of income earned. Ordinary income from a BDC is taxable to investors at ordinary rates, whereas the distribution of capital gains from the BDC is taxable at capital gains rates.
BDCs, which derive a large portion of profits from asset appreciation and management fees, are likelier to increase distributions to shareholders in times of economic growth and projected prosperity. But many BDCs have been flat or have lost value in the past six months.However, I sense the beginning of a positive change in this sector, especially because President Obama appointed Janet Yellen to lead the Federal Reserve beginning in January. Yellen’s appointment signals looser money, perhaps a larger monthly stimulus (some believe that it will be $125 billion or more a month) and a more accommodative business climate.
Investors looking to bolster their portfolio income and earn modest potential growth may find attractive issues in this sector.
Apollo Investment Corp.’s (AINV-$8.79) 80-cent dividend yields 9.1 percent. AINV, with $4 billion in assets, invests in middle-market companies with minimum revenues of $50 million. AINV makes mezzanine, senior secured loan and direct equity investments, with 81 companies in its management portfolio. The dividend could be raised to $1 next year, and the shares trade about a buck below net asset value. AINV could trade up to $12.50 in 2014.
KKR & Co. (KKR-$23.44), with $84 billion in assets under management, has a $1.62 dividend that yields 6.9 percent. This global asset manager has 14 offices in the U.S., Europe, Asia and Australia, and officers and directors own 62 percent of KKR’s common. KKR specializes in leveraged buyouts, management buyouts, special situations and distressed assets, debtor-in-possession and exit financing, and capital markets. The distribution should rise to $2 next year, and the shares could trade at $28-$29.

Hercules Technology Growth Capital (HTGC-$16.71) pays a $1.11 dividend that yields 6.6 percent. HTGC seeks to invest in companies with revenues between $10 million and $200 million that have capital needs of $5 million to $30 million and generate operating EBITDA of $2 million to $15 million. The dividend may be raised 10 percent next year, and shares could trade up to $22.
Main Street Capital (MAIN-$31.99) has raised its revenues, earnings and dividend each year since coming public in 2007, and the current $1.98 dividend, yielding 6.2 percent, may be raised to $2.18 next year. MAIN invests primarily in the South and the Southwest, co-invests with other firms and will not invest in startups or companies with speculative business plans. Excellent management could increase MAIN’s price to the high $30s next year.