I have written numerous times about the benefits of investing in tax-advantaged vehicles such as real estate investment trusts (REITs) and master limited partnership (MLPs). These investments pay super-high dividend yields because they are “pass through” entities that do not pay tax at the entity level. This eliminates the double taxation faced by most corporations. The less money that a company is required to pay to Uncle Sam, the more that is available to pay to shareholders.

Introducing: Business Development Companies

But there is yet another type of tax-advantaged investment vehicle with super-high yields that I haven’t written about yet: business development companies (BDCs). The U.S. Congress created BDCs in 1980 to encourage the flow of public equity capital to private business. Like real estate investment trusts (REITs), BDCs are not taxed at the corporate level as long as they pay out to shareholders at least 90% of their taxable annual net income each year and derive 90% or more of their gross income from dividends, interest, and capital gains on securities. Consequently, BDCs can offer investors much higher dividend yields than many other types of investments.

Congress allows BDCs and REITs to avoid double taxation in order to promote public policy. In the case of BDCs, the public policy is to encourage public investment in small and financially troubled businesses that often find it difficult to obtain financing from banks and the public markets. To qualify as a BDC, at least 70% of the company’s assets must be “qualified.” First, the company must be U.S. based; the U.S. government has no interest in subsidizing foreign companies. Second, the company must either: (1) not have any of its securities listed on a national exchange, or (2) have securities listed on a national exchange but whose common equity has an aggregate market capitalization of less than $250 million.

BDCs are Safer Than Venture Capital

BDCs are also required to offer “significant managerial assistance” to their portfolio companies, similar to a venture capitalist (VC). Also like a VC, a BDC assumes more risk and consequently gets to invest at a much lower valuation than would be available in the public markets. But unlike VC funds, which are open only to high-worth “accredited investors,” BDCs are open to the average Joe. Because of this, investors in BDCs are afforded statutory safeguards, which require the BDC to diversify its investment portfolio, limit its debt-to-equity ratio to 1 or less, and re-value its private investments every quarter.

BDCs Work Best in Retirement Accounts

As with REITs, the elimination of double taxation comes with a string attached – much of the cash a BDC distributes to shareholders is considered ordinary income and is taxed at an investor’s higher income tax rate rather than at the 15% rate for qualified dividends. For this reason, it usually makes sense to hold a BDC in an IRA, where taxes on capital gains and cash distributions are deferred or, in the case of a Roth IRA, exempt. Distribution percentages of ordinary income and long-term capital gains (which are taxed at a lower rate) vary among BDCs.

Confidence in a BDC’s Management is Everything

BDCs also vary in the types of industries they invest in. Having confidence in a BDC’s management to make the right decisions and value its portfolio accurately is critical to a successful BDC investment. Choose wisely.

Right now may be a good time to consider a BDC investment. According to the BDC Fifth Street Finance (NYSE: FSC), the pricing of small-cap financing deals is improving, which means larger profits for BDCs:

As signs of growth become more prevalent, we continue to believe that interest rates (which the Federal Reserve is keeping artificially low) will eventually turn upward but will remain low for the foreseeable future. Bank lending activity should also remain low, especially in Europe, with large banks hesitating to make new loans while they strive to reduce risk-weighted assets per Basel III capital requirements.

We remain optimistic about the prospects for deal flow in 2012 — and our ability to be competitive in the environment. We are aggressively hiring to ensure that we are adequately staffed for the anticipated increase in middle market activity.

Mergers and acquisitions activity began to pick up in March and our pipeline of deals has grown accordingly. We expect this latest M&A uptick to extend into the third calendar quarter, which should prove to be a warm-up for what we anticipate to be an extraordinary fourth quarter for M&A deals. Transactions should especially be driven by tax considerations, as buyers and sellers look to close deals ahead of tax code revisions expected in 2013.

BDC Investment Opportunities

For quick-and-easy diversified exposure, there are two BDC ETNs: the UBS E-TRACS Wells Fargo Business Development Company ETN (NYSE: BDCS) which currently pays 7.5% and its 2x leveraged twin (NYSE: BDCL) which pays 15.0%. Neither is very liquid, but the leveraged version has the larger average daily trading volume of around 34,000 shares vs. only 2,800 shares for the unleveraged version. A more-liquid ETF (avg. daily volume = 227,000 shares) is the PowerShares Global Listed Private Equity ETF (NYSE: PSP) with a 6.7% yield, but it is not a pure-play with only 20% of its portfolio in BDCs. Lastly, there is a closed-end fund called First Trust Specialty Finance (NYSE: FGB), but its liquidity is also low at only 31,000 shares traded per day. FGB currently trades at a 1.1% discount to its net asset value and 78% of its portfolio is invested in BDCs.

The latest of these four BDC funds to come to market was the 2x leveraged ETN in May 2011. Consequently, we have 11 months of trading history to compare performance. The winner by a landslide is FGB, the closed-end fund:

BDC Fund Comparison:

May 25, 2011 to April 25, 2012

None of the BDC funds outperformed the S&P 500 index, which is probably due to the lingering damage the European debt crisis caused for all finance-related companies over the past year. The especially poor showing by PSP was probably caused by its non-BDC financial holdings, which are a substantial majority of the portfolio. Surprisingly, the 2x leveraged ETN performed worse than its unleveraged twin despite its twice-as-large 15.0% yield. It just goes to show you that reaching for the highest yield without taking into account wealth-destroying factors like transaction costs and taxes is a recipe for disaster.

For those of you who are do-it-yourselfers (you know who you are), I ran a screen for BDCs that have a market cap of at least $500 million and have an annual dividend yield of at least 7%. Eleven names showed up. Don’t just buy these names willy-nilly. Further due diligence is required because the dividends of BDCs can be erratic. For example, one BDC that would have made the list back in 2008 is American Capital Strategies (NasdaqGS: ACAS). It’s not on the list now, however, because it suddenly discontinued its dividend due to losses on its private investments.

High-Yielding BDCs

Source: Bloomberg