Interest rates are headed higher, and despite chatter that the Federal Reserve efforts may slow in September, that will depend on when inflation decides to pause. Based on current food and fuel prices, that does not look to be anytime soon. Investors can count on at least a 50-basis-point increase next month and, depending on the data, it could be as high as 75 basis points.
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So what are balanced growth and income investors to do? The potential for capital appreciation on low coupon bonds is negligible, and with the market possibly primed for a continued big sell-off, risky high-yield or leveraged funds do not make any sense for those with low risk tolerance. What does make sense is looking at the business development stocks that pay outsized dividends and offer growth potential.

Commercial finance stocks are also known as business development companies (BDCs) and are organizations that invest in small and medium-sized companies, as well as distressed companies. A BDC helps firms grow in the initial stages of their development. With distressed businesses, the BDC helps the companies regain sound financial footing.

The analysts at Jefferies are very positive on six top BDCs and had this to say about the sector’s solid second quarter and prospects for the rest of the year:

While volatility picked up broadly in the second quarter, BDC fundamentals remain fairly stable and strong in terms of portfolio growth, credit and yield expansion. Net Asset Values declined on unrealized depreciation while credit remains in focus with the evolving market backdrop. While we remain selective, we consider six top companies as quality picks and with growing macro-uncertainty on the heels of robust industry growth, we remain selective on the space but nonetheless consider some high-quality BDCs as attractive investments.

It is important to remember that no single analyst report should be used as a sole basis for any buying or selling decision.

Ares Capital

This is a favorite BDC across Wall Street. Ares Capital Corp. (NASDAQ: ARCC) is a leading specialty finance company that provides one-stop debt and equity financing solutions to U.S. middle-market companies, venture capital-backed businesses and power-generation projects.

It originates and invests in senior secured loans, mezzanine debt and, to a lesser extent, equity investments through its national direct origination platform. The company’s investment objective is to generate both current income and capital appreciation through debt and equity investments primarily in private companies.
Top Wall Street analysts believe the strength of Ares Capital’s origination platform, sizable balance sheet and ample liquidity position it favorably in a very competitive investing environment. Some believe that with the current tight spread environment, the company has the scale and industry relationships to continue to make competitive, high-credit-quality investments.

Investors receive an 8.62% dividend. The Jefferies price target for Ares Capital stock is $24, and the consensus target is $21.54. The stock closed on Wednesday at $20.44.
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Barings BDC

This off-the-radar BDC offers solid total return potential. Barings BDC Inc. (NYSE: BBDC) is a publicly traded, externally managed investment company. It seeks to invest primarily in senior secured loans to private U.S. middle-market companies that operate across a wide range of industries.

The company specializes in mezzanine, leveraged buyouts, management buyouts, ESOPs, change of control transactions, acquisition financings, growth financing and recapitalizations in lower middle market, mature and later-stage companies. Barings BDC’s investment activities are managed by its investment adviser, Barings, a leading global asset manager based in Charlotte, North Carolina, with over $335 billion of assets under management firmwide.

Shareholders receive a 9.51% dividend. Jefferies has a $12.50 price target, while the consensus target is $11.46 and Wednesday’s close was at $10.20 a share.

Capital Southwest

Based in Dallas, which has been a hub for activity, this is another top BDC that offers long-term growth potential. Capital Southwest Corp. (NASDAQ: CSWC) specializes in credit and private equity and venture capital investments in middle-market companies, mezzanine, later stage, mature, late venture, emerging growth, buyouts, recapitalizations and growth capital investments.

It does not invest in startups, publicly traded companies, real estate developments, project finance opportunities, oil and gas exploration businesses, troubled companies, turnarounds and companies in which significant senior management is departing.

Capital Southwest seeks to invest in energy services and products, industrial technologies, and specialty chemicals and products. Within energy services and products, the firm seeks to invest in each segment of the industry, including upstream, midstream and downstream, excluding exploration and production with a focus on differentiated products and services, equipment and tool rental, consumable products, and drilling and completion chemicals. Within industrial technologies, it seeks to invest in automation and process controls, handling and packaging equipment, industrial filtration and fluid handling, measurement, monitoring and testing, professional tools, and sensors and instrumentation.
Within specialty chemicals and products, the firm seeks to invest in businesses that develop and manufacture highly differentiated chemicals and products including adhesives, coatings and sealants, catalysts and absorbents, cosmeceuticals, fine chemicals, flavors and fragrances, performance lubricants, polymers, plastics and composites, chemical dispensing and filtration equipment, professional and industrial trade consumables and tools, engineered solutions for HVAC, plumbing, and electrical installations, specified high-performance materials for fire protection and oilfield applications. It may also invest in exceptional opportunities in building products.
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Capital Southwest shareholders receive a 9.80% dividend. Jefferies has set a $25 target price. The consensus target is $24.41, and shares ended Wednesday trading at $220.52 apiece.

FS KKR

This very well-known name on Wall Street is offering a solid entry point at current levels. FS KKR Capital Corp. (NASDAQ: FSK) is a BDC specializing in investments in debt securities. It seeks to purchase interests in loans through secondary market transactions or directly from the target companies as primary market investments.

The company also seeks to invest in first lien senior secured loans, second lien secured loans and, to a lesser extent, subordinated or mezzanine loans. In connection with the debt investments, the firm also receives equity interests, such as warrants or options, as additional consideration. It also seeks to purchase minority interests in the form of common or preferred equity in our target companies, either in conjunction with one of the debt investments or through a co-investment with a financial sponsor.

On an opportunistic basis, the fund may invest in corporate bonds and similar debt securities. The fund does not seek to invest in start-up companies, turnaround situations or companies with speculative business plans. It seeks to invest in small and middle-market companies based in the United States. The fund seeks to invest in firms with annual revenue between $10 million and $2.5 billion. It seeks to exit from securities by selling them in a privately negotiated over-the-counter market.

The company recently posted stellar results and announced a continuation of a huge stock buyback.

Shareholders receive an 11.14% dividend. The $25 Jefferies price target is higher than the $22.94 consensus target. FS KKR Capital stock closed on Wednesday at $22.26.

Hercules Capital

This is another highly regarded BDC across Wall Street. Hercules Capital Inc. (NYSE: HTGC) is the largest non-bank lender to venture capital-backed companies at all stages of development in a broadly diversified variety of technology, life sciences and sustainable and renewable technology industries.
With over a decade of experience in venture debt, Hercules is uniquely positioned to quickly create innovative financing solutions that perfectly fit within a company’s existing capital structure and map to its business objectives. Recognized as the industry leader, Hercules understands the flexibility these types of companies need and has the experience to work closely with them, even through challenging times, to help them reach critical milestones.
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Its deep sector expertise, geographic presence and strong capital base have made Hercules the lender of choice for more than 480 innovative companies.

This stock comes with a $9.51% dividend. Jefferies has a $20 price target. The consensus target is lower at $18.44, and the shares closed at $14.85 on Wednesday.

Oaktree Specialty Lending

This lower-priced BDC stock offers investors the ability to buy more shares. Oaktree Specialty Lending Corp. (NASDAQ: OCSL) specializes in investments in middle-market, bridge financing, first and second lien debt financing, mezzanine debt, senior and junior secured debt, expansions, sponsor-led acquisitions, and management buyouts in small and midsized companies.

The fund seeks to invest in education services, business services, retail and consumer, health care, manufacturing, food and restaurants, construction and engineering, and media and advertising sectors. It invests between $5 million to $75 million principally in the form of one-stop, first lien and second lien debt investments, which may include an equity co-investment component in companies with enterprise value between $20 million and $150 million and EBITDA between $3 million and $50 million. The fund has a hold size of up to $75 million and may underwrite transactions up to $100 million. It primarily invests in North America, and the fund seeks to be a lead investor in its portfolio companies.

Investors receive a 9.70% dividend. The Jefferies price target is $8.50. The consensus target was last seen at $8.07. Wednesday’s final print was $7.06 per share.

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While the Jefferies price targets are not sky high, combined with the strong dividends, the total return possibilities for all the stocks look to be very solid. Given the sector also has been somewhat out of favor this year, the risk/reward also looks compelling, especially given the strong results that all six of the companies have reported so far.

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