Beware the dazzling yield Business-development companies offer tempting dividends. The payouts may be at risk.
By Herb Greenberg

(FORTUNE Magazine) – You'd think everybody would have learned by now that with high reward comes high risk. Investors might want to keep that in mind if they're lured by dividends pushing 10% at Allied Capital or 13% at American Capital Strategies, the largest of the two dozen or so public "business-development companies."

Like closed-end mutual funds, BDCs buy stakes in other companies and trade on the stock exchange. But unlike closed-end funds, which invest in public companies, BDCs tend to stick with small to mid-sized private companies that can't find funding elsewhere. They were created, under the same rules that govern mutual funds, to promote the flow of capital to American enterprise. By law they must pay out 90% of their taxable income to avoid taxation. (See next story for another investment vehicle with a similar structure but less risk.)

Most, like Capital Southwest and Equus II, take equity stakes in target companies, aiming for capital appreciation. They pay a negligible dividend but, the thinking goes, if the investments work, their stocks will rise.

However, the two giants of the industry--Allied and American Capital--with market capitalizations of $2.2 billion and $812 million, respectively, have a different modus operandi. They act more like subprime lenders, specializing in "mezzanine" loans to financially strapped companies. In return they often get both the interest payments on those loans and an equity stake in the companies. They pass on the profits from these investments to their shareholders in the form of the dividend. But beware: As both companies warn in their SEC filings, if everything doesn't go just right, these plump dividends aren't necessarily safe. And that has made Allied and American Capital magnets for short-sellers.

One of the biggest gripes: portfolio valuation. American Capital owns portions of 66 companies. Allied has stakes in some 130--from a fastener maker to a company that fills gas cylinders on barbecues. It's up to the BDCs to determine what those companies and loans are worth. Sometimes, the short-sellers contend, their estimates can be a bit generous.

American Capital, for example, had a stake in design outfit Decorative Surfaces. The company's finances soured, and it headed for bankruptcy. But American Capital, while writing off the equity portion of its investment, kept the full value of the debt on its books--even though the company was no longer keeping up with its payments. It then bought the whole company, wiping out the debt entirely and preventing the loan from becoming a loss. Had it counted as a loss, that could well have hurt the dividend.

BDCs also count on capital gains to help make up their dividend payout. This year, Allied says, gains on its investments will cover 12% of its dividend, up from just 1% last year. The trouble with relying on capital gains, says hedge fund manager David Einhorn of Greenlight Capital, is that they're discretionary and unpredictable. Last year, for example, Allied booked a record $60 million capital gain from selling training company Wyotech. This year it'll need at least that much, but Einhorn says Allied would have to sell off a massive portion of its portfolio to come up with that kind of cash again. Allied says it needs to sell only one or two of its companies to meet its needs.

Finally, critics of American Capital say the company simply pays out more in dividends than its operations bring in. For the first six months of this year, operating cash flow was $22.6 million, while dividends totaled around $50 million. "That's simply not true," says CEO Malon Wilkus, who contends that investors have to look at items other than operating cash flow, such as interest that is deferred until the loan is repaid, which eventually will be collected as income (assuming it is collected).

All of this, the short-sellers say, puts the consistency of the dividend in jeopardy. Allied insists it values its investments properly, and points out that it has paid, and grown, its dividend for 40 years--an impressive feat. But the company is a very different beast than it was even five years ago. It's much bigger and more exposed to the dicey economy. American Capital CEO Wilkus also says the company values its investments fairly. The biggest risk to its dividend, Wilkus says, is a recession deeper than the last one.

Perhaps, but bear this in mind: Whenever "business takes a sharp downturn...to keep the dividend steady, they have had to do some heroics in the portfolio," says hedge fund manager Mark Haefele of Sonic Capital. That could become tougher and tougher if the economy sputters. And if the dividend suffers, what's the point of owning these stocks?

Herb Greenberg is a senior columnist for TheStreet.com. Questions? Comments? Contact him by e-mail at herb@thestreet.com.