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One type of business that income-focused investors might have come across is the business development company (BDC), which invests in the debt and equity of middle-market companies. However, BDCs can employ very different strategies and not all are created equal.

Let's look at two popular BDCs, Hercules Capital (NYSE: HTGC) and PennantPark Investment (NYSE: PNNT), to see which is better for your portfolio.

Different approaches

Hercules Capital mostly invests in high-growth technology and life-sciences companies before their initial public offerings. Nearly 89% of its debt investments are first lien, senior secured (meaning no other obligation has priority if there is a default, and the loan is backed by collateral). And about 96% of its debt investments are at floating rates.

The company's investments typically come with warrants, which can convert into equity, giving Hercules a way to participate in the upside of the companies it invests in. At the end of 2023, it had warrants in 103 companies and equity investments in 74.

PennantPark, on the other hand, has a more diversified portfolio, with investments across 30 industries. About 96% of its debt portfolio is senior secured loans, although only 58% of its total portfolio is first-lien priority. About 96% of its debt portfolio is floating rate.

This BDC focuses on smaller companies that generate between $10 million to $50 million in earnings before interest, taxes, depreciation, and amortization (EBITDA), where there tends to be less competition for funding. By investing in the lower middle market, PennantPark is typically able to invest in companies with lower leverage while getting stronger contract terms.

Credit quality

When evaluating BDCs, looking at their credit quality is of the utmost importance. If their portfolio companies are struggling and not repaying their loans, the value of their investments will fall and will reduce how much income they are generating.

Last quarter, Hercules had one investment on non-accrual status (when interest payments are past due by 90 days or more). That investment had a cost of $30.9 million, representing 1% of its portfolio. The investment currently is carried at a fair value of $0.

PennantPark also had one non-accrual investment last quarter, accounting for 1% of its portfolio at cost and 0% at fair value.

During the height of the pandemic, which stressed their portfolios, Hercules had seven debt investments on non-accrual status representing 1.3% of its portfolio at cost and 0.5% at fair value at the end of 2020. PennantPark had no investments on non-accrual status at the end of 2020, although at the end of September 2020, it had two investments on non-accrual status representing 4.9% at cost and 3.4% on a fair value basis.

While both BDCs have had write-downs and defaults in the past, they have maintained strong credit quality with their debt investments over the years.

Dividends and yields

Hercules is currently paying a $0.40 base quarterly dividend, which is good for an 8.8% yield. BDC dividends are covered by their net investment income (NII), which was $0.56 per share last quarter for Hercules. It also paid a supplemental dividend of about an extra $0.08 per share.

PennantPark currently pays a $0.07 monthly dividend, for a yield of 12.2%. Last quarter, the company recorded NII of $0.24 per share.

Notably, both BDCs have benefited from higher interest rates given their floating-rate debt investments. If interest rates fall, NII income would decline, which could affect their dividends.

Valuation

BDCs are typically valued as a multiple of their net asset value (NAV), which represents the value of their underlying portfolios. These values can go up and down based on the performance of the underlying assets. The equity portions of the portfolios in particular can move.

By this measure, Hercules trades at about 1.6 times its year-end 2023 NAV per share of $11.43. That's a relatively high valuation, although the stock has generally commanded a premium and typically trades at a multiple between 1.1 and 1.7.

PennantPark, meanwhile, trades at only about 0.9 times its NAV of $7.65 per share, although last year its equity investments saw some pressure, which hurt its NAV. Those problems now appear to be behind the company, and it has lowered its equity exposure.

The better investment

Although more expensive, Hercules is the better option for investors who are looking for upside potential. The company can give exposure to up-and-coming tech and life sciences companies, while providing an attractive dividend yield that is well covered. Past investments include Palantir Technologies and DoorDash.

PennantPark, meanwhile, is a good option for investors looking for a high yield and a monthly payout. That dividend might decline a bit if the Federal Reserve cuts interest rates, but the stock is attractively priced by trading below its NAV.

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Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends DoorDash and Palantir Technologies. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.