When Lehman Brothers failed in September 2008, the U.S. financial system locked up and proceeded to plummet in a classic deflationary spiral. As the value of overpriced, overleveraged assets came back to Earth, the banks that had lent money and accepted those assets as collateral or as a valuable item on a balance sheet shut off the credit spigot they had left wide open in for years before.

As the economy quickly hit the skids, the availability of credit to businesses disappeared. Millions of Americans lost jobs as many small and mid-sized businesses downsized or went bankrupt.

Soon enough, phone calls from desperate small business owners to their commercial banking officers went unreturned. I’m not exaggerating. I have many friends and clients involved in small businesses and I’ve repeatedly heard the same story. What did they do when they wanted to obtain fresh credit? Forget about it.

In fact, this negative cascading effect was part of the motivation behind the $700 billion Troubled Asset Relief Program (TARP) in 2008. The design was that the controversial Term Asset-Backed Securities Loan Facility (TALF) would recapitalize the nation’s banks to enable them to lend money to consumers and businesses. But the program didn’t evolve as intended.

Enter the business development companies (BDCs).

BDCs are specialty finance companies that focus on managing senior loan investment portfolios, mezzanine financing and equity stakes in privately-held, middle-market organizations. And because they qualify as “registered investment companies,” BDCs are required to pay out at least 90% of their earnings in the form of dividends, as long as they invest at least 70% of their capital in qualifying assets. This exempts the company from paying federal income taxes (for now) and payouts to shareholders are treated as ordinary, 1099 income. The end result: Above-average yields, diversification and growth potential. [My colleague Andy Obermueller has just released a report on how Mitt Romney and other wealthy Wall Street elites have made a fortune by investing in these types of smaller, private businesses. To read his report, follow this link.]

But besides the organic growth potential that would pass through to shareholders as BDC portfolios rise in value, there’s something even more dynamic and exciting at play. As banks stepped back on loan offerings during the financial crisis, BDCs stepped up to the plate as business lenders. Not only will these companies capture market share in the near term, but they’ll keep and grow the business for decades to come. And this is changing the already-reconfigured banking environment as we know it.

So much better than banks…
I foresee the trend of BDCs taking over the role of banks as a source of business capital to continue. After all, if you compare the two, then you’ll realize how little they have in common.

— BDCs bring a deep bench of talent to the field. Compare the likes of PennantPark Investment Corp. (Nasdaq: PNNT), which was founded by Apollo Investment Corp. (Nasdaq: AINV) alumnus Arthur Penn, to the senior commercial lenders at the main branch of one of the big-money center or super regional banks in your hometown. Firms like PennantPark are typically founded by entrepreneurial types who have experience in operating a business. They often hire entrepreneurial-types to work with, well, entrepreneurs.

Chances are, the commercial department is likely staffed by capable people who I like to call “lifers.” These are folks who started working at the bank (or its predecessor) as a customer service associate (CSA) the week they graduated from college. Fifteen to 20 years later, they may have earned a special lapel pin, or the coveted “vice president” on their business cards. But they probably don’t understand what drives a medium-sized business that wants to go national. I’m sure they’re nice people, but the BDCs are run by the pros.

I was once held prisoner of war at a regional bank for a brief period of time, where I was convinced everyone there aspired to be in middle-management.

— Access to capital. BDCs can tap the capital markets in many different ways: from raising equity to debt issuance, to borrowing wholesale from mega banks. Banks don’t have these options — instead, banks depend upon deposit growth to drive funds to lend. In a zero interest rate environment, there’s no mad dash to buy a certificate of deposit at the local branch. The zero-rate world works well for BDCs. Borrow it at 2%. Lend it at 9%. Retain 0.7%. Pay the shareholders 6.3%.

— Better businesses. In the extraordinary environment we are in, bank margins are razor thin. Maintaining brick-and-mortar branches, and providing pay and benefits for an army of employees is expensive. Also, banks are still under the assumption they can be all things financial to all customers — a bank. A broker. An insurance agency. It’s hard to focus with so many distractions. BDCs don’t have drive-thrus or offer mortgage loans.

Risks to consider: While BDCs may be replacing banks in many ways, they are not, nor will they ever be, banks. BDCs  are not FDIC guaranteed. Owning shares of a BDC is a risk on investment. A BDC portfolio is only as good as the investments the company has made. Bad investments will result in poor portfolio performance. Select your names based on the age of the company and the experience of the management. Also, while low interest rates have been a bonanza for BDCs, rising rates are their kryptonite. Margins will be squeezed, dividend payouts will shrink, net asset values will decline. It’s extremely difficult to find a BDC that doesn’t use leverage. However, look at those who use it wisely and manage it well.

Action to take –> As BDCs have stepped in to lend money to businesses, investors are poised to benefit from this emerging trend which should have some decent legs as the space continues to evolve. Two names I like are PennantPark Investment Corp. (Nasdaq: PNNT), mentioned earlier, and Blackrock Kelso Capital (Nasdaq: BKCC).

At $10.89 a share, PennantPark trades with a forward price to earnings (P/E) ratio of less than 10 and yields about 10%. The company’s strength is the depth of management let by BDC veteran Arthur Penn. Blackrock Kelso has a forward P/E of 10.3 and also yields roughly 10%. This BDC leverages the power of money management titan Blackrock with BDC experts Kelso and Co.

As the economy heats up and the business cycle improves, look for these two BDCs to do things that banks couldn’t do in their wildest dreams.

P.S. — As I said before, Andy’s recent report tells you everything you need to know about BDCs and how they open up the “secret world” of finance that has made Wall Street hot-shots like Mitt Romney a fortune over the years. To read his special report, go here.