STRATEGIES

Most investors don’t realize that they too can get in on private equity deals, just by buying shares of these special financing companies, says Keith Fitz-Gerald of Money Morning.

Business Development Companies are publicly traded private-equity firms created expressly for individual investors. Yet BDCs are unloved, beaten down, and off the radar screen—all of which are key ingredients in the search for higher returns in today's markets, especially when it comes to income.

Structured much like the more familiar real estate investment trusts, BDCs typically pay out at least 90% of their net interest income as dividends. Right now, typical yields range from approximately 6.5% to 11%, or in some cases even more—making them extremely appealing for yield-starved investors.

There are a few other advantages, too:

  • Small- to medium-sized companies are often bought out, so funding them is really a direct shot into the mergers and acquisitions channel, long before bigger bankers even see the opportunity.
  • Yields are good. With Bernanke and his cronies holding rates down near zero, a 7% to 11% payout is a sweet spot that's very appealing.
  • Some companies fail, so the strongest really can yield big returns because they command a survivor's premium.
  • The bulk of small- and mid-sized companies attracting BDC investment actually have very conservative management, which means they have a vested interest in profitability.

Here are my top three choices at the moment:

Blackrock Kelso Capital (BKCC) has investments in everything from crane rentals to software, which makes it relatively diverse and a good entry point for investors who want to dip their toes into the private equity pool. Its yield is an appealing 10.4%, and the divergent nature of its businesses lends some stability to an otherwise very volatile investment.

It has capital resources exceeding $1 billion, which it primarily uses to invest in middle-market companies. Typically, the company's investment is in the range of $10 million to $50 million.

Triangle Capital (TCAP) has investments spread in a wide variety of industries. What makes it different from BKCC is that it specializes in lending something called "subordinated" debt to companies generating between $10 million and $200 million a year in revenue.

This gives it less protection against failure than "senior" debt holders if something blows up, but that's in exchange for higher rates and returns it can extract along the way. It's kind of like non-junk junk debt, if that makes sense.

The yield is around 7.7% at the moment. It typically invests $5 million to $30 million in leveraged buyouts, management buyouts, recapitalizations, growth financing, employee stock ownership plans, and acquisition financing.

Hercules Technology Growth Capital (HTGC) is focused on what I call the four horsemen of technology: Bio-tech, high-tech, enviro-tech, and medical-tech.

While the payout is presently 8.2%, that's varied widely in recent years, so volatility is definitely part of the package with this one. It typically invests in companies with capital needs from $5 million to $30 million, revenues of $10 million to $200 million, generating EBITDA of $2 million to $15 million.

As you might suspect, there are a few caveats when it comes to including BDCs in your income-investing portfolio:

  • First, the business development/private-equity cycle can be not only cyclical depending on broader economic conditions, but volatile too, depending on the underlying industries and companies chosen.
  • Second, just because these stocks have high yields today does not mean they will tomorrow.
  • Third, BDC income is taxed up to 39.6% as ordinary income versus the 20% hit you get with qualified dividends, so housing BDC investments inside tax-advantaged accounts may be best.

If income is important to you and you want to run with the big boys, BDCs are a solid choice offering the best of several worlds.

Read more from Money Morning here...

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Tickers Mentioned: Tickers: BKCC, TCAP, HTGC

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