You Don't Have to Be Mitt Romney to Cash In on Private Equity

03/21/2013 10:30 am EST

Focus: STOCKS

Mark Skousen

Editor, Forecasts & Strategies, High-Income Alert

You may not be able to buy shares in private-equity firm Bain Capital, Mitt Romney's company, but you can still participate...and profit...from the sector, says Mark Skousen of Forecasts & Strategies.

Our favorite private equity companies match or beat Bain Capital's performance. One of these is Kohlberg Kravis Roberts (KKR), which is already up 20% in 2013.

Based in New York and managed by billionaire Henry Kravis's firm, KKR specializes in investing in high-yielding corporate bonds (often mislabeled "junk" bonds), real estate, and natural resources.

KKR just posted its fourth-quarter results and they are spectacular. Co-CEO Kravis stated, "Our private-equity portfolio and our balance sheet both appreciated 24% in 2012, outperforming the S&P 500 and MSCI World indices by over 700 basis points."

KKR also reported a record quarterly distribution of 70 cents per share, paid on Valentine's Day. That payment is more than double the 32 cents that the company paid a year ago.

Kravis added, "In 2012, we completed transactions that returned over $9 billion to all investors in our private-equity funds and co-investment vehicles, the highest figure in our 36-year history, and contributed to a record annual distribution of $1.22 per common unit."

Based on the past four dividends, the annualized yield is 7.8%. Going forward, KKR could pay out 10% during the next four quarters. It is no wonder investors can't get enough of KKR.

I still think KKR is undervalued, based on its expected dividend yield (10%), its price-to-earnings ratio (between seven and eight) and its P/E-to-growth (PEG) ratio (0.17). Anything less than 1 is considered an excellent PEG ratio.

The recent quarterly report of San Francisco-based KKR Financial (KFN) is almost as good. Net income rose 9% to $348 million, and it announced a quarterly distribution of 21 cents, as well as a special dividend of 5 cents a share, to be paid this month.

I also recommend business development companies (BDCs) as a specialized form of private equity. They provide loan and equity capital to small, private growth companies.

BDCs are filling an important gap in bank lending these days. The Fed's cheap-money policy has the unintended consequence of driving private companies from traditional banks to private equity deals with specialty investment firms, since traditional banks are playing it safe by investing in Treasuries and government-backed mortgages.

It doesn't help that the Fed recently decided to start paying interest on excess bank reserves. Why should bankers bother taking the risk of investing in small business?

Our favorite BDC is Main Street Capital (MAIN). Based in Houston, Texas, it makes equity investments and lends money to small- and mid-sized companies.

Of the 74 companies in its portfolio, the largest sectors are commercial services, industrial suppliers, energy, and media. Geographically, 43% of its companies are located in Texas, Oklahoma, Arkansas, Louisiana, New Mexico, and Arizona. Another 29% of the companies are in the West, including California.

Main Street is unique. It pays a monthly dividend that has been rising since the 2008 crisis, and is currently 15 cents per share. It also pays a special dividend each January. (It paid 35 cents this year on January 2.)

MAIN is well positioned to grow as an alternative source of capital for mid-cap private companies.

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