The Poor Man's Private Equity Fund

05/17/2010 12:00 pm EST

Focus: STOCKS

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

Bryan Perry, editor of Cash Machine, says two business development companies give investors exposure to a market that’s been the preserve of institutions and the wealthy.

Business Development Companies, or BDCs, are investment pools set up in the form of closed-end funds that get special treatment from the SEC, mainly because they provide financing to thousands of companies that a lot of big banks wouldn't touch.

In fact, investments by BDCs into private, mid-sized companies range from $10 million to $50 million per deal, which is unique to this sector—too risky for most banks, too small for most Wall Street firms to underwrite, and just right for private equity.

So, it's a special class of security that has opened the door to markets that were closed to everyday investors.

With BDCs, we receive access to the public markets, where shareholders are not required to meet income, net worth, or sophistication criteria. This gives us the opportunity to gain access to the private equity markets through funds managed by major private equity players.

Since the majority of BDCs target middle-market debt financing deals, we can expect [them] to generate current income and offer some real opportunity for gains. BDCs are a pure play on the financing of small- to medium-sized businesses in a recovering economy.

Tight lending standards by banks haven't kept pace with the demand by small- to medium-sized businesses for capital to expand. This conundrum drives businesses to borrow from BDCs at 10% to 15% rates with equity kickers attached to every deal. That translates into fat dividends for investors that get 90% of the income [these assets generate]. 

Plus, BDCs avoid taxes on that portion of income and capital gains distributed to shareholders. That's because BDCs [have] some similar features [as] REITs. To maintain its regulated investment company (RIC) status, a BDC must distribute at least 90% of its investment company taxable income to its shareholders each taxable year.

Now, BDC distributions are generally taxed as ordinary income or capital gains, in much the same manner as mutual fund or closed-end funds' distributions. Shareholders recognize the taxable gain or loss when they sell their share. And many BDCs have dividend reinvestment plans for shareholders.

BlackRock Kelso Capital (Nasdaq: BKCC) and Fifth Street Finance (NYSE: FSC) are two very similar companies in scope and scale. Both carry market capitalizations of about $550 million, have loan/equity positions in roughly 55 companies within their portfolios, lend to companies with an average market value of $15 million and at present aren't using leverage to generate [their] high dividend payouts.

For first quarter 2010, BKCC saw its top line grow by 21.1% and earnings per share come in right on target. FSC fared even better, seeing its revenues for the quarter jump by 51.5% to $110.92 million while also meeting Wall Street consensus expectations.

BKCC declared a 32-cent dividend for the quarter, which translates to a 12.5% yield. And FSC raised their quarterly dividend by 7% to 32 cents, which ups the yield to 10%.

Buy BKCC up to $12 and FSC up to $14. (BlackRock Kelso closed above $10.50 Friday, while Fifth Street closed below $13—Editor.)

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