BDCs: They’re Not Just About Debt

by Will Ashworth | November 12, 2012 9:40 am

BDCs: They’re Not Just About Debt

Most business development companies provide high-yield debt to privately owned middle-market companies, and investors love them because of the income they generate. However, several BDCs specialize in equity investments.

Investment News, an investment site catering to financial advisers, published an article Nov. 6 highlighting the benefits of investing in these pre-IPO BDCs[1]. Fifteen years ago, it took approximately four years to go from startup to IPO; today, that’s up to 10. BDC equity financing keeps these private companies going long enough to reach the IPO finish line.

I’ll decide if any of these equity BDCs are worth owning.

Keating Capital

Keating Capital (NASDAQ:KIPO[2]) — managed externally by Keating Investments LLC, a Colorado-based registered investment adviser founded by Tim Keating in 1997 — raised $78.4 million net of offering costs between January 2010 and June 2011. Prior to establishing the BDC, Keating Investments specialized in helping companies go public.

The BDC looks for companies with at least $10 million in annual revenue, that are interested in going public within 18 months, and that can deliver at least a 200% return within a three-year holding period. Keating Capital’s average investment is $5 million. At the end of September, the fair value of KIPO’s investments was $64.8 million, with $10.8 million in cash available for further investments. Issuing shares at $10, the net asset value per share was $8.14 at the end of the third quarter.

So why invest?

Through Nov. 8, Keating Capital’s shares are down 21.6% in 2012 compared to an 11.6% gain for the S&P 500. Since starting the BDC, it has had three portfolio companies go public: NeoPhotonics (NYSE:NPTN[3]), LifeLock (NYSE:LOCK[4]) and Solazyme (NASDAQ:SZYM[5]).

Keating no longer owns any Neophotonics shares, having sold all 160,000 in the third quarter for a $121,428 loss on its $1 million investment. LifeLock, which provides identity theft protection services for consumers and businesses, went public Oct. 2 at $9 a share. Keating, currently in a 180-lockup that will expire in April, is sitting on a $2.4 million profit (on a $5 million investment) despite the shares being down 13% since the beginning of October. Lastly, it made a $1 million investment in Solazyme in July 2010. Solazyme went public May 27, 2011, at $18 a share. Since then, KIPO has bought and sold shares, holding 147,927 valued at $1.1 million as of Nov. 8. All told, Keating is at break-even on a total investment of $2.1 million.

Overall, its $8.1 million spread over three companies has to date delivered $2.2 million in profit, or a 27% return over two years.

Tim Keating says this about its investments: “We bill ourselves as being a high-risk, high-return investment opportunity, and a replacement for the highest-risk spectrum of a portfolio.” Heed Keating’s advice — especially considering KIPO trades a scant 10,000 shares a day on average. In other words, allocate no more than 5% here.

GSV Capital/Firsthand Technology Value Fund

Two other interesting technology-driven BDCs are GSV Capital (NASDAQ:GSVC[6]) and Firsthand Technology Value Fund (NASDAQ:SVVC[7]).

GSV Capital’s CEO is Michael Moe, known by growth investors across the country. His book –– Finding The Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow –– does an excellent job explaining how to find good growth stocks. It’s not Peter Lynch, but it’s a good read nonetheless.

Moe has raised $292 million between April 2011 and May 2012, taking the money to make bets on tech companies like Facebook (NASDAQ:FB[8]) and Groupon (NASDAQ:GRPN[9]) prior to going public. Unfortunately, in an effort to please shareholders, Moe made some investments at prices he shouldn’t have (Groupon), and they have come back to bite him in the you-know-where. GSV issued its shares at an average price of $15.35; they currently sit at at an all-time low around $7.

Firsthand’s portfolio is very similar to GSV’s, with at least three shared investments (Facebook, Gilt Group, Twitter) and both looking to make additional investments between $1 million and $5 million.

Firsthand got its start in April 2011 when an open-end mutual fund version of the Firsthand Technology Value Fund was reorganized into a closed-end BDC with eight previous investments valued at $19.3 million, plus $8.6 million in new investments and $69.4 million in cash, for total assets of $97.3 million. Its initial net asset value was $27.01 per share. In April 2012, SVVC raised an additional $111 million in equity; its net asset value at the end of September was $23.02 per share, a 15% decline over 17 months.

The big difference between SVVC and GSVC is that Firsthand has only deployed 15% of its cash, so it has lots of dry powder; GSV Capital only has $26 million in cash — or just 10% left — to invest.

Of the two, I prefer GSV because at this point you have a better idea of the investments. Needless to say, they’re both fraught with risk.

Capital Southwest Corporation

My favorite equity BDC of the group I’ve left for last. Capital Southwest Corporation (NASDAQ:CSWC[10]) is 51 years old and has been operating as a BDC since March 30, 1988. It tends to make non-controlling investments between $5 million and $15 million in profitable businesses with $10 million or more in revenue and historical growth of more than 15% per year.

Like every BDC and investment company around for more than a few years, Capital Southwest has made its share of mistakes. The biggest being its investment with Heely’s (NASDAQ:HLYS[11]), the trendy skate shoes from several years ago. CSWC put $102,500 into Heely’s in May 2000, long before it went public in 2006. At an all-time high of $40.09 in Q1 2007, its investment was worth $330 million.

However, being long-term investors –– a third of investments have been held continuously for over 20 years — patience can sometimes be a bad thing. Cut to the chase: Heely’s is being liquidated, and CSWC should end up with about $24 million — far less than what it could have realized by selling , but still an annualized return of 57.6%.

Over the past decade, CSWC basically has doubled its net asset value per share from $88.77 in March 2002 to $167.45 in March 2012 for an annualized return of 6.6% — 450 basis points higher than the S&P 500. However, CSWC is the most thinly traded of the bunch at just more than 5,000 shares per day, so make sure to use limit orders and tight stop-losses.

Good things sometimes take time. Capital Southwest definitely is the best of the bunch.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. pre-IPO BDCs: http://www.investmentnews.com/article/20121106/FREE/121109964?template=printart
  2. KIPO: http://studio-5.financialcontent.com/investplace/quote?Symbol=KIPO
  3. NPTN: http://studio-5.financialcontent.com/investplace/quote?Symbol=NPTN
  4. LOCK: http://studio-5.financialcontent.com/investplace/quote?Symbol=LOCK
  5. SZYM: http://studio-5.financialcontent.com/investplace/quote?Symbol=SZYM
  6. GSVC: http://studio-5.financialcontent.com/investplace/quote?Symbol=GSVC
  7. SVVC: http://studio-5.financialcontent.com/investplace/quote?Symbol=SVVC
  8. FB: http://studio-5.financialcontent.com/investplace/quote?Symbol=FB
  9. GRPN: http://studio-5.financialcontent.com/investplace/quote?Symbol=GRPN
  10. CSWC: http://studio-5.financialcontent.com/investplace/quote?Symbol=CSWC
  11. HLYS: http://studio-5.financialcontent.com/investplace/quote?Symbol=HLYS

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