I’m going to tell you about my new favorite income play. They’re known as Business Development Corporations, or BDCs for short.
Here’s the story on BDCs – there are plenty of businesses out there generating between $2.5 million and $100 million a year. The problem is, because of Washington’s bailout madness and banks hoarding cash, these businesses are starved for capital, so they’re turning to private financing instead.
One business I know of, for example, is making a new open source platform called Sailfish to compete with Google’s (NASDAQ:GOOG) Android, Apple’s (NASDAQ:AAPL) iOS and Microsoft’s (NASDAQ:MSFT) Windows 8.
At its nucleus is a team of developers initially laid off from Nokia (NYSE:NOK) when Sailfish’s prior incarnation, MeeGo, was ash-canned two years ago.
Because bankers could not get their minds around the concept of taking on the big boys, Sailfish is being bankrolled by a combination of severance pay, government business loans, and private financing to the tune of $13.5 million so far — all of whom will likely rue the day they passed on a project with more than $300 million in potential.
An Unloved Source of Higher Returns
That gets me to BDCs – most investors don’t even know they exist.
Brokers can’t tie private equity up in a nice neat bow; most analysts don’t understand the underlying concept well enough to effectively present the investment case to their clients, let alone the underlying business case; and the pundits find them too complicated to break down on TV.
Translation – 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.
I’ll get to that in a minute, but first let’s back up with a brief description of what private equity is so that the concept makes sense.
Private equity is an asset class of investors or funds which own equity securities in companies that are not publicly traded. It’s usually the domain of companies that need mezzanine financing or term-loans, and therefore fall outside traditional lending channels.
In some cases, the businesses being funded are like Sailfish, in that they are going after untapped markets in ways established players can’t, albeit with very seasoned management. In others, they are established businesses like Sur La Table, a premium kitchenware shopping experience for foodies.
In the past, big banks have filled the gap, but six years into the financial crisis, they’ve all but abandoned it for now. And therein is the opportunity.
Private equity deals are typically very exclusive and require one heckuva pedigree, not to mention millions of dollars to access. If you’re not a big firm running billions or an accredited investor worth millions, you won’t even see the deal flow.
How Investors Can Tap Into the Stream
BDC’s on the other hand, are publicly-traded private equity firms created expressly for individual investors. You still don’t see the deal flow, but you can sure see the results.
Structured much like the more familiar real estate investment trusts (REITs), BDCs typically pay out at least 90% of their net interest income as dividends.
Right now, for example, typical BDC 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. What’s ironic about this is that many of these small- to mid-sized borrowers are actually better credit risks than the big boys the banks actually do lend to at the moment.
- Yields are good. With Bernanke and his cronies holding rates down near zero, a 7-11% payout is a sweet spot that’s very appealing. Many are a whole lot higher. There’s no need to get greedy like the big banks who have abandoned the space — there’s plenty for everybody.
- Some companies fail, so the strongest really can yield big returns because they command a survivor’s premium. This translates into that rarest of all investments – serious income earners with significant appreciation potential. Normally, those two investing attributes are mutually exclusive.
- 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. You won’t find, for example, a bunch of 20-somethings cashing out because they’ve scored. These are usually seasoned executives running real businesses with real goods and services who have a vested interest in making it to the big leagues.
Three Ways to Invest in BDCs
Here are my top three choices at the moment:
Blackrock Kelso Capital (NASDAQ:BKCC): Blackrock 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. I like it for two reasons: a) its yield is an appealing 10.40%; and b) the divergent nature of its businesses lends some stability to an otherwise very volatile investment.
The company was formed in 2005 by management, BlackRock (NYSE:BLK) and principals of Kelso & Company. 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 (NYSE:TCAP): Like Blackrock, Triangle has investments spread in a wide variety of industries. What makes it different 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 7.70% at the moment.
The company was founded in 2005 and is based in Raleigh, NC. 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 (NYSE:HTGC): Tech-centered Hercules is focused on what I call the four horsemen of technology: bio-tech, high-tech, enviro-tech and medical-tech. You’ve heard me use this term before to describe the importance of sourcing higher-probability investments that the world needs, rather than simply wants. While the payout is presently 8.20%, that’s varied widely in recent years so volatility is definitely part of the package with this one.
The company was founded in 2003 and is based in Palo Alto, CA. 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. Stock prices will reflect that, so have no illusions: Use that to your advantage by dollar-cost averaging your way in to build up high-yielding, high appreciation-potential positions over time.
Second, just because these stocks have high yields today does not mean they will tomorrow. BDCs distribute 90% of their cash, which means that they have less of a buffer to absorb periodic operational hiccups than more traditional dividend investment choices.
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.
The bottom line?
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.
Do act quickly if you’re interested, though…I can’t believe that these will stay off the radar for long.