This month, StreetAuthority’s Nathan Slaughter tells you how to collect high, safe yields from business development corporations.
“Investing in the right initial public offering (IPO) can be highly lucrative. We all know that. How many times have we seen a hot new stock reward its first investors with triple-digit gains in a matter of weeks or months. But what about the farsighted investors who got on board years earlier, well before the company ever had its own ticker symbol? Odds are, they will enjoy the biggest payday.
“By the time a business has developed enough to list on an exchange, its early financial backers might recoup their initial outlay several times over. Goldman Sachs (GS) and Russia’s Digital Sky Technologies have quietly been funding Facebook’s growth in recent years. And those investments will pay off big. Recent transactions value the social networking juggernaut at $57 billion. Even a 1% sliver could be worth $570 million in the private market—and potentially much more should the company go public. Of course, exceptional businesses like Facebook don’t exactly grow on trees. But there’s no shortage of attractive, profitable young organizations that need capital to expand—and the lenders who provide it will share in the growth.
“We’d all like to grab a piece of the next Facebook or Google (GOOG) before they become household names. Unfortunately, this game has long been dominated by institutional traders, private equity firms, and accredited high net-worth speculators. But if you’d like to play with the big boys, there’s a vehicle for ordinary investors like you and me. A handful of enterprising organizations known as business development companies (BDCs) have sprung up in recent years. Their sole mission is to nurture small businesses by providing cash infusions and advisory services. That lending takes the form of unitranche loans, mezzanine debt and other exotic instruments—BDCs definitely go off the beaten path in search of income. But they themselves can be easily found on the NYSE or Nasdaq. Think of these accessible stocks as a publicly-traded way to participate in backroom private equity deals.
Bet with the Bankers
“Established companies can always issue new shares, sell bonds, or call their bankers to raise cash. But smaller, less creditworthy businesses don’t have that luxury. So finding the money to build and expand, recapitalize, or make acquisitions can sometimes be a challenge. That’s where business development companies come in. These firms play a valuable role by arranging loans and/or providing equity capital to small and middle-market companies. Of course, BDCs aren’t nonprofit enterprises. I won’t call them loan sharks, but let’s just say they are well-compensated for their trouble.
“Apollo Investment (AINV), one of the oldest BDCs, has nearly $3 billion tied up in loans to dozens of businesses ranging from healthcare providers to satellite manufacturers. Those borrowers are paying hefty rates of 8.7% on average for senior secured bank loans and 12.9% for riskier junior subordinated debt. Keep in mind, a 10% yield isn’t that compelling if your cost of capital is 9%. What matters most is the spread between borrowing costs and investment yields—the wider the better. And BDCs have an ace in the hole. They can pull up to the government’s Small Business Administration window and withdraw cash for a modest premium over the going rate on a 10-Year Treasury.
“Not surprisingly, many of these companies are spilling over with net investment income. And here’s the best part. BDCs are exempt from the bite of federal income taxes, provided they dish out at least 90% of their income and capital gains as dividends. So nearly all of the profits end up in shareholders’ pockets without Uncle Sam taking a cut off the top. ... The group offers superior yields that stand head and shoulders above other alternatives.
The Time is Now
“The financial crisis of 2008 took a heavy toll on BDCs. Frozen credit markets made it tough to raise capital, and plunging portfolio values led to costly write-downs. To avoid violating asset coverage ratios and breaching loan covenants with their own creditors, many were forced to hastily unload portfolio assets (often at depressed prices). Needless to say, dividends were slashed or eliminated across the board and share prices collapsed. But those days are over. First, improved business conditions have boosted the value of portfolio holdings and reduced the threat of loan defaults. Meanwhile, middle market loan growth rebounded 145% through the first nine months of last year. Balance sheets are also much healthier now, and all but two BDCs have reinstated regular distributions.
“And the immediate future looks even brighter: The credit crunch shook out and consolidated many middle-market lenders. Numerous hedge funds have abandoned the market, and commercial and investment banks are primarily concerned with larger corporate clients. Fewer participants and less competition means that BDCs can almost name their own terms on loans. That could mean anything from better pricing and richer fees to equity ‘kicker’ warrants. Over $800 billion in loans issued between 2004 and 2007 is set to mature and will need to be refinanced. Leveraged buyouts (LBOs) and other merger and acquisition activity is heating up. That will trigger demand for new loans to close these deals. And since BDC’s have a stake in many of the acquisition targets, they will also collect premium prices for existing positions (many of which were bought at a discount during the recession).”
Nathan Slaughter, StreetAuthority Market Advisor, 2/24/11
