Business Development Companies: The Private Equity Alternative

Unless you've been hiding under a rock for the past two weeks, you probably know that Facebook has decided to take the leap and go public, filing the necessary paperwork last week.

A review of its filing documents reveals that the biggest profiteers from its listing will be equity-holding Facebook employees, members of its board, and a handful of venture capital firms like Silicon Valley-based Accel Partners and Russian Internet holding company Digital Sky Technologies. Indeed, any money made by investors after the social networking giant actually hits the big board will be peanuts in comparison.

In addition to feeling insanely envious, this got me thinking... is there any way for the not-already-ridiculously-wealthy investor to participate in pre-public investments? And the answer, it turns out, is yes, through something known as a business development company, or BDC. What follows, in turn, is brief description of this investment vehicle as well as a cursory glance at three such companies.

Business development companies explained
A BDC is a publicly traded private equity firm. Sounds like an oxymoron, right? Let's break it down and see why it isn't. Like the firms that invested in Facebook, BDCs finance companies that are not traded publicly -- thus the "private" equity qualification. Unlike those firms, however, BDCs are themselves publicly traded -- thus the "publicly traded" part. In other words, BDCs give investors like you and me the opportunity to get in on companies that are otherwise walled-off from public participation.

In terms of investments, BDCs are particularly attractive to income-seeking investors. Like the ever-so-popular mortgage real estate investment trusts, BDCs are entitled to pass-through tax treatment so long as they distribute at least 90% of their earnings to shareholders via dividends. And it's for this reason that many sport yields reaching into the double-digits. Apollo Investment (Nasdaq: AINV  ) , one of the largest BDCs by market capitalization, provides a perfect example with its 14.1% dividend yield.

But those who giveth may also taketh away, as the direct relationship between dividends and earnings make a BDC's dividend payment much more volatile than, say, a Fortune 500 consumer products company like Proctor & Gamble. Whereas P&G's dividend payment has grown steadily over the last five years, Apollo's was cut dramatically following the collapse of the financial markets in 2008. And not surprisingly, its stock price took a plunge as well, falling from a range of $15 to $20 down to its current price of $7.10 today.

Three business development companies worth a look
Now that you know what a BDC is, let's take a brief look at three of the market's most popular.

The aforementioned Apollo is one of the largest and most recognizable of BDCs. It touts a market capitalization of $1.4 billion and a dividend yield of 14%. Apollo invests in middle-market companies in a variety of sectors including building materials, business services, cable television, chemicals, consumer products, direct marketing, distribution, energy and utilities, financial services, health care, manufacturing, media, publishing, retail, and transportation. It trades for 0.88 times book value, though it has failed to turn a profit in the trailing 12 months.

Founded in 1988 and based in New York City, Prospect Capital (Nasdaq: PSEC  ) follows closely on the heels of Apollo in terms of both size and yield. It has a market capitalization of $1.2 billion and pays an 11.4% dividend. While it purports to invest across industry sectors, its expertise lies in the energy sector, pursuing investments in oil, gas, and coal production, as well as oil-field services, utilities, pipelines, and power generation and distribution, among others. It trades for one time book value and a paltry 7.6 times earnings.

The smallest of the three discussed here, Main Street Capital (NYSE: MAIN  ) has a market capitalization just south of $600 million and pays a smaller but still legitimate 7.2% dividend yield. It invests in middle-market companies, though it limits its portfolio to "traditional or basic businesses" located primarily in the Southern, South Central, and Southwestern regions of the United States. It trades for 1.55 times book value and nine times earnings.

Foolish bottom line
Ultimately, while BDCs offer investors exposure to private equity deals, deciding to invest in one of these companies should be predicated on their fundamentals and prospects for future growth. To discover the identity of more potentially lucrative financial stocks, check out our recently released free report about stocks only the smartest investors are buying. It includes an industry giant that recently came to Warren Buffett's attention, as well as a smaller bank that we believe he would have liked in his early days. To access this free report while it's still available, click here now.

Fool contributing writer John Maxfield does not have a financial stake in any of the securities mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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  • Report this Comment On February 09, 2012, at 4:30 PM, laurence56 wrote:

    BDC's are primarily lenders not equity investors.

    See PSEC's 10-K. First page reads

    " We invest primarily in first and second lien senior loans and mezzanine debt, which in some cases includes an equity component...."

    If PSEC was an equity investor in growth companies, where would they get the money to pay the huge dividend?

    PSEC lends to private companies who don't have limited access to the capital markets. The interest rate charged to these borrowers is rather high because they are riskier. High leverage ratios and sometimes the loan is subordinated. The equity component often comes from warrants issued by the borrower to keep the debt service managable. Right now the BDC market is doing ok as the economy is doing better. But if the economy were to falter, some of these loans will go into default.

    You don't get a 10+% dividend payout without taking on a fair amount of risk. Consider a BDC investment like a part of a high yield fund. You aint going to find the next Facebook or Netflix in those portfolios

  • Report this Comment On February 13, 2012, at 10:56 AM, okiedivot wrote:

    One nice mathematical quirk on PSEC and MAIN. Monthly dividend stocks have a smaller drop on ex-div date. Paying 1/12th monthly just smooths out the stock price. Not rocket science, but maybe one more reason to have them in the portfolio.

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AINV $6.00 Up +0.05 +0.84%
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PSEC $8.01 Down +0.00 +0.00%
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