Private equity may seem like an asset class only for the rich and famous, but a fast-growing industry gives you a chance to stake your claim in private companies.
Meet the business development company industry, a small subset of the financial industry that deals with businesses too small for Wall Street.
Here are five reasons every investor should own a BDC.
1. True growth stocks are dead
The truly great growth stocks are no more. Sure, we have high fliers like LinkedIn or Facebook, but these examples are few and far between as smaller companies stay private.
Over time, a combination of regulation and takeovers have kept good companies off the public market. Smaller firms are waiting longer to come out with an IPO -- Facebook waited until it earned a $100 billion valuation to list publicly -- which keeps many growth stocks out of investors' portfolios. In 2000, there were more than 6,400 stocks in the Wilshire 5000 index. Today there are fewer than 3,700.
BDCs are one of the few ways investors can invest in smaller companies with market caps of less than $100 million. It often doesn't make sense to list on a national exchange for businesses that size or smaller.
2. Smaller companies outperform
History provides evidence that the smallest companies outperform larger companies. That outperformance boils down to the reality that small companies have much more room to grow, and such companies are generally underowned and undercovered by Wall Street's best and brightest.
Several BDCs offer exposure to smaller companies. Main Street Capital (NYSE: MAIN ) holds 20% of its portfolio in equity positions in lower middle-market companies -- businesses that have revenue of less than $150 million per year. These smaller middle-market companies offer tremendous growth opportunity as well as income potential, as 75% of its equity investments are currently paying dividends.
Likewise, American Capital (NASDAQ: ACAS ) holds 35% of its portfolio in middle-market equity investments. Another 18% is dedicated to preferred stock investments, making it one of the most equity-heavy BDCs on the market.
3. Market indexes ignore them
Financial stocks make up nearly one-sixth of the S&P 500 index (NYSEMKT: SPY ) but there isn't a single BDC in the index. Unless you seek out BDCs to hold in your portfolio, you likely don't own one.
4. Superb yields
The best way to think about a BDC is to think of a bank that doesn't have an internal growth goal. BDCs have to distribute at least 90% of their annual income to shareholders, which often means dividend yields of 10% or more.
Generally speaking, banks are in a very similar business, but they don't distribute a majority of income to their shareholders -- not even close. Established and slower-growing major national banks like JPMorgan Chase and Citigroup paid out only 21.4% and 1% of their income as dividends in the latest 12-month period, respectively.
BDC Prospect Capital (NASDAQ: PSEC ) paid out 86.4% of investment income in monthly dividends during its most recent quarter, with plans to step up its dividends in every month through March 2014, as it has since 2009.
5. Active managers on your side
Active management doesn't get the respect it deserves. In small corners of the market -- think junk bonds or microcaps -- an active manager can much more easily outperform the asset class as a whole.
Business development companies are active debt and equity investors that make deals with businesses that are too small to get attention from big investors. That's a corner where it makes sense to have an active manager making decisions on your behalf.
The Foolish bottom line
Bigger isn't always better. Investing in BDCs is a sure-fire way to get access to leading companies that may be Wall Street's next hot IPO-companies that you can't own unless you have millions of dollars and connections to create your own opportunities. For the little guy -- the individual investor -- there may be no better way to get your foot in the door of private equity than to add a few high-yield private equity companies to your portfolio.
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