5 Reasons You Shouldn't Ignore This Industry

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.

Source: Wilshire Associates.

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.

 

Source: State Street Global Advisors data on SPDR S&P 500 ETF.

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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Read/Post Comments (5) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 09, 2013, at 2:40 PM, bmc007 wrote:

    In PSEC already. Thanks for confirming my choice! :-)

  • Report this Comment On September 09, 2013, at 5:23 PM, msevier31 wrote:

    True growth stocks are dead? I guess we're just ignoring the entire pharma/biopharma sector, along with a whole host of small and mid-cap stocks across various sectors when making that kind of absurd statement. Don't resort to foolish generalizations in a feeble attempt to bolster your point or pad your article. Just let the facts speak for themselves.

    Long PSEC

  • Report this Comment On September 09, 2013, at 7:09 PM, TMFValueMagnet wrote:

    BMC007 - PSEC is definitely one of my favorites in my coverage list. Great management and plenty to love on the balance sheet.

    msevier31 - I'm not looking to pad my article, or the point. Companies are waiting much longer to list on the market. I'm a shareholder in a company that was previously listed on a major exchange. After Sarbanes-Oxley, managers found that the onslaught of regulatory codes and costs weren't worth a public listing. They went to the pink sheets.

    The equity value rests at just under $200 million, but even today, it doesn't make sense to relist.

    In the future, we'll see fewer and fewer tiny companies on the market as those nearing IPO-size realize that staying private may be their best option. Funding from BDCs and other private equity groups is more economic at that size. I guess a better way to put it is that the growth IPOs of the future will be much more mature than those of the past. Thanks for your comment.

  • Report this Comment On September 11, 2013, at 8:01 PM, spokanimal wrote:

    Mitt Romney's Bain Capital was a BDC, and Mitt Romney was very successful at "turning around failing entities" at Bain.

    The U.S. is a country with huge debt, out of control spending, and a tax structure that does very little to facilitate the formation and deployment of investment capital... which, in turn, is the reason why nobody is hiring anybody and GDP is growing so sluggishly despite both massive fiscal stimulus (deficits) and massive monetary stimulus (0% fed funds and QE3).

    Romney was uniquely qualified to be one of the most outstanding leaders that our country might have ever had the opportunity to elect.

    I didn't agree with all of Romney's positions, but I believe he was the best U.S. president that we ever failed to elect.

    Spokanimal

  • Report this Comment On September 12, 2013, at 10:32 AM, DAG1996MF wrote:

    Actually, Bain Capital is a Private Equity firm, not a BDC ... there are similarities, but also important differences.

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