Small PE Companies: High Yield Exposure to Smaller Companies

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There is a booming market for investments in smaller private companies which are very lucrative.  There are numerous publicly traded companies currently focused on finding small companies to invest in.  These companies’ investments can yield anywhere from 8% to 15% per year.  This return is often paid out to shareholders in the form of large dividends.  The large dividends can result in a substantial total return over long periods of time.

I stumbled upon Blackrock Kelso Capital Corp. (NASDAQ: BKCC), a relatively small business development company that is essentially a well-run private equity firm.  The market cap is only $772 million.  The stock currently has a yield of 10%.  The high yield piqued my interest and I quickly discovered that they have numerous competitors who also yield bountiful dividends.

Other smaller PE companies are Prospect Capital (NASDAQ: PSEC), Triangle Capital (NYSE: TCAP), Gladstone Investment Corp (NASDAQ: GAIN), and Apollo Investment Corp (NASDAQ: AINV).  All of these companies pay dividends over 8%. 

Prospect Capital pays a monthly dividend of $0.11 for a yield of roughly 11%.  The company is set to report earnings on Feb. 7.  Despite a solid performance in their last quarter, the company still disappointed the market, so it may be safer to hold off on investing in the company until after earnings.  That way investors can verify the quarter was a 1-time event.

Triangle Capital pays a quarterly dividend for a 8% yield.  The company increased their dividend as recently as November 2012.  The stock has had a very strong run over the past several years.  It is now trading at $27 and was trading around the $10 level in 2008 and 2009.  The stock is now well above net asset value, of $15.33.  The company is broadly diversified, with investments in 78 different companies.  Due to the low yield and relatively volatile stock price, relative to other BDCs, this doesn't fit the type of investment I look for in BDCs.

Gladstone Investment is currently trading below net asset value, of $8.65 per share.  The company pays a monthly dividend of $0.05, for a yield of just over 8%.  Their investments are relatively concentrated, with investments in only 20 companies.

Apollo Investment pays a quarterly dividend yielding roughly 9%.  The company is scheduled to report earnings on Feb. 6.  The company is trading just above the last reported net asset value of $8.46.  The company has a broad investment base, with investments in 69 companies.  Given the small following of the stock, investors should hold off until the company reports earnings.  Once earnings are reported, investors can verify they are comfortable with the company investments and management.

These firms invest in smaller private companies, generally with up to $1 billion in market cap.  It is nearly impossible for average investors to gain direct exposure to private companies, especially smaller ones.  These firms use a variety of instruments to invest, such as senior secured loans, secured notes, subordinated debt, equity investments, and sometimes options.  Often these firms have investments in 40 to 50 different companies, so they are diversified in case an investment loses value.

Several of these PE firms highlight that the size of companies they invest in are ideal buy-out targets for larger companies and PE firms.  Any buyout of their investments could result in a higher return or earlier cash flows for the firm.

Also, management of these companies takes into account diversification across industries.  I prefer companies with at least 40 different investments in different industries which provides a broad base and helps absorb industry, regional, or company specific shocks.  Below is a figure from the Blackrock Kelso quarterly report, showing their investments by sector.


<img src="/media/images/user_15781/chart_large.png" />

As a result of this broad diversification amongst smaller US companies, the health of each company’s portfolio is highly correlated to the US economy.  As the US economy improves, the companies these firms invest in will do better, resulting in more profitable investments.

Generally, there are few analysts covering these stocks.  Since there are few analyst opinions to rely on, it is best to look at the track record of each company’s management.  Their track record will show how well they pick and manage investments over the long term and in particular, how well they performed through the recent financial crisis.  The past 5 or 6 years give potential investors a good sample of how managers performed in a variety of market conditions.  Nearly all of these companies' charts show that they took a significant hit during the financial crisis but many leveled out quickly after that.

I think that small BDC's such as Blackrock Kelso will turn out to be good low-beta investments over the next several years as the economy continues to improve due to their strong dividend and proven track record.

ahokiealum has a long position in Blackrock Kelso Capital. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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