Small Companies, Big Returns

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Imagine investing in Microsoft or Apple before they went public.  Pleasant thought, huh?  Who wouldn’t want to be in on the ground floor of a growing company with a groundbreaking idea or product?  For venture capitalists, it’s how they make their living.  Fortunately, in 1940 Congress opened the door for small investors to join the venture capital game.

Private Equity Results for the General Public

With the Investment Act of 1940, Section 54, Congress created so called “Business Development Companies,” or BDC’s.   These are venture capital firms that typically invest in small private companies seeking financing but can’t get it from banks.  By law, BDCs must pay out at least 90% of their taxable earnings to shareholders, they can’t leverage themselves into oblivion (like certain banks did not too long ago), and no single holding can account for more than 25% of the BDC’s total portfolio.  Also,  BDC’s must offer “significant managerial assistance” to the companies they invest in.  That is, BDC’s actively interact with the companies they invest in.  Ideally, this managerial assistance will help the small company succeed (see this pdf for a more lengthy review of the Act).  In 1980, Congress amended the 1940 Act to allow BDCs to go public and raise capital via stock offerings.  Even though BDCs have been allowed since 1940, it has only been since 2000 or so that the number of BDCs has grown.  

What’s In It For Me?

By law, a BDC must invest at least 70% of its total assets into the companies it supports.  The terms of the investment are generally generous for the BDC.  Remember, a BDC is frequently helping a small private firm looking for financial backing and typically not getting it from banks or other traditional sources.  Between favorable financing and active engagement with the private firm, the returns for investors generally exceed those of traditional dividend stocks or REITs.  It is by no means unheard of for a BDC to pay its stockholders an 8-12% dividend and experience some capital gains.  Most BDCs elect to be a Regulated Investment Company and thus avoid corporate taxes on capital gains and dividends paid to shareholders.  As mentioned above, at least 90% of earnings must be paid to shareholders; most financial reviews report BDCs usually pay out closer to 98% of their earnings.

So What to Invest In?

BDCs may focus on one particular type of business or a limited geographic region.  Alternatively, they may diversify into a range of companies to limit risk.

For example, Apollo Investment Corporation (NASDAQ: AINV) invests primarily in various secured debt instruments of private middle-sized companies in a broad range of businesses.  According to S&P, business services make up 9% of Apollo’s portfolio, with education, broadcasting, insurance and other businesses making up the remainder.  Right now, Apollo pays a 10.3% dividend.  The stock has been slowly climbing off its three year lows and sells at a P/E of 6.8.  Its most recent earnings report showed a modest increase in income and net asset value.  S&P recently raised its target price to $8.50 (compared to the recent price of about $7.70) given, among other things, Apollo’s forays into niche markets, particularly energy.

While Apollo offers a 10.3% dividend, Main Street Capital Corporation (NYSE: MAIN) offers an enviable capital gains record.  In November 2009, Main sold for roughly $14 per share.  Today, it sells for $30, with the past year especially showing significant gains.  This helps offset the relatively (emphasis, relatively) modest dividend of 6%.  According to TD Ameritrade, return on equity is over 22% and earnings per share growth over the past 12 months was 42%.  The P/E is 8.3.  Main Street invests in established traditional businesses typically based in the Southern, South Central, or Southwestern parts of the United States.  Speculative or start up companies need not apply.  Main Street’s latest very positive earnings report reflects this successful approach to funding established rather than speculative companies.

A slightly different opportunity lies with Prospect Capital Corporation (NASDAQ: PSEC).  This BDC invests in a broad range of companies across the United States and the Cayman Islands.  According to Prospect’s website, it pays a monthly dividend of slightly more than $0.10 per share, with an annual yield of 11.66%.  However, the stock dove on Oct. 29 when Prospect announced a new offering of 35 million shares, a 20% expansion of its float.  Here’s where it gets interesting: how will Prospect handle the proceeds?  According to its prospectus (page S-7), the company will repay debt and expand its investments, but made no hint regarding how much money will be allocated to which activities.  The recent sell-off may be a great investment opportunity.  Prospect recently announced a 77% increase in investment income.  If the new proceeds underwrite this kind of successful investment activity, impressive investment income gains should continue.

Dark Cloud On the Horizon?

With the re-election of Barack Obama, the Affordable Care Act is with us for awhile.  This may impose significant employee health insurance costs on the small businesses BDC's invest in.  These small businesses may experience reduced earnings and, in some cases, increased risk of bankruptcy.  Will tax credits and insurance exchanges offset these higher costs?  Time will tell.  I suspect small businesses will find the mandated employee health insurance a significant burden.

Bottom Line

BDC's provide everyday investors a venture capital investment vehicle.  Generally, the dividend is the primary attraction but, as in the case of Main Street, capital gains can be hard to ignore.   The Affordable Care Act throws some uncertainty into the picture.  However, the stock market sell off following the Presidential election may have priced these concerns into BDC stocks. This presents a buying opportunity for those looking to add some venture capital excitement to their portfolio.

dylan588 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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