Private Equity for the Rest of Us

The world of private equity -- securities of companies that are not listed on a public exchange -- has essentially been off-limits to regular folks. Only the seriously rich or institutional investors, such as pension funds, can meet the terms of the standard private-equity fund, such as a $5-million minimum and a ten-year commitment to an investment that pays no annual distributions.

But there's another way to get into the game -- and receive enticing dividends -- for no more than the $20 price of a liquid, publicly traded stock. Business development companies, or BDCs, are listed investment companies that provide debt and equity capital to small, privately owned enterprises. Typically, such borrowers have annual revenues of $50 million to $500 million and strong cash flows but lack access to bank financing.

Congress passed the legislation creating BDCs in 1980. Under federal guidelines, these investment outfits pay no corporate tax. Rather, like real estate investment trusts, they must distribute at least 90% of their ordinary taxable income to shareholders -- hence, investors reap plump annual dividend yields of 7% to 9% from the steadily growing ranks of BDCs.

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How they work

A typical BDC raises money by issuing stock, then makes long-term loans at interest rates of 12% to 13% to a diversified group of privately held companies. BDCs may also buy actual stakes in businesses. A typical borrower is a company experiencing a change of ownership through, say, a buyout. By regulation, BDCs can take on only as much debt as they hold in equity capital and must update the value of their portfolios quarterly.

You can view the role of BDCs in your portfolio in several ways. As a form of private equity, BDCs provide the diversification of an alternative investment -- one that doesn't necessarily move in sync with the overall stock market. Through their holdings in small, unlisted enterprises, they provide exposure to a vibrant segment of the economy that you cannot get through stocks. Because BDC portfolios are stuffed with high-interest loans, you can also look at the shares as a kind of high-yielding investment -- albeit one that's capable of expanding its annual distributions.

When analyzing a BDC, investors should look at numbers such as the ratio of price to book value (assets minus liabilities), dividend yields and growth in the BDC's income, from which dividends are paid. Because most distributions are in the form of ordinary income, tax-deferred accounts make a nice home for these stocks.

Three attractive picks

Malon Wilkus established American Capital Strategies in 1986 in the living room of his Bethesda, Md., condominium. Since then, American Capital (symbol ACAS) has quietly emerged as the BDC industry giant, with $12 billion in capital and a stock-market value approaching $7 billion. Since going public in 1997, American Capital shares have returned a sizzling 23% annualized, including lush dividends, which have swelled each year.

Wilkus, who is president and chief executive, sees size as an advantage. "We can write the entire check," he says, referring to American Capital's ability to provide equity and lend money in various ways to privately owned customers. Most other buyout financiers, Wilkus says, typically have one office (American Capital has ten), a half-dozen staffers (American Capital has 200 professionals) and about $350 million in capital. "This is a mom-and-pop industry ripe for rationalization," he says.

At $47, American Capital shares seem fairly valued. The stock yields 7.5% and sells for 1.7 times book value. But this BDC has a new private-equity asset-management business in Europe and the U.S. that generates strong recurring fees, which could lead to a richer stock price.

The granddaddy of the industry is Washington, D.C.-based Allied Capital. Had you invested $10,000 in Allied (ALD) when the firm went public in 1960 (and were prescient enough to hold on), you'd be sitting on $22 million now (an 18% annualized return), assuming reinvestment of the generous dividends.

As other BDCs do, Allied lends money to dozens of small, private companies in need of financing for buyouts, growth or acquisitions. But Allied's real forte has been its skill in buying pieces of its customers' businesses. "Allied is the one BDC that has definitively demonstrated not only good debt investing, but also good equity investing," says Donald Destino, of JMP Securities.

In fact, Allied so successfully harvested gains in 2006 from private-equity investments that it ended the year with an unusual problem: huge undistributed capital gains. Under BDC tax rules, Allied may need to pay a 4% excise tax on a portion of its surplus taxable income -- which, at $600 million, is equivalent to nearly two years of dividends -- a penalty seldom seen in the industry. The company seems to think this is an acceptable price to pay for signaling to shareholders that it has a healthy ability to pay dividends. Allied's stock trades at $31, or 1.5 times book value, and yields 8.1%.

Some analysts prefer BDCs, such as Apollo Investment Corp., that have invested nearly their entire portfolios in debt instruments rather than in equity. One such analyst is David Chiaverini, of BMO Financial Group, who reasons that it will be less risky to be a lender than an owner if the economy weakens this year.

Since going public in 2004, Apollo (AINV) has constructed a $2-billion, well-diversified, debt-dominated portfolio from scratch. Its affiliation with Leon Black's Apollo Management, a heavyweight New York-based private-equity shop, gives the outfit a fine pedigree. "The name gives Apollo Investment access to high-quality deals," says Scott Valentin, of Friedman Billings Ramsey. Apollo is a bit cheaper than American Capital and Allied, selling at 1.4 times book value and yielding 9.1% on a recent price of $22.

HOLDINGS

Companies They Finance

Business development companies lend money to or take equity stakes in a wide variety of companies that are not publicly traded. Below are examples of the kinds of businesses our three picks are supporting with equity capital or loans.

Allied Capital

Meineke Car Care Centers (auto-care franchisor); Insight Pharmaceuticals (over-the-counter drug maker that sells, among other things, Sucrets and Anacin); Healthy Pet (operates about 40 veterinary hospitals).

American Capital Strategies

Gibson Guitar (designs and makes guitars and other instruments); Rocky Shoes and Boots (manufacturer of rugged boots); Beacon Hospice (provider of hospice services in New England).

Apollo Investment

ALM Media Holdings (publisher of legal periodicals); Deluxe Entertainment Services (film-processing services for the movie industry); Tumi Holdings (maker of travel accessories).