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“BDCs: Private Lending, Secret to 16% Gains”

By Travis Johnson, Stock Gumshoe, August 29, 2007

These things tend to run in cycles — here we are with yet another Motley Fool teaser, after chatting up rule makers yesterday.

Today, it’s the Motley Fool Income Investor newsletter that’s being teased, by editor James Early … and it’s still on sale, for $119, for what that’s worth (“normally” $199, though it was on sale for $119 back in June when I last saw an ad, too).

Aside from the pick that might have been his in the Rule Makers teaser, ADP, I think I’ve only looked at one of his teaser picks before — Alliance Resource Partners, an MLP stock. It has been down since his recommendation, the other MLP stocks we’ve sleuthed out (remember those “American Oil Pension” ones?) have performed better overall — but that’s not necessarily a fair comparison because those were picked in April, when MLPs were a little cheaper than they were when Early picked his in June. Nearly all the MLPs have performed somewhat poorly of late.

But that’s old news — what have we got today?

They pull out the old saws, the “Government Guarantee” and the “obscure act of Congress” to tease this one. I guess that makes these investments seem more secret or mysterious.

“Government-Enacted 16% Dividend Payouts YEAR IN and YEAR OUT…”

OK, so that sounds pretty nice … they go on to say that these high yields are locked in in perpetuity, and that the “U.S. government will penalize these companies if they don’t pay you at least 90 cents for every $1 they earn!”

Ah, guaranteed money, right?

Well … that assumes, of course, that they earn that dollar … but let’s see what they’re really talking about.

Early is talking about three stocks that offer “High Yield With Serious Growth Potential”

And these are a special kind of company involved in the private equity markets, but the Fool characterizes this as a “highly profitable yet SAFER layer to private investing.”

They’re talking about (and I’m not revealing anything just yet, they say as much in the ad) Business Development Companies, also called BDCs.

These are a special class of investment vehicle, indeed authorized by “Act of Congress”, that essentially works just like a REIT, though with a different focus. They invest in, finance, or lend money to other businesses, and pay out 90% of their income to shareholders. Unlike REITs, they don’t have to focus on real estate, but otherwise I think they’re conceptually the same kind of company. I’m sure they have all kinds of rules and such that they have to follow, but I won’t try to fool you into believing that I’m an expert on BDCs, it’s been a while since I’ve looked at most of these. (I do hold one in my portfolio, TINY, that doesn’t have any income and, as you might guess, therefore doesn’t pay a dividend … definitely not one of the ones the Fool is teasing us with).

They put on the tease pretty hard for these: “In the next year or so, these 3 stocks will likely shoot up in value. And our tight-knit group … is expecting safe 50% gains or more.”

So what are the “James’ top high-yield recommendations right now,” which the Fool says “could very well be our most profitable recommendations ever?”

We’ll check ’em out one at a time:

Number 1.

This one has an unusually large “spread,” according to the Fool, twice that of “many conventional lenders”

The “spread,” for those not hip to the lingo, is the difference between what a finance company has to pay to borrow money (ie, the coupon rate on their bonds) and what it can charge to its borrowers.

Grew “commercial lending and investment assets” at 43% in 2006.

8.8% current dividend.

And the Fool sez: “You could pocket safe annual returns in the neighborhood of 16% with this stock!”

Not a lot to go on, huh? And therefore I can’t be certain about this. My guess, among the several BDCs that have a yield near 8.8%, would be Allied Capital (ALD). That’s the granddaddy of this business, has been around for closing in on 50 years, and has a current yield of 8.7% … another possibility, though I think it’s less likely, is Gladstone.

And … Stock #2

“If you’ve eaten a popular brand of tuna, or had your car serviced at a company you see all over the place, you’re familiar with this company’s investments…”

Finally, a decent clue!

“The company started in the founder’s apartment in 1986.”

Thankfully, this one is a little easier …

American Capital Strategies (ACAS)

The tuna company they invested in through a mezzanine loan was Bumble Bee — according to their current list of investments they’re out of Bumble Bee Seafood at the moment. Malon Wilkus is the head honcho that started ACAS in his apartment in 1986, not too far from me in the suburbs of DC.

These guys are credited with breathing some new life into the business, especially by creating debt instruments instead of issuing secondary offerings of stock to raise capital and grow their portfolio. Compared to Allied Capital they look a little racy, with a higher growth rate and dividend, but I don’t have any idea what their spread is, or whether the general problems with commercial debt at the moment are trickling through to these folks.

So … we move on, to stock #3.

“When it comes to private equity, a few names are now legendary. One such name has generated compound annual returns of 34% since its 1990 inception.”

This company has a “child” company that does private lending of some type, apparently.

So, according to the Fool, “this firm has a world-class parent company that funnels it deals — the vital raw ingredient of private finance.”

James values this stock at around $30 per share, which provides more than 30% of upside from today’s levels. Plus, it already sports a 8.6% yield!

There are several candidates for this one, too, and I’m having trouble being definitive because I don’t know when they wrote this teaser — the stock that I think it is has a higher yield now because the price has declined of late, but it could have fit these criteria a month or two ago.

And, according to what I’ve read, this company has outperformed that 34% compound annual growth rate … they claim 40%.

So what company is this that I think is a good match?

Apollo Investment Corporation (AINV)

This is a fairly new company, started in 2004 (and I actually held shares in it for a few months back then, though I don’t now). It is the child of the “legendary” Leon Black’s Apollo Advisors (number 5 on the Fortune “power” list), which itself was indeed launched in 1990. If memory serves, this is structured a little bit differently than ACAS and ALD in that the parent charges its child a fee not unlike what hedge funds charge to investors (paid by AINV to Apollo, I think, and I believe they get the familiar 2/20 deal, 2% annual fee and 20% of returns over a certain threshold).

So, with the clues we’ve got it’s hard to be absolutely certain about numbers 1 and three above — I know that ACAS is correct, but I’m less sure about Apollo and Allied Capital … though all three are certainly among the leading lights of the BDC world.

If you want to know more, the Fool did an explanatory article about BDCs at the beginning of this year that summarizes what they do fairly well (and talks about Allied Capital specifically).

And there aren’t that many BDCs, as I noted, and even fewer if you’re talking about the ones that are making a profit (and aren’t really venture capital firms). Quantumonline.com is a good resource for basic information and lists of these (as it is for almost all high-income investments — you do have to register, but it’s free).

The Fool also chatters on for a bit about how important dividend growth is to these companies — and, since we’ve been in a pretty sweet spot for private equity in general, you might imagine that these companies have shown some nice dividend growth in the past. Certainly true in many cases, and one assumes that if they continue to grow their businesses they’ll be compelled to raise their dividends, and if you’re compounding that return does indeed get to be signficant over time (that’s how these 8-9% yields turn into the 16% teaser rate).

But of course, these are businesses — there’s no guarantee that these companies will continue to outperform or be profitable, or that they will be able to raise their dividends.

And for individual investors, the usual metrics of PE ratios and such don’t always make lots of sense for these guys — Apollo and ACAS both have trailing PE ratios of under 5, but that doesn’t really tell the whole story about their business, nor does it mean those two are dramatically less risky than Allied Capital with it’s PE of 13. If you’re tempted to invest in these it would probably be worth your while to really dig in, do your research, and understand the business.

One might argue either that these firms will be hurt because it’s hard for them to get financing or to sell bonds or securitized loans on the secondary market, or that they will be in better position because the companies they might lend to don’t have as many other places to go anymore, so their rates might be higher. I don’t know which one of those is the more accurate assessment of the future, but probably both have some merit.

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14 years ago

Thanks for deciphering these. You’re an ace, as usual. Also, a good way to get an overview of these kinds of companies is to look at the holdings of PSP, the Powershares Private Equity ETF. If you look at their portfolio, using Morningstar or some such, you’ll see how abysmal the performance of many of these companies, particularly of Allied Capital, has been this year. Their balance sheet reeks! Pepe Le Pew would appreciate them. Early must know something we don’t in order to recommend these at such an inopportune time.

WWP: Woman With Portfolio

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14 years ago

Taking a recommendation like these without a enough facts on the internal guts of the operation is operating on faith. Who do these guys lend to? What is their record of success? How good is management? A PE ratio in this business tells me what the business is worth. YUK

13 years ago

I owned ACAS for quite some time and was very happy with the results. It came highly recommended to me by a friend that I respect his business judgement highly. I got out before the big downslide and got into natural gas. But now I’m looking back again as it appears priced rather good.

I read this very interesting assessment today

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