Why Invest in Business Development Companies?

What do former President George H.W. Bush, former Secretary of State James Baker, former British Prime Minister John Major, and former-IBM CEO Louis Gerstner all have in common?

All of these prominent and influential men, along with hosts of other recognizable names, have served as consultantsand/or investors in the Carlyle Group, an $83 billion private equity fund based in Washington, D.C.

The Carlyle Group's business is fairly simple: The company has close to 60 different private equity and venture capital funds under management, each with a different area of focus. Some assist management teams in leveraged buyout deals to take their own companies private. Carlyle also lends money, acquires equity investments, makes real estate investments and provides consultation services to firms of all sizes.

The firm has been enormously successful: According to a recent Washington Post article, the fund has provided investors an average annualized return of +26% net of fees over its existence. Let's put that into perspective -- a $10,000 investment over 21 years at a +26% annualized return would be worth nearly $1.3 million. There are few investments that can rival that return.

Unfortunately, the fund is all but closed to new investors. Unless you have an account the size of Abu Dhabi's sovereign wealth fund or the state of California's pension fund, don't hold your breath waiting to put money in a Carlyle fund.

But that doesn't mean you can't mimic the strategy of this enormously successful entity. There is a class of security trading on the major U.S. exchanges that follows some of the same basic strategies as a private equity or venture capital firm: business development companies (BDCs).

Like private equity firms, BDCs typically offer debt financing, equity investment and consultation for privately held firms. While private equity firms usually invest in businesses of all sizes, venture capital companies and BDCs focus their attention on smaller private companies that are too small to publicly list their stock; many are also considered too risky or untested to receive a large loan from a bank. In short, the types of firms that ecis invest in are largely underserved by Wall Street and the banks.

But that doesn't mean these firms aren't solid investments. Consider that before Google (Nasdaq: GOOG) went public, the company received investments and financing from a handful of venture capitalists and private equity firms; those investors scored truly gigantic gains when Google went public. Apple (Nasdaq: AAPL) and Intel (Nasdaq: INTC) also were, at one time, private firms that used private investments to fund their growth.

Of course, not every small stock turns into a Google or an Apple; some BDC investments will never manage to turn a profit and will end up bankrupt. But BDCs typically invest relatively small amounts in a large number of firms, often in a variety of different sectors -- this diversifies their risk considerably.

And because business development companies target underserved firms, they typically can charge higher interest rates on loans, helping to compensate for any additional risk. In addition, BDCs will often take an equity stake in the companies they finance -- if these small private firms go public, the BDC scores a windfall.

Even better, they offer tremendous tax advantages. The federal government wants to encourage investment in small businesses -- according to the U.S. Small Business Administration (SBA), small companies hire more than half the U.S. private sector workforce and have accounted for 60-80% of all new American jobs over the past decade. Therefore, BDCs are a special type of organization exempt from federal taxation.

To qualify, a company must meet certain specific criteria. First up, it must pay out 90% of its income to shareholders as dividends. Not all of this cash must be paid out immediately --some can be carried forward to smooth out dividends over time, but the cash must be paid or the BDC faces taxes on part of its earnings.  This is why most BDCs offer high dividend yields, approaching 20% in some cases.

#-ad_banner_2-#And because the companies they invest in are considered riskier, the government also requires BDCs retain relatively low leverage. Business development companies must have $1 in equity for every $1 borrowed -- their debt-to-equity ratio cannot exceed 1.0. Thus, your average BDC has far less debt than an average bank of equal size.

But thanks to the law, even if some of a BDC's investments go south because of a weak economic environment, they don't have huge fixed charges in the form of debt repayments to worry about.

And don't forget that the worst markets often offer the best opportunities for BDCs. When credit markets are dried up and banks are unwilling to take on risky lending, BDCs are one of the few sources of financing for many small companies. This gives them the opportunity to extract particularly favorable terms for their investments.

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