During the past several weeks, I’ve noted that I want to provide my portfolios with exposure in the part of the financial sector that sports high yields.

When I keep reading how difficult the lending environment for mid-size private companies is, it only makes sense to take a hard look at a couple of the Business Development Companies, or BDCs.

As a Wall Street broker for more than 20 years, I was never able to offer most of my clients a way into the private equity markets, since they normally are reserved only for the wealthiest of clients.

While everyone heard about these private pools of capital that were consistently crushing the S&P 500’s returns every year, there was a catch. If a client couldn’t pony up $1 million or more to play, access was denied.

This relatively new type of security is an exciting way for retail investors to jump headlong into the private equity market and engage in a pure play on the financing of small- to medium-sized businesses in a recovering economy. Tight lending standards by banks haven’t kept pace with the demand for capital by small- to medium-sized businesses.

It has been a catch-22 for banks. While they are awash in cash, after getting shell shocked by the recession, they aren’t willing to put that cash into the system in the form of new small business loans that the Fed had hoped the banks would provide under its current policy. This conundrum drives businesses to borrow from BDCs at 10%-15% interest rates with equity kickers attached to every deal. This gets translated into fat dividends for investors who get 90% of the income that is generated by these Cash Machine-like assets.

Essentially, BDCs are investment pools that have been set up in the form of closed-end funds that get special treatment from the Securities and Exchange Commission (SEC) because they provide financing to thousands of companies that many big banks won’t touch. In addition, the Small Business Investment Incentive Act of 1980 was enacted to promote public investment in private companies and to enable BDCs to compete with private venture capital enterprises.

The 1980 act modified certain provisions of the 1940 act by providing BDCs with more flexibility than the typical closed-end fund. Specifically, BDCs can now issue derivative securities, use leverage and charge performance fees. Since BDC managers (unlike other registered funds) may charge performance fees, they have greater flexibility than the typical registered funds in using leverage and in engaging in more esoteric transactions with the companies in their portfolios.

Here are the four basic tenets of BDCs that make them attractive investments for us.

Permanent Capital: Business Development Companies allow investors the same degree of liquidity as other publicly traded investments, while providing their managers with “permanent capital” that’s not subject to shareholder redemptions like open-ended mutual funds are. Open-ended mutual funds are structured in such a way that investors can only sell and buy shares directly to and from the fund itself. In contrast, BDCs are closed-end funds and don’t suffer the huge redemption pressure (when the market is down) and huge investment pressure (when the market is up).

Let’s face it, with the highly illiquid nature of the assets within the typical BDC portfolio, the last thing the fund managers need is a lot of hot money jumping in and out of the fund… and usually at the wrong time. By being structured like a closed-end fund, the ownership must change the hands on the exchange if someone wants to sell or buy shares.

Pool of New Investors: BDCs provide access to public markets where shareholders are not required to meet income, net worth or sophistication criteria. Retail investors may welcome this opportunity to gain access to the private equity markets through the funds that are managed by major private equity players. In fact, BDCs are designed specifically for retail investors. Institutional investors are less likely to invest in BDCs because they generally charge a higher fee, higher than those that are charged by typical private equity funds.

Higher Fees: Speaking of higher fees, another plus of the BDC structure is that managers immediately may begin earning management fees on the amount of capital that is raised from the BDC’s initial public offering. On the other hand, traditional private equity managers only can charge a fee on the funds that have been invested. BDC managers may also double their annual management fees by borrowing funds equal to the amount of the BDC’s net asset value, which is the maximum allowed.

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The point to be made here is that BDCs can calculate their management fees based on gross assets, including any borrowings. In addition, unlike traditional closed-end funds, BDC managers may charge performance-based fees similar to those of hedge funds.

Mezzanine Financing Opportunities: Most BDCs target middle-market debt financing deals. We tend to expect that this type of investment will generate current income and offer some opportunity for gains. Therefore, investors may find that BDCs serve as a relatively safe vehicle to get a big dividend yield and to realize some upside at a time when interest rates are still low and when most fixed income instruments offer meager returns.

Another reason BDC managers have jumped on the middle market is because they view the market as vastly underserved in terms of financing. Many banks shy away from these mid-sized companies because they view them as a higher risk than large institutional borrowers.

Big Dividend Yields Mean Business Is Good

As with many other pass-through securities that I’m attracted to, I like BDCs that are raising their dividends as a direct result of improving business conditions. The middle market that BDCs are targeting is comprised of a huge herd of tens of thousands of companies.

BDCs avoid taxes on the portion of income and capital gains that is distributed to shareholders because they are regulated investment companies (RIC). To maintain its RIC status, a BDC must distribute at least 90% of its investment company taxable income to its shareholders during each taxable year. How’s that for a shareholder friendly company?

If a BDC is performing as it should, then it should be raising new money constantly, enhancing the yield it charges for borrowing and doing all it can to maximize its internal rate of return (IRR). I’m looking for BDCs that have an IRR of at least 12%.

How Uncle Sam Treats Income

Generally, distributions by a BDC are taxable as ordinary income or capital gains — similar to distributions from mutual funds and closed-end funds. A BDC shareholder will recognize a taxable gain or loss when the shareholder sells his or her shares. In addition, many BDCs have dividend reinvestment plans for shareholders.

Just like any other sector of the stock market, there will be winners and losers. Success in these companies rests purely on the talent of its management team. The pressure to invest fresh funds is great and the long-term winners in this sector have deft and opportunistic management teams that aggressively put new capital to work.

To sum up, let me reiterate that there are many good reasons to own a couple stocks in this sector:

  • You get exposure to an avenue of investing that we know works the majority of the time.
  • The gene pool of talent working for publicly traded private equity firms is cutting-edge, and we want it that way because a successful fund manager can take home a rock star-sized paycheck that is tied to strong performance.
  • The demand curve for middle (mezzanine) market financing has legs.
  • The growth in the number of mid-sized companies during the current economic upturn has provided BDCs with a new “sweet spot” of opportunity.

The trends that are in place are showing good visibility and are providing a great yield in companies that are raking in outsized cash flow for investors and delivering strong capital gains. I’ll be adding a couple BDCs to my Cash Machine high-yield service by the year’s end. If you want in on those picks and my model portfolio that’s paying out a blended yield of 8.3%, then click here to sign up for Cash Machine and treat yourself to an early Christmas gift!

Get a FREE copy of Bryan Perry's latest research report: My Top Monthly Dividend Payer

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You'll also receive Bryan Perry's weekly e-letter, Dividend Investing Weekly, at no cost, along with other associated financial content and special offers.