My New Favorite Way to Make Killer Income

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I'm going to tell you about my new favorite income play. They're known as Business Development Corporations, or BDCs for short.

Here's the story on BDCs – there are plenty of businesses out there generating between $2.5 million and $100 million a year. The problem is, because of Washington's bailout madness and banks hoarding cash, these businesses are starved for capital, so they're turning to private financing instead.

One business I know of, for example, is making a new open source platform called Sailfish to compete with Google's Android, Apple's iOS and Microsoft's Windows 8.

At its nucleus is a team of developers initially laid off from Nokia when Sailfish's prior incarnation, MeeGo, was ash-canned two years ago.

Because bankers could not get their minds around the concept of taking on the big boys, Sailfish is being bankrolled by a combination of severance pay, government business loans, and private financing to the tune of $13.5 million so far — all of whom will likely rue the day they passed on a project with more than $300 million in potential.

An Unloved Source of Higher Returns

That gets me to BDCs – most investors don't even know they exist.

Brokers can't tie private equity up in a nice neat bow; most analysts don't understand the underlying concept well enough to effectively present the investment case to their clients, let alone the underlying business case; and the pundits find them too complicated to break down on TV.

Translation – BDCs are unloved, beaten down and off the radar screen — all of which are key ingredients in the search for higher returns in today's markets, especially when it comes to income.

I'll get to that in a minute, but first let's back up with a brief description of what private equity is so that the concept makes sense.

Private equity is an asset class of investors or funds which own equity securities in companies that are not publicly traded. It's usually the domain of companies that need mezzanine financing or term-loans, and therefore fall outside traditional lending channels.

In some cases, the businesses being funded are like Sailfish, in that they are going after untapped markets in ways established players can't, albeit with very seasoned management. In others, they are established businesses like Sur La Table, a premium kitchenware shopping experience for foodies.

In the past, big banks have filled the gap, but six years into the financial crisis, they've all but abandoned it for now. And therein is the opportunity.

Private equity deals are typically very exclusive and require one heckuva pedigree, not to mention millions of dollars to access. If you're not a big firm running billions or an accredited investor worth millions, you won't even see the deal flow.

How Investors Can Tap Into the Stream

BDC's on the other hand, are publicly-traded private equity firms created expressly for individual investors. You still don't see the deal flow, but you can sure see the results.

Structured much like the more familiar real estate investment trusts (REITs), BDCs typically pay out at least 90% of their net interest income as dividends.

Right now, for example, typical BDC yields range from approximately 6.5% to 11%, or in some cases even more, making them extremely appealing for yield-starved investors.

There are a few other advantages, too:

1) Small- to medium-sized companies are often bought out, so funding them is really a direct shot into the mergers and acquisitions channel long before bigger bankers even see the opportunity. What's ironic about this is that many of these small- to mid-sized borrowers are actually better credit risks than the big boys the banks actually do lend to at the moment.

2) Yields are good. With Bernanke and his cronies holding rates down near zero, a 7-11% payout is a sweet spot that's very appealing. Many are a whole lot higher. There's no need to get greedy like the big banks who have abandoned the space — there's plenty for everybody.

3) Some companies fail, so the strongest really can yield big returns because they command a survivor's premium. This translates into that rarest of all investments – serious income earners with significant appreciation potential. Normally, those two investing attributes are mutually exclusive.

4) The bulk of small- and mid-sized companies attracting BDC investment actually have very conservative management, which means they have a vested interest in profitability. You won't find, for example, a bunch of 20-somethings cashing out because they've scored. These are usually seasoned executives running real businesses with real goods and services who have a vested interest in making it to the big leagues.

Three Ways to Invest in BDCs

Here are my top three choices at the moment:

Blackrock Kelso Capital Corporation (NasdaqGS:BKCC): Blackrock has investments in everything from crane rentals to software, which makes it relatively diverse and a good entry point for investors who want to dip their toes into the private equity pool. I like it for two reasons: a) its yield is an appealing 10.40%; and b) the divergent nature of its businesses lends some stability to an otherwise very volatile investment.

The company was formed in 2005 by management, BlackRock, Inc. andprincipals of Kelso & Company. It has capital resources exceeding $1 billion, which it primarily uses to invest in middle-market companies. Typically, the company's investment is in the range of $10 million to $50 million.

Triangle Capital Corporation (NYSE:TCAP): Like Blackrock, Triangle has investments spread in a wide variety of industries. What makes it different is that it specializes in lending something called "subordinated" debt to companies generating between $10 million and $200 million a year in revenue. This gives it less protection against failure than "senior" debt holders if something blows up, but that's in exchange for higher rates and returns it can extract along the way. It's kind of like non-junk junk debt, if that makes sense. The yield is around 7.70% at the moment.

The company was founded in 2005 and is based in Raleigh, NC. It typically invests $5 million to $30 million in leveraged buyouts, management buyouts, recapitalizations, growth financing, employee stock ownership plans and acquisition financing.

Hercules Technology Growth Capital Inc. (NYSE:HTGC): Tech-centered Hercules is focused on what I call the four horsemen of technology: bio-tech, high-tech, enviro-tech and medical-tech. You've heard me use this term before to describe the importance of sourcing higher-probability investments that the world needs, rather than simply wants. While the payout is presently 8.20%, that's varied widely in recent years so volatility is definitely part of the package with this one.

The company was founded in 2003 and is based in Palo Alto, CA. It typically invests in companies with capital needs from $5 million to $30 million, revenues of $10 million to $200 million, generating EBITDA of $2 million to $15 million.

As you might suspect, there are a few caveats when it comes to including BDCs in your income-investing portfolio.

First, the business development/private equity cycle can be not only cyclical depending on broader economic conditions, but volatile too, depending on the underlying industries and companies chosen. Stock prices will reflect that, so have no illusions: Use that to your advantage by dollar-cost averaging your way in to build up high-yielding, high appreciation-potential positions over time.

Second, just because these stocks have high yields today does not mean they will tomorrow. BDCs distribute 90% of their cash, which means that they have less of a buffer to absorb periodic operational hiccups than more traditional dividend investment choices.

Third, BDC income is taxed up to 39.6% as ordinary income versus the 20% hit you get with qualified dividends, so housing BDC investments inside tax-advantaged accounts may be best.

The bottom line?

If income is important to you and you want to run with the big boys, BDCs are a solid choice offering the best of several worlds.

Do act quickly if you're interested, though…I can't believe that these will stay off the radar for long.

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. H. Craig Bradley | April 8, 2013

    HOW MUCH IS UNDERVALUED?

    The two risk factors here are price and return. Throw in allocation, as well. More input is needed.

    What will the future rate of returns be? As Keith said, BDC's are cyclical. Right now we are in an up-cycle w/ low interest rates. How about later when higher interest rates cause a down cycle? What is a fair price for these things and how much is the market currently discounting them? Keith was a little short on the downside and assumes unrecognized implies a significant market discount. He is speculating that the market will wake-up to them eventually and you get a capital gain.

    Smart long term investors need to be able to estimate how much discounting is going on. Otherwise, you are just in them until the cycle turns down. Hedge funds are largely illiquid. Not all of them are home runs either. Can you hope to accurately call the next down cycle? While many try, few can do that beforehand. So, an investor's allocation to BDC's should be somewhat limited. How limited, as a total percentage of financial assets?

    .

  2. Jo | April 9, 2013

    This is a great tip, I've been thinking of doing BDC investments for a while, although I wasn't quite sure they were the right path to follow. Thanks for confirming this.

  3. H. Craig Bradley | April 9, 2013

    BDC OR ABC

    Well, with central banks around the world debasing their own currencies new technologies and even forms of money are bound to emerge. The world is beginning to look for a different kind of "money" besides that which is tied to any individual sovereign state. I thought it might be the "ducat", an old "tried and true" European coin (gold or silver) with a rich history of its own. Guess I was wrong. What's next?

    Well, technology entrepreneurs seem to be onto something truly different and new: digital money. A group of big-name technology entrepreneurs are throwing their weight behind a new platform dedicated to trading in "bitcoin," an emerging alternative to paper money (reported by Wall Street Journal, April 9, 2013). Most people will overlook the significance of this development: Its a Big Deal and potential game changer or at least a precursor to one. It all depends.

    The bitcoin, which has been around for awhile and already is taking off like a wildfire in decrepit sovereign states like Argentina (ahead of us by maybe 10 years). Agrentina's economy and currency has already crashed (collapsed) numerous times. They are on their way to dictatorship. Their government now controls about every movement their citizens attempt, except one: the Bitcoin.

    Argentina citizens are buying bitcoins and then cashing them in Chile for services such as taxi cabs. Their own currency is near worthless after so many devaluations and capital controls limit what other alternatives, except bitcoins. Its a monetary loophole for victums of bankrupt sovereigns.

    So, in response, a group of technologist's want to build an international platform to trade this relatively new digital currency. Of course, it might just be a pioneer on the way to a dollar replacement on the global market. Investing in any startup is extremely risky. That is, you might be on the right trend (internet telephony) but have the wrong company (Net 2 Phone). Picking the home run, which all private equity firms would love to do is a hit or miss proposition, mostly miss. It takes many misses to get one home run. So I would similarly expect with Keith's Business Development Corporations, as well.

  4. Jeff Heimdal | April 10, 2013

    would like to receive Money Morning Newsletter

  5. Carl Gethers | April 13, 2013

    Sign me up.

  6. Nik | June 24, 2013

    Off-the-radar excellence!

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