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My readers know that one of my favorite ways to protect investors from rising rates and inflation is to use private equity-affiliated business development companies that earn high cash returns. I've recommended Blackstone Inc. (NYSE: BX) before, but there are two more BDCs that are now on my radar that I think represent an excellent opportunity to fill out an alternative income portfolio.
I have followed the adventures of private equity leader KKR & Co. Inc. (NYSE: KKR) for decades. Back in the 1980s, when I started in the markets, the leveraged buyout firms like KKR were the pirates of the markets, firing cannons supplied by Michael Milken and the junk bond industry and taking down fattened corporations of all shapes and sizes.
Among those pirates, KKR was king. They took out corporate giants like RJR Nabisco, Beatrice Industries, Safeway, and Duracell by enormous amounts of leverage.
They made enormous amounts of money for their investors.
As the years have gone by, the leveraged buyout industry has become the more gentlemanly private equity industry and is the cornerstone of the alternative investing world.
KKR adapted, expanding into other areas of alternative investing. For example, they offer real estate investment products, energy funds, infrastructure investments, and even venture-type investing in technology companies.
They have also offered several income strategies to public investors through commercial mortgage REITs, closed-end funds, and business development companies (BDCs). I have done very well buying and recommending these to my readers at various times over the years.
Their latest move is a merger that has created the second largest publicly traded BDC in the United States, with more than $16 billion in total assets. It combines upside appreciation potential of 25% or more over the next year with shares that yield 12.6% at the current price.
Read on for the ticker and a bonus trade...
This Merger of Two Financial Giants Is More Than the Sum of Its Parts
The new BDC is called FS KKR Capital Corp. (NYSE: FSK) and merges two of KKR's subsidiary BDCs in a partnership with FS Investments, a leading alternative investment firm.
One of the best reasons to buy this BDC is that they have access to KKR's research and contact to find, qualify and fund deals most of their competitors will never see.
FS-KKR's size allows them to be one of the few BDCs active in the upper end of the middle market lending business. Most BDCs fund smaller companies that usually carry more risk than lending to larger companies. Having size and access to KKR's capital markets contacts is why FS-KKR is a lead or sole lender on 95% of their loans.
They are very picky about which companies they will lend money to. They put them through the same type of rigorous analysis that KKR uses to evaluate private equity investments. Last year they looked at over 1600 potential deals. Only 345 made it to the investment committee meeting to be discussed.
Only 87 were eventually funded.
The current portfolio has 193 investments spread across 22 industries. Seventy percent of the portfolio is in senior secured loans.
Eighty-seven percent of the loans are floating rates, which adds a considerable level of inflation protection to shareholders of this BDC.
Shares of FS-KKR are trading at a twenty percent discount from the net asset value of the loan portfolio, so there is an upside appreciation potential of 25% or more over the next year.
The shares also yield 12.6% as of this writing.
Another indicator I like to follow for companies like this is whether or not there's a lot of insider buying. And I've got a second pick that fits the bill - and it's the only BDC that's bigger than FS-KKR.
Execs Are Snapping Up Shares of This Firm
Ares Capital Corp. (NASDAQ: ARCC) has a staggering $19 billion in assets under management. While their private equity parent is not as well known as KKR, Ares Management Corporation was founded in 2022 to take advantage of private credit and private equity market opportunities.
In 2004 they founded ARCC, and it has since been a top performer in the BDC universe.
Ares Capital prefers to invest in defensive areas to the private equity markets. They like to lend to established technology, healthcare, and manufacturing businesses. They avoid more cyclical market areas like steel companies, forest products companies, airlines, shipping companies, and other industries where a weakening economy could cause delinquencies and write-offs.
Seventy percent of the loan portfolio is in senior secured loans at a floating rate, so there is an element of protection against inflation and rising rates.
At the current price, Ares Capital shares are yielding 8.6%.
And best of all, Ares has seen heavy buying by officers and directors recently.
Two insiders, including a co-President, have purchased almost 60,000 shares worth over $1 million.
Buying shares of high-yielding private equity affiliated business development companies with insider buying when markets are falling has worked pretty well for me over the years as part of an alternative income strategy.
I am highly confident that this time will be no different.
It's more important than ever for investors to find ways not only to preserve existing capital but position themselves for the best gains when markets recover. Because they also can benefit from higher interest rates, banks are one area where investors are taking refuge.
But there are two additional key market sectors where a new flood of buying is going to create opportunities for potentially massive profits, especially in small-cap stocks that often get overlooked by the major players.
Money Morning Chief Investment Strategist Shah Gilani has a strategy to narrow thousands of these stocks down to the few with the biggest potential to be the next market winners.
About the Author
Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of "Max Wealth."