News Analysis date published New: 
Monday, January 7, 2013 - 11:30
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Monday, January 7, 2013 - 11:30
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Monday, January 7, 2013 - 11:30

7 Rules for Picking the Ultimate "Secret Wealth" Investment

Monday, January 07, 2013 11:30 AM

It's over.

Gov. Mitt Romney did not win the presidential election. A majority of Americans, in the final accounting, chose to support another political vision.

Time will tell how that turns out.

I don't do political commentary. But... Whatever Romney's politics, it's accepted as fact that Mitt's business acumen is almost unfailingly spot-on. The methods he used at Bain Capital to build his fortune are indisputable, and he has 250 million ways to support that argument.

Your ticket to a hidden world
Now, to get in on private equity like Bain Capital, you either need to have a liquid net worth of more than $2 million, excluding your house, and a very cushy salary. That's what federal law says. In practice, most "relationships" with private equity are in the $5 million range, though there are plenty of larger funds that aren't likely to return your call if that's all you have to invest. If you're not super-rich -- a movie star, sports star or captain of industry -- the rarified world is altogether off-limits.

The reality is, publicly-traded private equity firms and a special class of securities called business development companies (BDCs) are the only way most of us are going to get in on these deals. They lend to and buy pieces of small "middle market" private companies. The gains they can realize are stratospheric -- ten-baggers are commonplace in the private equity and BDC world.

You've heard it takes money to make money. In this instance, that is certainly true. The rich are different: They don't have to be satisfied with a broad-market return.

BDCs don't just pull back the curtain on this hidden world, they allow average individual investors to get a piece of the action. So you have strong income, strong price appreciation potential, an "in" to The Next Big Thing AND a chance to be a part of deals that would never normally cross your radar screen.

These entities function a lot like the Bain Capitals of the world: They find businesses poised to grow and help them achieve it. There really isn't any more to it than that, so I won't belabor the point.

This assistance doesn't come cheap: BDCs typically get an ownership stake in the businesses they help build. As the developing company grows, the value of this stake can soar, as it did with Staples, the office supply store Romney helped launch.

Because they tend to pay rich dividends, BDCs are often thought of as income investments. They can function in that capacity. But in my Game-Changing Stocks newsletter, I like to keep an eye on BDCs for another reason -- they are a great place to look for The Next Big Thing.

If some new business concept is out there, you can bet that BDCs will be all over it if they think it's viable. So while income isn't generally our aim here, locating the next mega trend certainly is. These securities, thus, fit right into our wheelhouse.

Rules for picking a BDC
Here are my seven rules for picking a BDC investment:

1. Seek BDCs that make safe loans to strong businesses that are generating positive cash flows.

2. Look for BDCs that do the best job of managing risk by diversifying their holdings. The law says BDCs can't invest more than 25% of its assets in one position. I like to see BDCs well under that threshold.

3. Prefer BDCs that are able to borrow at extremely low rates. BDCs with low levels of debt can borrow additional funds far less expensively than peers who are more leveraged.

4. Along the same lines, choose BDCs that have minimized their debt. The law also helps with this one: Federal rules say every dollar of BDC debt has to be covered by two dollars of assets.

5. Select companies that have strong insider ownership. A CEO whose net worth is tied to his stake in the company is a CEO who will always act in the company's best interest.

6. Opt for BDCs with a stable dividend history.

7. Finally, hone in on BDCs that have delivered consistent, above-average gains over the long haul.

Action to Take --> This is an asset class that has managed to profit handsomely during the difficulties of the past couple of years, so it's worth it to keep an eye on this sector.

[Note: If you want to lean more about BDCs, I've compiled a list of the 10 best-performing BDCs, with in-depth research on each and every company, in the November 2012 issue of Game-Changing Stocks. You can access it for free if you're a subscriber. You'll also receive a special research report, Everything You Need to Know About BDCs, just for signing up. Learn more here.]

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.