News Analysis date published New: 
Tuesday, September 4, 2012 - 13:30
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Tuesday, September 4, 2012 - 14:46
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Tuesday, September 4, 2012 - 13:30

How to Invest in Some of the Smallest, Fastest-Growing Companies in the World

Tuesday, September 04, 2012 1:30 PM

Have you ever wanted to own a stake in that fast-growing auto-parts manufacturer on the other side of your town? How about that local bakery chain that draws a crowd every morning? Maybe you'd like to become a silent partner in the nearby road-construction company that seems to always win your state government's road-maintenance contracts. Trouble is, since these entities aren't publicly-traded, you're left on the sidelines…

Or are you?

My colleague, Andy Obermueller has just released a report on how Mitt Romney and other wealthy Wall Street elites have made a fortune by investing in these types of smaller, private businesses. And up until recently, this area of investing has been off-limits to regular investors. But thanks to a little-known type of investment, which is publicly traded on major stock exchanges, this is now widely available to individual investors.

I'm talking about business development companies (BDCs). Thanks to BDCs, you can own stakes in privately-held businesses such as the ones I mentioned above, and many more. BDCs loan money to small private companies, and in return for taking the risk of loaning them money, the businesses pay the BDC interest and often offer an equity stake. The best part is that BDCs are great income tools, as they are required to pay at least 90% of their profits to investors. In other words, they're true income machines.

For better or worse, most BDCs are lumped into the same conversation as real estate investment trusts (REITs) or mutual funds. This categorization isn't a stretch either -- most BDCs exist to pay owners strong dividends like REITs generally do, while deploying investor capital similar to the way a mutual-fund manager picks stocks for the fund's investors.

Yet, the reason an investor would want to consider owning shares in BDCs is how they differ from REITs and mutual funds. A BDC can -- and will -- provide exposure to startup businesses that mutual funds and REITs are simply incapable of owning.

And many times, owning these startup businesses can pay off big-time.

A case study
What sort of returns are BDCs able to achieve by taking on stakes in nonpublic companies? And for that matter, what sort of companies are out there to invest in? Though it's been some time since this particular trade took place, Rand Capital Corp. (Nasdaq: RAND) may have one of the best success stories to use as an illustration.

In the late 1990s, a company called Pathlight Technology was working on building a hardware and software system that could handle large digital files in a network setting (the explosion of digital data was already underway by then). To meet the growing demand, Pathlight needed cash to beef up what it could offer its clients. During the course of a four-year span, Rand Capital provided $1.17 million worth of funding, in return for a combination of a small ownership stake and an outright loan. A year later, Pathlight's business had grown so well that the company was acquired by Advanced Digital Information Corp. Rand Capital eventually cashed out its stake for a profit of $6.3 million. That's a 438% return on the company's initial funding.

No, not every investment BDCs make pay off so well, or so quickly. The idea is clear, though -- like many of its BDC peers, Rand Capital found the sweet spot in a company's timeline. It was able to participate in Pathlight's growth after it had grown enough to be taken seriously by larger clients, but before it had gotten so big and profitable that it began to attract suitors.

Pathlight is just one of many right time/right place examples of opportunities that BDCs cultivate.

2 winners you could never touch on your own, unless through these BDCs

Despite being in business for more than 40 years and amassing more than 25,000 customers across three continents, most investors have never heard of Ranpak Corp. Nor should they have, since it's not a publicly-traded company. But this doesn't mean the packaging material organization hasn't needed money to support its expansion. Ranpak simply chose to not raise that money by issuing stock to the public. Instead, it sought out BDC Apollo Investment Corp. (Nasdaq: AINV) for a more private capitalization, in exchange for partial ownership and a secured loan.

While the current value of the loan is now being carried on the books a little lower than the initial loan amount, the equity stake in Renpak has paid off handsomely for Apollo and its shareholders. By how much? The value of Apollo's stock holding in the packaging business has grown from an initial investment of $5 million to the current value of $8.3 million. Renpak has clearly made good on its growth prospects.

Gladstone Investment Corp. (Nasdaq: GAIN) did similarly well with its funding of a small company called Acme Cryogenics in 2007.

Acme Cryogenics manufactures manifolds and pipes for industrial gases. It's admittedly a boring business, but also a business that's in persistent demand. Moreover, for such an organization that's properly funded and well managed, growth prospects are quite high.

To help Acme take that proverbial "next step" in expansion efforts in early 2007, Gladstone Investments funded the manufacturer with $22.5 million in exchange for a combination of subordinated debt, preferred stock and common stock. That combined stake is now worth $27.4 million, representing a return of 21.8%. It may not be an enormous return, but it's a much stronger return than what an index fund could have offered for the same timeframe.

Risks to Consider: Investing in traditional stocks can be just as overwhelming for mutual funds or BDCs as it is for the average investor. While BDCs tend to negotiate very favorable loan terms that allow them to pay strong dividends, it's not as if the lendees are default-proof. Business development companies are fully capable of making bad bets, too.

Action to Take --> There just aren't enough big growth opportunities in the publicly-traded market. There are, however, thousands of nonpublic, high-growth opportunities out in the private sector, and only through BDCs can investors have access to them in one single investment.

Even within the business development company world, there are a lot of style choices. Most BDC stocks tend to lean heavily on debt-based investments to drive their nice dividends. With the two BDCs mentioned above, however, there's more equity than what we normally would see from their ilk, so shareholders can have a nice balance of income and growth.

While any of the three would be a worthy addition to any portfolio, the top name may be Apollo Investment Corp. It's got the best dividend yield at this point, at nearly 10% ,and with an average forward-looking price-to-earnings (P/E) ratio of 9.3, it's also arguably the cheapest. Gladstone Investment Corp. also sports a nice yield of about 8%, but the shares have a slightly higher P/E ratio of 11.4.

P.S. -- Business development companies aren't the only way that retail investors can access the previously untouchable private market. In fact, another investment gives you a backdoor into the market where Mitt Romney made his millions. For years, this arena has been off-limits to investors like you and me. But thanks to StreetAuthority's latest research, we've found a way you can access this underground market. You can learn more about BDCs -- and this "second" way to access the private markets -- by clicking here now.

James Brumley 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.