What does Paris Hilton have in common with Andrew Carnegie, J.P. Morgan, Carl Icahn, T. Boone Pickens and Henry Kravis, along with a host of other ultra-wealthy people?
I am not talking about anything as obvious as having lots of money. The core concept here is a never-changing rule of wealth in a capitalistic society: Nearly every vast fortune was built upon investing in businesses.
Businesses are the cornerstone of capitalism, and private equity and debt is the fuel that transforms them into society-sustaining enterprises. Since the Industrial Revolution, wealthy investors have been directly involved in providing equity, leadership and knowledge to growing companies. These growing entities, in turn, enrich their risk-taking, life providers, beyond belief in many cases.
This rarefied world of directly helping companies thrive is no longer just reserved for the wealthy. Today, anyone with a brokerage account can get involved in the business of funding a business. One of the easiest ways to do this is to invest in business development companies (BDCs).
In fact, by investing directly in companies, BDCs have advantages that even the world's wealthiest families would have a hard time attaining. The primary advantage available to the small investor in BDCs -- other than access to a variety of vetted and proven companies -- is liquidity.
When wealthy investors and institutions invest directly in private companies, there is generally a lockup of funds. This lockup means the invested dollars are unavailable for a period of time, which can sometimes be years. In contrast, shares of BDCs can be bought and sold with zero lockup of capital. This is a huge positive, particularly in a volatile economy.
Other advantages include consistently high dividend payouts, diversification across a wide swath of sectors, expert guidance, no corporate income tax, and the potential to profit despite rising interest rates. Let me explain the advantages in terms of taxes and rising rates.
Tax Advantages: In the eyes of the Internal Revenue Service, BDCs are pass-through entities, meaning they don't pay corporate income taxes. Instead of directly paying tax, BDCs must pay out a minimum of 90% of their net income to shareholders, generally through dividends. In other words, shareholders are taxed on the dividends rather than the company being taxed.
Rising Interest Rates: This can create headwinds for nearly every investment. However, BDCs can be different. If the majority of a BDC's funds are in floating-rate investments and it's borrowing money at a fixed rate, the BDC can charge higher rates as rates increase, but the rates locked in by the BDC remain the same. This can result in the BDC increasing its earnings in an environment of rising rates.
My favorite BDC is Fifth Street Finance (Nasdaq: FSC), which fits all the points made above and has been in business for 15 years.
Fifth Street Finance calls itself an alternative lender that provides capital to proven small to midsize companies alongside world-class private equity companies. Here's how it works: A private equity firm finds a company it wants to purchase, with the goal of unlocking the untapped potential or other value inherent within the targeted company and selling the company at a profit. The private equity firm provides the equity to purchase the company, and Fifth Street steps in by providing the needed debt. Fifth Street's profits come from interest and capital gains.
Fifth Street is widely diversified across various sectors such as health care, technology, defense and energy, among others. It pays a monthly dividend of about 10 cents per share, which works out to about a 12% yield. As of late March, 74% of Fifth Street's debt investments are in floating-rate securities. As I explained, this stands to benefit the company should interest rates continue to increase.
What closed the deal for me on Fifth Street is the recent buying by insiders and institutional investors. On June 19, Fifth Street CEO Leonard Tannenbaum added 20,000 shares to his portfolio. In addition, a variety of other company officers have recently increased their holdings -- and there's no stronger endorsement than insider buying. In addition, hedge fund manager David Einhorn of Greenlight Capital recently purchased almost 2 million shares, and even analysts at JPMorgan Chase (NYSE: JPM) say the dividend is "secure."
Technically, I like this stock as a momentum play. Buying now after the breakout makes technical sense.
Risks to Consider: Fifth Street Finance does its best to mitigate risk through diversification and investing alongside top-tier private equity companies, but losses are always a possibility. In addition, be aware of the risks of overleveraging and being locked into illiquid investments. Always use stops and position size properly when investing.
Action to Take --> Adding Fifth Street Finance to your portfolio of high-dividend stocks is an ideal way to diversify and add another revenue source.