A business development company (NYSE:BDC) is a publicly-traded company designed to help growing companies in the early stages of development or expansion. Similar to venture capital (NYSE:VC) funds, BDCs usually offer higher yield. But, higher yield comes at higher risk.
Before 1980, only professional venture capitalists were able to get in early on a company's start-up. The 1980 amendments to the Investment Company Act of 1940 allow publicly-traded private equity firms to trade like stocks and give individual investors access to higher-yield income distributions. As registered investment corporations, they must pay out at least 90% of their taxable ordinary income.
The venture capital funds and business development companies both attempt to strike a healthy diversification of the risk naturally involved with start-ups. The VC funds or BDCs both invest in and lend to the developing or expanding companies. Income is produced by borrowing at lower interest rates and then lending the money at higher rates. Both charge investors management fees and take a share of the profits before distribution in exchange for managing the investment.
Compass Diversified Holdings (NYSE:CODI) functions like a BDC but is not. It is a trust investing in small to middle market companies. It acquires the majority interest in companies from private entrepreneurs or from corporate parents wishing to divest non-core business. Compass' current portfolio contains 8 companies - 4 with growing branded products and 4 in niche industrial businesses. Besides acquiring controlling interest, Compass is the sole lender to the 8 subsidiaries. Compass' primary cash flow is to the interest paid on the loans from the subsidiaries.
Compass' financial performance from 2011 to 2012 was solid. It is continuing to perform into 2013. Revenue increased 45.8% from $606.6 million in 2011 to $884.7 million in 2012. The cash flow available for reinvestment and for distribution to shareholders grew 12.6% from $69 million in 2011 to $77.7 million in 2012. Revenue in 2013's first quarter was $241.6 million, a 23.7% year-over-year gain. Cash flow was $20.8 million, a 25.2% increase year-over-year.
Compass found the stage for mergers and acquisitions of middle-market businesses quiet through 2012 and into 2013 due to economic uncertainty. In the first quarter conference call, Compass management stated:
"Although the timing of any acquisition can be difficult to predict, we remain cautiously optimistic that we will be able to complete at least 1 platform acquisition in 2013."
As Compass continues to diversify its holdings, investors should understand, for tax purposes, Compass is a partnership. This not only means that the tax obligation on income is passed to partners but it also means taxable gains on shares are impacted by the company's debt. The rules are explained in the company's 2012 annual report:
"We may incur debt for a variety of reasons, including for acquisitions as well as other purposes. Under partnership tax accounting principles (which apply to the Company), debt of the Company generally will be allocable to our shareholders, who will realize the benefit of including their allocable share of the debt in the tax basis of their investment in shares. At the time a shareholder later sells shares, the selling shareholder's amount realized on the sale will include not only the sales price of the shares but also the shareholder's portion of the Company's debt allocable to his shares (which is treated as proceeds from the sale of those shares). Depending on the nature of the Company's activities after having incurred the debt, and the utilization of the borrowed funds, a later sale of shares could result in a larger taxable gain (or a smaller tax loss) than anticipated."
In its 2013 first quarter reporting, Compass had $16.5 million in cash and cash equivalents. Compass had both a term loan facility with $251.9 million outstanding and a revolving credit facility of $290 million with approximately $261 million of borrowing availability. Then, on April 3, 2013, Compass expanded its term loan facility by $30 million increasing the borrowings to $281.9 million. The proceeds were used to repay outstanding borrowings from the revolving credit facility. The pricing terms for both the term loan facility and revolving credit facility were reduced by 1.25% and 0.50%, respectively. The maturity date for the revolving credit facility was extended to April 2017. To fund the first quarter distribution, Compass borrowed $15 million from the revolving credit. Management did stress that transaction was simply due to cash flow timing.
Besides understanding Compass' high-level financial position, its 2013 plans and the tax implications of buying and selling Compass stock, potential investors may want to gauge the financial situation of each subsidiary. The following table provides pertinent data from the 2012 annual report for analysis:
Primary Basis Owned by CODI
2012 Annual Revenue
2012 Annual Operating Income
2012 Y/E Debt Owed CODI
Quick-turn, prototype and production of printed circuit boards
Upholstered furniture manufacturing
Arnold Magnetic Tech
Engineered magnetic and magnetic assemblies manufacturing
Hydration products for outdoor, recreation and military apps
Wearable baby carriers and stroller travel systems
Fox Racing Shox
Mountain bike and off-road suspension products
Premium home and gun safe products
Medical theraputic support services product line
See note (1) below
Note (1): During the 2013 first quarter, redemption of $17 million of internal preferred stock was recapitalized into intercompany debt for Tridien.
Another point of consideration for potential investors of Compass is how to determine the fair value of Compass' share price. An open-ended fund uses net asset value (NYSE:NAV) as fair value. It calculates the NAV of its holdings once a day. NAV is calculated by subtracting the liabilities from the assets and then dividing by the number of outstanding shares.
For closed-end funds, however, share price is determined by the market and is not wholly dependent on NAV. Because closed-end funds and BDCs and Compass own unlisted securities, determining asset value can be muddled. The fair values of assets and liabilities are determined by the company's management team. The management team does consider market value and information supplied by independent appraisers. The valuations are reviewed annually.
Compass pays an annual management fee equal to 2% of its "consolidated net assets." In 2012, the management fee was $17.633 million. Based on the management fee, "consolidated net assets" in 2012 were valued at $881.65 million. Outstanding shares totaled 48.3 million. So, consolidated net asset value per share at year-end 2012 was $18.22. This is not to be confused with NAV because liabilities are not addressed when determining the "consolidated net assets" value for the management fee. The consolidated net asset value after first quarter 2013 reporting was $863.2 million based on the quarterly management fee. Therefore, consolidated net asset value per share equated to $17.87 at quarter-end.
The common P/E ratio often used to gauge fair value can be misleading when viewing Compass. It is necessary to understand that "earnings per share" for Compass is calculated by dividing the cash flow available for reinvestment and distribution by the total number of outstanding shares. Most companies divide net income by outstanding shares to determine earnings per share. So, Compass' 2012 EPS was $1.61 based on $77.7 million of cash flow and 48.3 million shares. In contrast, the Compass 2012 year-end Income Statement reflects an annual EPS of ($0.08). First quarter 2013 EPS was $0.43 based on $20.8 million of cash flow and 48.3 million shares.
Analysts are expecting Compass to grow cash flow available for reinvestment and distribution by 11% annually for the next few years. Modifying a typical YPEG calculation to use cash flow per share data derives a fair value range of $20.68 to $21.80 (based on extrapolating growth from 2012 vs. the current average of 2014 estimates).
Since Compass has a relatively high debt-to-equity ratio of 62.8, reviewing the ratio that compares enterprise value to sales is informative. The enterprise value (NYSE:EV) of $1.1 billion is determined by adding the debt of $297 million to an average market cap of $816.3 million (based on the 50-day moving average) and subtracting cash of $16.5 million. Dividing the EV of $1.1 billion by the trailing twelve months revenue of $930.96 million creates an EV/S ratio of 1.18. The list below compares the EV/S ratio of Compass to the ratios of a handful of respected BDC companies:
Weighing in with such a low EV/S ratio, Compass may well be trading at a discount.
Compass has paid a quarterly distribution since its inception in 2006. In the most recent 9 quarters, the distribution rate was $0.36. With a 90% payout requirement and growth projections of 11%, the distribution could easily expand in 2013. Once an individual investor decides to trust Compass' valuations, payout consistency, organic growth potential and expansion plans, it may be easier to decide the price he'll pay for Compass shares by simply determining his/her expectation of return. For example, if Compass paid a $0.40 quarterly distribution and an investor wanted a 100% return in 10 years or 40 quarters, he'd have to pay less than $16.00 per share. For a company like Compass Diversified Holdings, it's less about the direction of the market price and more about how long you're willing to hold.
Additional disclosure: I intend to recommend CODI to my investment club at the June meeting.