How to Invest in Private Equity Through Public Markets

Private equity funds are much maligned for being inaccessible and merely being a vehicle for the rich to get richer. Well, if you can’t beat them, join them! A little known asset class made a few headlines in recent days when two participants – Ares Capital Corp. and Apollo Investment Corp. – filed public offerings to raise capital. These two companies are a subset of a little known asset class which was created to provide small investors access to private equity investments while also providing more capital to help small and middle market companies grow.

These companies are known as Business Development Companies (BDC) and, when publicly listed, are roughly akin to closed end funds. Ares and Apollo represent the most typical style of BDC – those which provide financing through debt and equity instruments to middle-market companies. Typically speaking, the deals that these types of BDCs invest in are leveraged buyout transactions sponsored by a who's who of middle market private equity firms – GTCR, Audax, Apax, etc.

In order to classify as a BDC, the companies must follow two very particular guidelines. First, they must maintain leverage no greater than 200% their net assets. Second, they must distribute 90% of their income. This generally means that BDCs are slow moving, high yielding stocks and well suited for income-oriented investors.

Over the past year, BDCs have fallen out of favor and their stocks have nose-dived. Declining investor appetite towards debt investments as well as forced sales in debt and equity securities have taken a toll on the market value of BDC investmnts. Two of the most well known BDCs – American Capital Strategies (ACAS) and Allied Investments (ALD) – have fallen on hard times and are in the process of deleveraging through forced sales on their portfolio. In the case of BDCs, the 200% of net assets rule can turn into shackles despite the company’s modest leverage (versus other financial institutions).

BDC stocks, however, have fallen at an even greater rate than their net asset value. Before the “Great Recession of 2008-2009,” BDCs, much like closed-end funds, almost always traded near or above net asset value. Today, very few trade at even 90% of NAV. Instead, analysts believe that the funds are now priced on dividend yield with investors demanding significantly higher returns for the perceived risk. Could the recent success of capital raising activities by Apollo and Ares be a sign that investor appetite for private equity originated securities be returning? If so, BDC shares could benefit both by a rebound in portfolio market prices as well as a return to “closed end fund-like” valuations.

Interested in potentially investing in this space? A “related companies” search on Google Finance pulls up nearly every participant of note. A word of caution, while these businesses provide access to investments in private equity companies, it is often difficult to get much information outside of the names and market values of each portfolio company through public filings. Furthermore, since very few are trading at market caps representative of the book value of their investments, it is advisable to spend time reading each Company’s 10Q before taking a dive into this space. I would suggest looking for BDCs with time left on debt commitments, net asset value to debt <1.9x and as much liquidity as possible.

Full Disclosure: Author does not have a position in any of the stocks listed in this article.

Comments

[Chemist29:]

AINV and ARCC are best of breed for sure, as evidence by being able to raise funds near NAV, however ACAS and ALD are in much worse straights (still in technical default). Whether or not they survive is speculation, although might be speculative plays.

Aug 16 11:34 PM

[Tack:]

Excellent article and a remaining undervalued investment area.

A few other names to consider: PSEC, HTGC, TICC, GLAD

Aug 17 12:03 AM

[Chancer:]

TICC (technology) has held up and continued with their dividend without cuts.


On Aug 17 12:03 AM Tack wrote:

> Excellent article and a remaining undervalued investment area.<br/>
>
> A few other names to consider: PSEC, HTGC, TICC, GLAD

Aug 17 01:00 PM

[maryanne:]

TICC is probably the only one with NO debt. HTGC is good too. Lost big on ACAS and ALD

Aug 17 07:02 PM

[cgm:]

Author is misinformd as to ACAS. They are not being forced to liquidate anything. They are selling only when they get a price that fully recognizes the value. They are patient in waiting for such offers. No fire sales. That means that they are less liquid that would be ideal, but in the long run that will work to shareholders' benefit.

Aug 23 04:02 PM

[sticktoitiv...:]

I averaged into arcc at 4.50, sold most of the shares at 7.50, man do I look like a chump.

Aug 26 01:21 PM

[Michael Con...:]

Business development companies are inappropriate as public investment vehicles. Because they have to pay out 90% of their earnings in dividends, they are unable to fund themselves through internally generated cash flow. Thus they're wholly dependent on the capital markets for capital - an investment banker's dream! When markets are rising and debt is readily available this all works well. However, when equity markets are depressed and equity can only be sold at low values, if at all, and debt costs are high, if available, then the entire enterprise is at risk. This is compounded by the spiraling effect of decreasing values in the investment portfolio, made more severe because BDCs buy when capital is available, and capital is most available when valuations are the highest.

Aug 26 02:58 PM

[Zachary Sch...:]

While BDC's offer exposure in areas that most individual investors do not typically have access to, I'm actually more interested in private equity COMPANIES who have the benefit of running these private equity funds and collecting on the profit.

For instance, Blackstone (zachstocks.com/2009/08.../) has several new funds including a Yuan denominated fund and manages billions in AUM and collects management fees on these funds. The management fees are nice, but the real money is made through incentive allocations. These companies usually get to keep 20% of the profits of their investors. The stocks have been hit hard over the last 2 years as incentive allocations have been low but the environment is changing.

At this point, Blackstone has plenty of dry powder (and has had the cash for the last 9 months) to put to work at depressed prices. As some markets recover, the company is able to build those incentive fees and investors should see the stock rise quickly. A healthy dividend yield pays you to wait at the same time. So while investing in the individual funds or BDOs could be worthwhile, I think owning the company that manages those funds makes even more sense.

zachstocks.com

Aug 27 07:34 AM

[Factation:]

One of, prospectively the most interesting ways to speculate in private nanotechnology companies is to invest in TINY, (Harris & Harris Group, Inc. is a venture capital firm specializing in seed, start up, and mid venture investments. It primarily invests in tiny-technology-enabled companies with a focus on nanotechnology, microsystems, and microelectromechanical systems technology. Harris & Harris Group, Inc. was founded in 1981 and is based in New York, New York.) ( www.tinytechvc.com) Management is excellent! TINY has no debt. Well worth going to their web site and
reading thoroughly!

Aug 27 08:55 AM