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Investing In the Investors

13 December 2013 in Trading Ideas

One can debate the power that continued low interest rates have had in reviving the economy.

But one thing’s for sure: It has clearly helped companies that buy other companies. As the Wall Street Journal reported recently, low rates have spurred private-equity fund managers to finance new deals at their fastest rate in five years.

Through nearly the first nine months of this year, private-equity funds had raised $304 billion, the best nine-month total since 2008, according to industry tracker Preqin.1

But low interest rates and a rising stock market hasn’t just been a boon for the targets of so-called business development firms and private-equity firms. It’s also been pushing up the value of the predators – to the point where six new BDCs have gone public since 2012.2

It’s this rise in private investing, both as a financial-market phenomenon and as an increasingly accessible investing opportunity, that spawned our newest motif, Private Equity.

The motif comprises stocks of business development companies and private equity firms that tend to buy the debt or equity of small- to medium-sized publicly traded companies in the hopes of increasing the target company’s value for a profitable exit down the road.

BDCs have the potential added attraction for investors in that they’re similarly structured to REITs or MLPs: BDCs are required to distribute 90% of the gross annual income to shareholders.

In addition, each BDC already offers some diversification, since every one of them is required to have more than half their portfolio in a variety of investments, none of which can account for more than 5% of the portfolio. Also, BDCs have to limit their investment size to no more than 25% of any one portfolio company’s assets.

Of course, another potential upside is the chance for investors to align with companies that can generate returns that outperform traditional equities. A study this summer by Ernst & Young of PE deals from 2006 to 2012 showed that PE-backed firms spawned a return of more than five-fold that of investor returns on publicly held companies.3

Of course there’s the general rule that with higher yields comes greater risks that need to be fully considered and with BDCs and PE firms, you need to understand the unique liquidity and interest rate risks that can impact the performance of these investments in certain market conditions.

The continued strong performance by the stocks of publicly traded PE firms and BDCs isn’t guaranteed, but investors who believe in a continued upside may want to consider this alternative.

1Murray Coleman, “Private-Equity Funds Head for Banner Year,” WSJ.com, Sept. 25, 2013.

2Eyal Seinfeld, “Business Development Companies and the JOBS Act,” Ernst & Young, July 2013, http://www.ey.com/Publication/vwLUAssets/Business_development_companies_and_the_JOBS_Act/$FILE/1307-1106095%20EYs%20BDC%20and%20JOBS%20Act_July%202013.pdf, (accessed Dec. 11, 2013).

3Vincent Ryan, “How Private Equity Is Driving Value,” CFO.com, Aug. 5, 2013, http://ww2.cfo.com/ma/2013/08/how-private-equity-is-driving-value/, (accessed Dec. 11, 2013).

Investing in Business Development and Private Equity companies, involve unique risks including liquidity, credit, and market risks that you need to be aware be aware of prior to making an investment decision.