In late 2000, BARRX Medical, a medical device manufacturing company, had a great idea...
As one of the leading companies working to treat Barrett's disease, a condition known to cause certain types of esophageal cancer, BARRX developed a breakthrough treatment device known as the Haloflex ablation system.
Right out of the gate the Haloflex system showed promise. It was FDA approved by 2001. And when the time came for the first commercial system to be launched in January of 2005, the BARRX medical team had already conducted multi-center clinical trials to demonstrate the safety and efficacy of the system on humans.
Everything was going great, and it looked like the company was going to hit a big pay-day for its recent development.
But then BARRX hit a road block... it ran out of money.
To keep the dream alive, and the company solvent, BARRX had to resort to taking out loans. But finding a lender is easier said than done.
Major banks won't do it, they're still reeling from the effects of the latest financial crisis. Going public normally isn't an option either. The costs and fees associated with the filing alone can be in the millions.
So what's the answer for cash strapped small businesses like BARRX then? It's simple: business development companies, or BDCs.
Business development companies loan capital (and sometimes expertise) to small private companies.
In return for taking the risk, BDCs usually get back interest and -- in many cases -- an equity stake in the companies they loan to. So if one of the companies in its portfolio is acquired or goes public, the BDC gets a piece of the action.
What does this mean for income investors? By law, BDCs must distribute 90% of their earnings to shareholders. As a result, BDCs usually have rich dividend yields.
As it turns out, providing loans to small private companies makes a great business model...
For one, it's not nearly as risky as it may seem. Yes, BDCs lend money to high-risk start-up companies. But BDCs look to build a diversified portfolio where no single investment accounts for too large a portion of its portfolio. Typically, a BDC will hold over 50 different loans or investments spread out over 20 or more different industries.
Business development companies are also required to maintain a low amount of leverage. The government prohibits BDCs from acquiring more debt than equity. By law, the highest debt-to-equity ratio allowed is 1:1. For comparison, investment banks are often levered as high as 30:1.
To add to the allure, I think market fundamentals are shaping up for BDCs to have a great year over the next 12 months. Here's why...
Banks are getting hammered.
Even though the banking sector has been improving, there were still 844 banks on the FDIC Problem Bank List in the third quarter of 2011, and bank failures remain a weekly occurrence. Banks are still struggling to strengthen their capital and have been less willing or able to lend new money. This means BDCs and other venture capital firms are able to find stronger companies to loan to -- companies that would have been able to secure conventional bank credit in the past.
Then there are the yields...
The Federal Reserve intends to keep its interest rates near zero, potentially through 2014. This policy has resulted in record-low interest rates on Treasuries. Investors dependent on income aren't finding much to love about a 5-year Treasury yield of 0.7%. As a result, income investors are scrambling for higher-yielding securities.
Furthermore, I'm expecting the market for initial public offerings (IPOs) to rebound in the coming year. By the middle of 2011, it was already looking to be a strong year for IPOs. But when European debt worries flared in the summer, market conditions became too risky for most companies to go public. As a result, there is a bit of a backlog of companies poised to go public in 2012.
With more companies going public, BDCs should reap the benefits as their shares of small private companies convert to publically traded stock.
In BARRX's case, the company didn't end up going public. But they did receive a buyout offer from Covidien (NYSE: COV) for $325 million. After the sale, the leading BDC funding BARRX's operations had a nice payday.
The business development company loaned BARRX $1.5 million in 2005. After the sale of BARRX is official, the BDC will turn its $1.5 million investment in BARRX into a net gain of approximately $2.2 million. That represents a total return of 147%. Since BDCs are required to return at least 90% of its income in dividends, the bulk of that $2 million dollar windfall should be distributed back to shareholders.
It's a win-win situation. BARRX received ample capital to continue to financing its breakthrough technology, and the BDC earned a 147% return for its shareholders.
And with more opportunities like BARRX in the pipeline given the current market, I think business development companies might be among the best income investments available right now.
Always searching for your next paycheck,
Chief Investment Strategist -- The Daily Paycheck
P.S. -- If you haven't done so, you can learn more about my income investing advisory, The Daily Paycheck, here. In the past year, I've collected more than $16,000 in dividends. Learn more about how you can do the same thing by visiting this link.
Disclosure: Neither Amy Calistri nor StreetAuthority own shares of any securities mentioned in this article. In accordance with company policies, StreetAuthority always provides readers with at least 48 hours advance notice before buying or selling any securities in any "real money" model portfolio.