That interesting little quote comes from a great series of books titled Bloomberg Personal Bookshelf. My favorite in the series, naturally, is Investing in Small-Cap Stocks by Christopher Graja and Elizabeth Ungar, PhD.

That quote got us reminiscing about investments we’ve written about in other publications — stocks whose businesses are focused on lending money or investing directly in new and existing businesses. Those small-caps have done extremely well:

These two small-caps are business development companies (BDCs). Regulated by the Investment Company Act of 1940, A BDC must be organized in the U.S. for the purpose of investing in or lending to mostly private companies and giving them managerial assistance when needed. BDCs can receive capital from shareholders and other sources all in an effort to invest in long-term, privately held businesses. Ares and MCG are prime examples of a type of business where investors can buy shares in what are really a basket of privately owned companies.

While these can be great investments, you should be warned of their typical growth patterns…

When a private equity firm is in its infancy and only starting to develop its portfolio, its first few initial investments will probably have low or negative returns. It’s a phenomenon known as the J-Curve Effect.

Returns will be heavily impacted by management fees, which are taken out of the firm’s committed capital. It may take some time before the portfolio grows in value to overcome the fees and show just how good its managers are at making profitable private investments.

If you plotted the firm’s returns in the early years up to and past the point that management fees are overcome by investment profitability, it would form a “J” pattern.

Eventually, the private companies in which the firm has invested will hopefully appreciate, garnering a valuation for the private equity firm that’s higher than the sum of the original investments. Ultimately, big gains can be realized as some of these investments are sold off for large cash sums.

There are no guarantees here, of course.

Not all BDCs can be like the legendary Allied Capital (NYSE: ALD). On April 24, 2007, the company declared its 175th consecutive quarterly dividend! That’s almost 44 years of not missing a dividend payment. And for the last 10 years, Allied’s internal rate of return on its investments and loans has been approximately 22%.

BDCs can be a great source of high yields and high returns. We’ll be looking at several BDC candidates for upcoming issues of Small-Cap Strategy Report and Small-Cap Insider.

Until next time,
Craig
May 11, 2007

Small-Cap Records was originally featured in the Penny Sleuth.