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. The Food
and Drup Administration approved it in 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
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
Major banks won't do it, they're still hemorrhaging losses from the
latest financial crisis.
normally isn't an
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 such as
BARRX then? It's simple, business development companies, or BDCs.
BDCs loan money to small private companies. They provide the
capital that keeps many of the U.S. roughly 27 million small
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 gets acquired or goes
gets a piece of the action. By law, BDCs must distribute 90% of
to shareholders. As a result, BDC's have very rich
As it turns out, providing loans to small private companies makes a
For one, it's not nearly as risky as it may seem. Yes, BDCs lend
money to high-risk start-up companies. But due to government
requirements, BDCs look to build a diversified portfolio where no
single investment accounts for more than 25% of its total holdings.
Typically, a BDC will hold more than 50 different loans or
investments spread out over 20 or more different industries.
BDCs are also required to maintain a low amount of
. The government prohibits BDCs from acquiring more debt than
equity. By law, the highest
allowed is 1:1. For comparison, investment banks are often levered
as high as 30:1.
To add to the allure, I think
fundamentals are shaping up for BDCs to have a great year this
year. Here's why...
Banks are getting hammered.
Even though the banking sector has been improving, there were still
844 banks on the
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
firms are able to find stronger companies to loan to -- companies
that would have been able to secure conventional bank credit in the
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
. Investors dependent on income aren't finding much to love about a
of 0.7%. As a result, income investors are scrambling for
better-yielding securities, increasing the demand for
investment trusts (REITs) and BDCs.
Furthermore, I'm expecting the market for 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
of companies poised to go public in 2012.
With more companies going public, BDCs should reap the benefits as
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
for $325 million. After the sale, the leading BDC funding BARRXs
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 about $2.2 million.
This represents a total return of 147%.
Action to Take -- >
Because BDCs are required to return at least 90% of its income in
dividends, the bulk of that $2 million dollar windfall will 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.
That's the power of investing in BDCs. Not every company in a BDCs
portfolio will be a winner, but when it is, it normally means a big
payout for its investors.
: In my February issue of
Stock of the Month
, I profiled a business development company that currently yields
8.5%. Not only does it already own shares in the some of the most
lucrative private companies around, it recently made an offer to
buy 307,500 shares of the social media giant Facebook. You can
learn about my
Stock of the Month
advisory, and how I'm earning 21.0% on each of my closed trades, by
visiting this link
-- Amy Calistri
Amy Calistri does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.