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This Cheap 7% Yielder Is Up 35% This Year

Chad Tracy

In 2008, Apollo Global Management (APO) co-founder Joshua Harris was on a losing streak.

The firm's $430 million investment in big-box retailer Linens N' Things went south when the company filed for bankruptcy.

Investments in Claire's retail stores, Realogy Holdings (RLGY), and Harrah's Entertainment all came under pressure as the global credit crisis hit. Apollo was forced to shut off cash interest payments to investors and to issue more debt.

But Harris didn't let a little bad luck stop him. He and his partners kept making deals.

In a classic contrarian move, he purchased more shares of troubled plastics-maker LyondellBasell Industries (LYB), even as the company was sliding toward bankruptcy.

The result? By 2013, the firm's initial $2 billion investment had turned a $9.6 billion profit, the largest gain ever on a private equity investment.

Apollo Management was a private equity firm until its IPO in 2011. And even though Apollo is an excellent company, it's the idea of private equity I would like to talk about today.

If you're a regular StreetAuthority reader, you may have heard of business development companies (BDCs). BDCs allow you to invest in private equity firms on the open market. And their structure gives stockholders several unique advantages.

Because business development companies target underserved firms, they typically can charge higher interest rates on loans, helping to compensate for any additional risk. In addition, BDCs will often take an equity stake in the companies they finance -- if these small private firms go public, the BDC scores a windfall.

Even better, they offer tremendous tax advantages. The federal government wants to encourage investment in small businesses -- according to the U.S. Small Business Administration (SBA), small companies hire more than half the U.S. private-sector workforce and have accounted for 60% to 80% of all new U.S. jobs over the past decade. Therefore, BDCs are a special type of organization exempt from federal taxation.

To qualify, a company must meet certain specific criteria. First, it must pay out 90% of its income to shareholders as dividends. Not all of this cash must be paid out immediately -- some can be carried forward to smooth out dividends over time, but the cash must be paid or the BDC faces taxes on part of its earnings. This is why most BDCs offer high dividend yields, approaching 20% in some cases.

And because the companies they invest in are considered riskier, the government also requires BDCs retain relatively low leverage

Business development companies must have $1 in equity for every $1 borrowed -- their debt-to-equity ratio cannot exceed 1.0. Thus, your average BDC has far less debt than an average bank of equal size.

But thanks to the law, even if some of a BDC's investments go south because of a weak economic environment, it doesn't have huge fixed charges in the form of debt repayments to worry about.

Even the worst markets can offer great opportunities for BDCs. When credit markets dry up and banks are unwilling to take on risky lending, BDCs are one of the few sources of financing for many small companies. This gives them the opportunity to extract particularly favorable terms for their investments.

StreetAuthority expert analyst Amy Calistri has had incredible success with BDCs in her Daily Paycheck portfolio. When she recommended Hercules Technology (HTGC) in February 2010, the stock was trading for a little more than $10 a share.

Today, HTGC is trading near $15 a share. A 50% gain in three years isn't too shabby -- but let's not forget the rich 7% yield that Hercules has been paying out over that same time. By reinvesting her dividends, Amy (and the subscribers who took her advice) is enjoying a total gain of 104% on her position.

And here's the thing: At today's prices, Hercules is still a bargain.

Hercules makes money by providing finance to tech companies at all stages of development -- from startups to mature companies looking for growth.

These companies are major players across the tech spectrum. From Achronix Semiconductors to Zoom Media Group, Hercules' investments include companies that operate in communications and telecom infrastructure, computing and storage infrastructure, digital media and consumer Internet, e-commerce, security and cloud computing.

Over the past two years, HGTC has been on a remarkable run:

But despite a 35% rise in share price this year, the stock still trades at a forward price-to-earnings (P/E) ratio of 11 and a price-to-book (P/B) ratio of 1.5.

As mentioned, HGTC's dividend yield is 7%. And that's on the low end for Hercules: Thanks to the dividend-friendly BDC structure, the company has paid annual yields ranging from 7% to 16% over the past five years.

For context on Hercules' attractive share price compared with its yield, consider this: The average company in the S&P 500 currently yields 2% and trades at a P/E of 19 and a P/B of 2.5.

Amy made a smart move when she added Hercules to her portfolio in 2010, and she's been smart to keep the company in her portfolio. If you haven't already, you might be smart to add Hercules to your portfolio today. 

Risks to Consider: BDC dividends are taxed as ordinary income rather than the lower 15% dividend rate. So it is preferable to hold BDCs in a tax-advantaged account. BDCs are sensitive to interest rates, and a sharp rise could make dividends and share prices volatile.

Action to Take --> HTGC is a strong buy for income-oriented investors at today's prices.

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