There has been a lot of talk in the media lately about business development companies (BDCs) trying to go public. A business development company can be thought of as a combination of a closed-end fund and a hedge fund. The company uses the IPO process to raise money for a fund, then often charges hedge-fund-like fees on the money it raises and returns. Recently, the private equity firm Apollo, run by former Michael Milken associate Leon Black, raised money for its BDC,

Apollo Investment

(AINV) - Get Report

.

These BDC plays are hard to evaluate from day one, primarily because the entities are all cash initially and have not yet begun to roll out their investments. The only value above the cash in the bank is the intangible value of the investment prowess of the managers.

Also, the management company of the BDC is taking a management fee of usually 2% of assets right off the top. On top of that management fee, a business development company may also charge an incentive fee of up to 20%, meaning that each year it takes 20% of the returns.

Furthermore, at IPO time, the investment bank takes a fee right off the top so that initially, the BDC is trading at a premium to the cash in the bank because of the fees. Because most closed-end funds tend to trade at a discount eventually, it's not unreasonable to assume that the IPO is not the right time to invest in these vehicles.

There are some advantages, though, to investing in a BDC:

  • Retail investors have access to investing talent (for instance, the folks at Apollo) that previously was only accessible to qualified investors in hedge funds.
  • In a BDC, as opposed to a private equity fund, the managers can reinvest the money after an exit from an investment. Typically, in a private equity fund, if an investment pays off, the proceeds are usually distributed to the investors of the fund.

Prospect Energy's

(PSEC) - Get Report

stated goal is to invest "primarily in mezzanine loans and dividend-paying equity securities of middle-market private companies in the energy industry." Fair enough.

I'm more curious, however, about the strange behavior Prospect exhibited at its IPO time, which is similar to the behavior that's sometimes seen in closed-end funds.

Here is the five-day chart of Prospect since its IPO:

No Opening Pop
The stock didn't move much after the IPO

How often do you see a chart that hardly moves for days at a time on hundreds of thousands of shares of volume?

Some closed-end funds often seem to exhibit this behavior. For instance, here is the three-month chart of

Capital and Income Strategies Fund

(CII) - Get Report

:

Vanishing Premium
This closed-end fund was flat for days after going public, then declined

The stock remained at $20 for the first eight days of trading after its IPO. Its daily volume ranged from 14,000 to 173,000. As mentioned in my

July 15 column on closed-end fund arbitrage, many of these stocks tend to trade at a premium at IPO time and then go to a discount.

But why do they trade at exactly the IPO price for so long? Who benefits if there is any type of prior arrangement to support a stock after the IPO? What is the legality of any such arrangement?

Prospect Energy raised $105 million in its IPO. According to its N-2 filing with the

Securities and Exchange Commission

, it is paying a 7% fee to its underwriters right off the top. In the filing it also says no capital gains are anticipated in the first year. But it will charge a management fee and have other expenses charged to shareholders in the first year. In the 8-K filing made on IPO day, it anticipates those expenses to be about 3%.

So right off the bat, investors on IPO day are paying a 10% premium on a closed-end fund that is going to be sitting on mostly cash for quite some time. Then the stock was mysteriously held up for several days before the bid was finally dropped Wednesday, and the stock dropped accordingly.

Prospect Street has a great track record as a private equity firm, and I'd be willing to bet that track record continues. However, I wouldn't look to invest in Progress Energy until the stock hits at least $13.50 or lower (probably lower, because most closed-end funds trade at a discount). If I were more aggressive I would look into shorting, but sometimes it's best to stay away when you don't completely understand a situation.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Prospect Energy to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

James Altucher is a managing partner at First Angel Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of

Trade Like a Hedge Fund

. At the time of publication, Altucher had no positions in any of the stocks mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback and invites you to send it to

james.altucher@thestreet.com.

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