4 Reasons to Like Business Development Companies

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Amy Calistri

NEW YORK ( StreetAuthority) -- In 2011, the large health care and pharmaceutical company Johnson & Johnson ( JNJ) generated $13.9 billion in free cash flow and maintained its "AAA" credit rating.

The drug maker Pfizer ( PFE) had more than $29 billion of cash and short-term investments on its balance sheet as of October 2011.

The tech giant Oracle ( ORCL) had roughly $30 billion of cash and short-term investments on its balance sheet as of November 2011. In October 2011, computer company Dell ( DELL) was sitting on more than $13 billion of cash on its books.

Do I want to invest in these cash-rich companies?

Not particularly.

These large and mature bellwethers have to work hard to provide enough growth each year to budge their bottom lines. That's one reason they buy so many young, small companies that are at the beginning of their growth spurts.

For instance, in the past few years, Johnson & Johnson bought a number of small, fast-growing companies, such as Peninsula Pharmaceuticals, Tibotec-Virco NV and Acclarent.

Meanwhile, Pfizer scooped up BioRexis Pharmaceutical, FodRX Pharmaceuticals and Excaliard Pharmaceuticals. Oracle acquired Ksplice, Eneca Technologies and Sleepycat Software. And Dell picked up Ocarina Networks, Boomi and Force10 Networks.

All of this leads me to ask: Why should I buy slower-growing mega-companies if I can buy what they are buying?

There's a hitch of course. All of the small companies I listed above were privately-held companies -- not publicly-traded on a stock exchange. But there is a workaround.

I may not be able to directly buy into small, privately-held companies -- but I can invest in a company that does.

Business development companies (BDCs) loan money to private companies. In return, BDCs get back interest and -- in many cases -- an equity stake in the companies they loan to. If one of the companies in its portfolio is acquired or goes public, then the BDC gets a piece of the action. By law, BDCs must distribute 90% of their earnings to shareholders. As a result, BDCs have very rich dividend yields.

There are a number of reasons I like BDCs right now:

1. The hunt for yield

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 five-year Treasury yield of 0.7%. As a result, income investors are scrambling for better-yielding securities, increasing the demand for real-estate investment trusts (REITs) and BDCs.

2. Strong merger and acquisition environment

In 2011, there were 10,241 merger and acquisition deals in the United States, worth a total of $1.03 trillion, up 15% from 2010. More than $219 billion of activity was generated by technology-related mergers, an increase of 17% compared with 2010.

Companies still have a lot of cash on the balance sheet. Global demand for goods and services may continue to be slow in 2012. And buying growth through acquisition is likely to continue to be the best course of action for large multinational companies this year.

3. IPOs set to rebound

By the middle of 2011, it was looking to be a strong year for initial public offerings. 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.

Most companies will likely wait, however, until Facebook goes public this year. Once that happens, I think a dam of smaller IPOs will be ready to break.

4. Weak banks and stronger domestic companies The banking sector was one of the hardest-hit during the financial crisis. Even though the 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.

Risks to Consider: The vast majority of BDC holdings are small domestically-focused companies. International growth may slow due to Europe's debt woes, but the U.S. economy is on more solid footing, having grown by 2.8% in the fourth quarter. Also, unemployment has been on a downward trend.

Action to Take --> There are a number of available BDCs for investors. Some invest in a wide range of private enterprises, from small restaurant chains to small tool and die companies. Other BDCs are more specialized. For instance, there is one BDC, Medallion Financial ( TAXI), that primarily loans money to taxicab companies.

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.

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