Funds That Invest Like Mitt Romney

NEW YORK ( TheStreet ) -- As Mitt Romney's career famously demonstrated, private-equity investments can generate huge returns.

During the 10 years ended in 2012, institutional private-equity funds returned 17.9% annually, compared with 7% for the S&P 500, according to research firm Preqin. Taking notice of the fat results, plenty of pensions and endowments, have been shifting assets into private equity. According to Wilshire Trust Universe Comparison Service, institutions with more than $1 billion of assets have 9.1% of their holdings in private equity, up from 4% in 2006.

It has long been difficult for retail investors to gain access to private equity. But recently several exchange-traded funds have appeared that provide some exposure. Choices include ProShares Global Listed Private Equity ( PEX) and Market Vectors BDC Income ( BIZD). There is also an exchange-traded note in the field, UBS ETRACS Wells Fargo Business Development Company ( BDCS).

Can the funds make you as rich as Romney? Probably not. The former Massachusetts governor and GOP nominee for president succeeded because of an unusually deft investing touch and lots of leverage. Still, the new funds could prove to be intriguing sources of income.

Part of the reason that private equity can deliver outsized returns is that it is often cheaper to acquire stakes in private companies than it is to buy the stock of comparable public companies. Investors demand discounts because the private shares may be difficult to unload. In contrast, stocks that trade on public markets command higher prices because they can be bought and sold in an instant with a keystroke. Part of Romney's secret was to buy illiquid private companies at low prices -- and then sell them for higher prices in liquid public markets.

ETFs don't invest in private equity directly. Instead, the funds hold the public shares of companies that own private equity. Some of the ETFs specialize in business development companies (BDCs). The BDCs can buy private stock or they can make loans to private businesses. Because of low interest rates, loans have been especially profitable lately. In a typical deal, a BDC raises cash by borrowing at 6%. Then the company turns around and issues loans at 10%.

BDCs are a small industry with a total market capitalization of around $26 billion. But the industry has been growing rapidly as small companies seek sources of capital. There are now 30 BDCs, up from four a decade ago.

Under tax rules, BDCs must pay shareholders 90% of their income. These days, the income has been rich. As a result, the ETFs have been paying fat dividends. Market Vectors BDC ETF yields 7.7%, while the ETRACs ETN yields 7.2%.

Make no mistake, the funds come with significant risks. When interest rates rose in May, BDC stocks slipped. Investors worried that rising rates could hurt profits by making it more expensive to borrow. Since then, the stocks have rebounded. During the past year, the ETRACS ETN returned 21.6%, compared with 27% for the S&P 500, according to Morningstar.

The greatest risk for BDCs are defaults. The companies typically make loans to small and mid-sized companies. Such businesses often turn to the BDCs because they can't obtain cheaper financing from conventional banks. During the financial crisis, the BDC stocks declined sharply. Analysts say that the companies are on sound footing these days because they are using less leverage and loaning to companies with stronger balance sheets.

ProShares Listed Private Equity holds public shares of 28 companies. A BDC in the portfolio is BlackRock Kelso Capital ( BKCC). Market Vectors BDC Income holds shares of 26 companies, including Prospect Capital ( PSEC) and Apollo Investment ( AINV).

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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