In a bull market, it’s attractive to invest in growing companies, as they can provide higher returns than larger companies – albeit with greater risk.
However, private investors tend to find themselves at the bottom of Wall Street’s pecking order, given little or no chance of buying winners like Alibaba (BABA). Instead, they’re left with large allocations of anything that turns out to be a dog.
For income investors, who rarely see any dividend income from small, growing companies, the situation is even worse.
Luckily, there’s another way for income investors to invest in growing companies – plus score dividend yields that regularly approach double digits.
An Attractive Middle Ground
That option is mezzanine finance.
These unique investments exist because growing companies need a middle ground between debt and equity (thus “mezzanine”). They don’t want to dilute their equity by issuing too much stock, but they also don’t want to rely too heavily on senior debt investors, who are conservative about the percentage of the balance sheet they’ll finance.
Thus, mezzanine finance (which generally consists of high-coupon debt or preferred stock, perhaps with some warrants attached) allows issuers to finance more of their assets than they could through senior debt, at a cost far below that of an additional issue of stock.
Now, mezzanine finance is typically not attractive to commercial banks, because regulators require them to commit too much capital against their book of mezzanine finance assets.
Therefore, specialized institutions have popped up – some staffed by middle market commercial bankers, some with ties to investment institutions – that make mezzanine investments, financing themselves with moderate amounts of debt and with publicly issued equity.
The attractiveness of mezzanine finance companies rests on the quality of their deal sourcing and assessment. If they have access to a wide variety of mezzanine finance opportunities and structure their deals so that only a few fail, they don’t suffer the erosion of capital that can affect other high-dividend investments, such as mortgage REITs and energy MLPs.
It’s also important to check that the company’s expenses are reasonable and that the premium to net asset value isn’t too great. (Since the assets are mostly loans, net asset value is a highly meaningful number.)
There’s also one advantage: Since most deals have warrants attached, any profit on the warrants can be used to replace assets that are lost through deals that get in trouble.
This Way to the Mezzanine
Let’s take a look at a few potential investments.
BlackRock Kelso Capital Corporation (BKCC) is controlled by the giant BlackRock Group, so it has access to excellent deal flow. It invests across all industries in debt, preferred stock, and equity investments, some with warrants attached.
With long-term investments of $1.02 billion, long-term debt of $329 million, and equity of $729 million, BKCC is only moderately leveraged. It’s currently trading about 10% below net assets of $9.79 per share and, with a quarterly dividend of $0.21, it yields 9.8%. Finally, earnings in recent quarters have covered the dividend.
Other companies, such as Prospect Capital Corporation (PSEC) and PennantPark Investment Corporation (PNNT), also have attractive dividend yields… but their earnings after write-offs don’t currently cover their dividends, so some erosion of capital is likely.
However, a fourth company, Hercules Technology Growth Capital (HTGC), has the additional advantage of investing primarily in venture capital-backed tech companies (it’s headquartered in Palo Alto). Hercules is slightly smaller than BKCC, with $910 million in investments, and is about equally leveraged with $298 million of debt and $650 million of equity.
It’s currently yielding 8.6% with a $0.31 quarterly dividend, and its earnings are sufficient to cover the dividend. HTGC’s main disadvantage is that it’s trading at a 39% premium to book value, with the shares having risen some 50% in the last two years. However, you may feel that the warrant and equity opportunities in Silicon Valley justify the premium.
Bottom line: For income investors, the right mezzanine investment company can provide an excellent yield and some chance of capital appreciation. Bought in moderation, they’re great income investments.