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How to
Invest in the Next Google |
Published:
September 15, 2008
What
do former President George H.W. Bush, former Secretary
of State James Baker, and former IBM (NYSE: IBM) CEO Louis Gerstner all have in common?
They have all have served as consultants and/or
investors in the Carlyle Group, an $83 billion private equity
fund based in Washington, D.C. And it has been enormously successful: A recent
Washington Post article reported the fund has returned an average
of +26% annually
during its 21
years in existence -- enough to turn a $10,000 investment into
$1.3 million.
Unfortunately, Carlyle is all but closed to small investors.
Unless you have an account the size of Abu Dhabi's sovereign
wealth fund or the state of California's pension fund, don't
hold your breath waiting to put money in the group.
But that doesn't mean you can't mimic the strategy of this
enormously successful entity. There is a class of security
trading on the major U.S. exchanges that follows some of the
same basic strategies as a private equity or venture capital
firm: business development companies (BDCs).
Like private equity firms, BDCs typically offer debt financing,
equity investment and consultation for privately held companies. BDCs
generally focus
on private companies that are too small to publicly list
their stock; many are also considered too risky or untested to
obtain bank financing.
But that doesn't mean these little companies aren't solid
investments. Google (Nasdaq: GOOG) received investments and
financing from a handful of venture capitalists and private
equity firms; those investors scored truly gigantic gains when
Google went public. Apple (Nasdaq: AAPL) and Intel (Nasdaq: INTC) also were, at one
time, private firms that used private investments to fund their
growth.
In particular, we found one business development company we
particularly like:
Apollo Investment Corp. (Nasdaq:
AINV, $17.16) is a BDC that invests
primarily in debt securities of small to mid-sized companies -- but
will seek larger companies if the opportunity is there. The
firm also provides mezzanine financing -- a sort of loan that is a
combination of both a debt and equity (stock) position.
Catalysts: Apollo is the least leveraged business
development company available, with a debt-to-equity ratio of just
0.40. Thus, AINV has scope to take advantage of opportunities that
emerge in coming quarters.
Signs are that AINV is finding the opportunities it has been looking
for. Apollo tends to invest in larger and more well established
companies than most BDCs; when credit conditions were solid in 2006
and the first half of 2007, such firms had no problem accessing debt
markets. That meant the company didn't have many opportunities that
fit its criteria.
However, that's clearly changing. With the credit markets in turmoil, AINV is being approached by banks looking to sell their debt
positions in many of the firms that fit Apollo's
traditional investment portfolio. Many of the banks looking to sell
are large multinationals seeking ways to raise cash and improve
their balance sheets. According to AINV, these banks are willing to
help finance the purchase of loans they're selling and are offering these
loans at significant discounts.
AINV has actually created a special fund to buy up these secondary
loans. Two if its first purchases were loans to the parent company
of Texas utility giant TXU and transactions processing firm First
Data. These are two giant companies with a long history of financial
stability; both companies are now owned by large private equity
firms. The multinational banks that loaned money to these firms on attractive terms are
now willing to accept a
low price just to raise cash.
Competitive Advantages: BDCs tend to focus their
attention on small, privately held firms and typically invest
relatively small amounts in each company. While many of the firms
AINV targets would be considered small, the company tends to target
larger, established firms compared to most in the industry.
For example, the average company in AINV's portfolio has earnings
before interest, taxation, depreciation and amortization (EBITDA) in
excess of $200 million, compared to an average size of $10-100
million for most BDCs.
Larger firms tend to be more financially stable than smaller
companies. In addition, larger companies tend to have more exposure
outside the U.S. market. These factors should help the companies
weather the current weak economic environment better than their
smaller peers.
This is reflected in Apollo's results -- the company has reported no
defaults or late payments over the past few quarters, and only one
loan looks to be troubled at the current time.
Valuation and Outlook: AINV trades at 10.5 times
forward earnings and has a long term growth rate of +7%. Trading at
nearly 1.5 times its growth rate, the stock is at a premium to
most other business development companies; however, my staff and I
believe a premium valuation is justified by Apollo's high credit
quality and extraordinarily low leverage.
More importantly, the stock trades at only a slight premium to its
near $16 net asset value per share. The shares could easily see
upside to the mid-$20s as AINV takes advantage of the weak credit
markets to expand its loan portfolio. The stock also offers a
healthy dividend yield of more than 12% thanks to quarterly payments
of $0.52 per share.
Action to Take --> Thanks to its
strong balance sheet, AINV is taking advantage of banks' willingness
to sell loans of top-tier companies at rock bottom prices. The BDC
looks like a solid "Buy" under $20 per share.
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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