A Powerful IPO Trend Investors Can Harness

Recently I’ve noticed an interesting trend in the structure of several initial public offerings. Traditionally, a company goes public to gain access to the capital markets to fund expansion or improve its balance sheet – or often a combination of both.
However, there have been several recent IPO deals that appear to be structured around buying out previous investors, usually private equity investors. Indeed, private equity firms and business development companies (BDCs) are raising and keeping huge amounts of “dry powder” – money committed to private equity funds but not yet invested – on the sidelines.
The question I’ve been asking myself is whether or not this is a symptom of an IPO market that was broken after the financial crisis and is only just springing back to life, or whether this is a new trend of hot IPOs that aren’t attractive to new shareholders.

What You Should Know About ‘Dry Powder’

Though the jury is still out on whether these new private equity friendly IPOs are more the symptom or cause of a trend, one thing is clear: Investors need to know about the huge amount of cash held on the sidelines by private equity investors.
What exactly am I talking about?
In fast-food chain Bojangles’ (NASDAQ: BOJA) S-1 filing – the main SEC filing prior to an IPO – the company disclosed that it “will not receive any proceeds from the sale of shares in this offering.”
Indeed, the company’s private equity investor – Advent International – sold some of its shares to the public during the offering while maintaining a large enough stake that it’s still the majority owner.
The IPO trend that I’m seeing is that private equity, which has been providing companies with funding in the absence of a strong IPO market, is looking to get out of its investments and raise money. The result of this has been rising cash balances at some of the largest private equity firms and business development corporations.
The chart below illustrates this trend, showing the rising dry powder balances, which have now topped $1.2 trillion. Consider that this is cash on the sidelines that can be used to spur merger and acquisition activity, buy public companies to take them private, or provide funding to companies that do not wish to go public through an IPO.

These high cash balances represent dry powder that private equity firms and BDCs can put to work buying and investing in companies.
What’s more, since these companies typically employ leverage in their deal making activities, the dry powder sitting on balance sheets only represents a fraction of the total buying power these companies possess – estimated to be over $4 trillion.

How to Invest

There are a number of ways to invest in this trend. First, you could buy one of the actual BDC stocks.
TCP Capital (NASDAQ: TCPC) invests in the debt of middle-market companies worth between $100 million and $1.5 billion. The stock has largely traded sideways, but investors gain value through its outsized dividend. The stock yields nearly 9%.
Fifth Street Finance (NASDAQ: FSC) and Prospect Capital (NYSE: PSEC) are similar bets on this side of the market. These companies both invest and make loans and typically keep their leverage low, reducing the likelihood of a major blowup. Fifth Street yields more than 10% but trades more erratically than TCP Capital, while Prospect yields more than 12%.
Ares Capital (NASDAQ: ARCC) is one of the bigger and more well-known BDCs. Besides its 9% dividend yield, the stock is already up nearly 6% for the year.
There are plenty of ways to invest in this trend through exchange-traded funds and notes as well.
The Market Vectors BDC Income ETF (NYSEArca: BIZD) yields over 8%, but it appears to be constantly underperforming the market as a whole.
The ETRACS Wells Fargo Business Development Company Index ETN (NYSEArca: BDCS) and the ETRACS 2xLeveraged Long Wells Fargo Business Development Company Index ETN (NYSEArca: BDCL) are linked to the same index and have had similar trading histories. The former yields 8%, while the latter yields nearly 18% due to its leveraged approach.
I’ll keep watching these stocks and ETFs as this dry powder moves off the sidelines to bring you the best ways to invest in this powerful IPO trend.

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