What are examples of when it makes sense to pay more than the usual price or fair value for an item or asset?
Topics covered include:
- Why we are willing to pay a premium for convenience, scarcity, status, and to avoid waste
- What is the difference between net asset value and book value
- Why business development companies can sell at a premium
- Why farmland REITs sell at a premium
- Why closed-end funds sell at a premium
- How to decide whether to pay a premium or not
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Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode—386. It’s titled “When Should You Pay a Premium?”
Business Development Companies
Last week, The Investor’s Podcast released a conversation I had with Trey Lockerbie. We discussed a wide range of topics, including about a five-minute conversation on business development companies. If you recall, we covered business development companies or BDCs a few weeks ago in Money For the Rest of Us episode 381.
BDCs are a niche asset class with about $53 billion in assets outstanding. They’re relatively new. They’re a type of closed-end investment company that directly funds businesses that have revenue between $10 million and $1 billion. That’s called the middle market.
BDCs had been around since the early 2000s, and they’re somewhat of a hybrid between a traditional bank and a private equity fund, in that they extend credit, but they also can provide some equity, some guidance, and counseling about managing operations.
After the episode of The Investor’s Podcast was released, I was perusing the comments on the video version that was hosted on YouTube. One of the comments stung a little. The commenter said, “I wish you would stick to higher-quality interviewees. This guy (me) doesn’t understand why business development companies will sell above NAV” or the Net Asset Value.
In other words, he’s saying “I don’t know why investors would pay a premium to purchase a business development company.” He went on, “Guessing you can’t believe Google sells above book value either.” Now we’ll see in this episode, there’s a big difference between book value and net asset value.
And what he said wasn’t entirely accurate; we ran out of time, we weren’t able to get into as much detail on BDCs as potentially that particular listener, who must be an expert, wanted us to. Fortunately, I have my own podcast, so we can go into more detail.
In that episode, the specific BDC I was referring to was Hercules Capital. I didn’t mention it by name. The ticker is HTGC. It was about a week ago selling for a 60% premium to its net asset value. And again, I’ll define net asset value here in a few minutes.
I said in the episode, I was viscerally opposed to holding something at that much of a premium if there was a chance it could fall. But his comment brings up a good question, “When should we pay a premium for something?”
When Do We Pay a Premium?
Now, there are different uses for the word premium. But in this case, the premium definition that we’re focused on is the idea of paying more than the usual price, or the suggested retail price for something.
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