In late 2000, BARRX Medical, a medical-device manufacturing company had a great idea…

As one of the leading companies working to treat Barrett’s disease, a condition known to cause certain types of esophageal cancer, BARRX developed a breakthrough treatment device known as the Haloflex ablation system.

Right out of the gate, the Haloflex system showed promise. The Food and Drup Administration approved it in 2001. And when the time came for the first commercial system to be launched, in January of 2005, the BARRX medical team had already conducted multi-center clinical trials to demonstrate the safety and efficacy of the system on humans.

Everything was going great, and it looked like the company was going to hit a big pay-day for its recent development.

But then BARRX hit a road block… it ran out of money.

To keep the dream alive and the company solvent, BARRX had to resort to taking out loans. But finding a lender is easier said than done.

Major banks won’t do it, they’re still hemorrhaging losses from the latest financial crisis. Going public normally isn’t an option either. The costs and fees associated with the filing alone can be in the millions.

So what’s the answer for cash-strapped small businesses such as BARRX then? It’s simple, business development companies, or BDCs.

BDCs loan money to small private companies. They provide the capital that keeps many of the U.S. roughly 27 million small businesses afloat.

In return for taking the risk, BDCs usually get back interest and — in many cases — an equity stake in the companies they loan to. So if one of the companies in its portfolio gets acquired or goes public, the BDC gets a piece of the action. By law, BDCs must distribute 90% of their earnings to shareholders. As a result, BDC’s have very rich dividend yields.

As it turns out, providing loans to small private companies makes a great business model…

For one, it’s not nearly as risky as it may seem. Yes, BDCs lend money to high-risk start-up companies. But due to government requirements, BDCs look to build a diversified portfolio where no single investment accounts for more than 25% of its total holdings. Typically, a BDC will hold more than 50 different loans or investments spread out over 20 or more different industries.

BDCs are also required to maintain a low amount of leverage. The government prohibits BDCs from acquiring more debt than equity. By law, the highest debt-to-equity ratio allowed is 1:1. For comparison, investment banks are often levered as high as 30:1.

To add to the allure, I think market fundamentals are shaping up for BDCs to have a great year this year. Here’s why…

Banks are getting hammered.

Even though the banking sector has been improving, there were still 844 banks on the FDIC Problem Bank List in the third quarter of 2011, and bank failures remain a weekly occurrence. Banks are still struggling to strengthen their capital and have been less willing or able to lend new money. This means BDCs and other venture capital firms are able to find stronger companies to loan to — companies that would have been able to secure conventional bank credit in the past.

Then there are the yields…

The Federal Reserve intends to keep its interest rates near zero, potentially through 2014. This policy has resulted in record low interest rates on Treasuries. Investors dependent on income aren’t finding much to love about a five-year Treasury yield of 0.7%. As a result, income investors are scrambling for better-yielding securities, increasing the demand for real estate investment trusts (REITs) and BDCs.

Furthermore, I’m expecting the market for IPOs to rebound in the coming year. By the middle of 2011, it was already looking to be a strong year for IPOs. But when European debt worries flared in the summer, market conditions became too risky for most companies to go public. As a result, there is a bit of a backlog of companies poised to go public in 2012.

With more companies going public, BDCs should reap the benefits as their shares of small private companies convert to publically traded stock.

In BARRX’s case, the company didn’t end up going public. But they did receive a buyout offer from Covidien (NYSE: COV) for $325 million. After the sale, the leading BDC funding BARRXs operations had a nice payday.

The business development company loaned BARRX $1.5 million in 2005. After the sale of BARRX is official, the BDC will turn its $1.5 million investment in BARRX into a net gain of about $2.2 million. This represents a total return of 147%.

Action to Take — > Because BDCs are required to return at least 90% of its income in dividends, the bulk of that $2 million dollar windfall will be distributed back to shareholders.

It’s a win-win situation. BARRX received ample capital to continue to financing its breakthrough technology, and the BDC earned a 147% return for its shareholders.

That’s the power of investing in BDCs. Not every company in a BDCs portfolio will be a winner, but when it is, it normally means a big payout for its investors.

[Note: In my February issue of Stock of the Month, I profiled a business development company that currently yields 8.5%. Not only does it already own shares in the some of the most lucrative private companies around, it recently made an offer to buy 307,500 shares of the social media giant Facebook. You can learn about my Stock of the Month advisory, and how I’m earning 21.0% on each of my closed trades, by visiting this link.]