Business development companies, also known as BDCs, make money by investing in private businesses typically located in the United States. The prototypical BDC invests the majority (85% or more) of its capital in loans to businesses, with the remainder in preferred or common equity, or other “riskier” investments. BDC stocks can be part of a good income-generating portfolio.
Why invest in BDC stocks?
BDCs generally pay dividend yields of 8-12%, and sometimes more. Like mutual funds or closed-end funds, BDCs become “Registered Investment Companies,” and are therefore required to pay out more than 90% of their income to avoid corporate taxes. BDCs are pass-through entities. Dividends are usually taxed as income vs. lower dividend or capital gains tax rates.
Where did BDCs come from?
Business development companies were created when Congress enacted the Small Business Investment Incentive Act of 1980. These are also referred to as the 1980 Act, or 1980 Amendments. This allowed investment managers to raise money from the public (via the stock and bond markets) to invest in private companies. BDCs have experienced two major “booms” in their history. The first occurred in publicly-traded BDCs following a 2004 IPO boom. The second occurred in non-listed BDCs in the recovery years following the 2008 Financial Crisis.
What’s the advantage of a BDC?
- BDCs have “permanent capital” – Theoretically, managers can earn higher returns by investing in illiquid assets, and the BDC structure allows for these kinds of investments.
- BDCs can invest in private companies – Private companies have historically traded at lower prices, which could lead to higher returns. In addition, private equity has historically not been available to retail investors.
- BDCs offer liquidity – Where many private debt and equity funds have lockup periods, BDCs trade on public markets. Investors can sell at any time.
- BDCs can use higher leverage – By law, business development companies can leverage their portfolio by up to 1:1. This is known as the asset-coverage ratio.
What are some disadvantages of BDCs?
- BDC management fees can be high – It’s common for managers of BDCs to earn management fees of 1.5-2% of assets, plus 20% of returns as an incentive fee. This is similar to criticized hedge fund fees.
- BDCs are cyclical – The industry makes risky loans to fund private equity buyouts and highly-indebted companies. Loan losses tend to be higher than other lenders in downturns. However, BDCs also collect large coupons — 7% all the way up to 15%, in some cases — on their debt investments.
- There is no firm value for BDCs – Like closed-end funds, BDCs can trade at large discounts and premiums to the accounting value of their assets. Some BDCs have traded for 1.7x their net asset value, or book value, while others trade as cheaply as 0.3x. Theoretically, you could pay more than book value for a BDC only to sell it at a discount to book value, and lose money on your investment.