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Everything You Wanted to Know About BDCs

The second-longest bull market in U.S. history hasn’t deterred yield-seeking investors from turning toward relatively unknown products to maximize their returns.

Despite being around for several decades, business development companies (BDCs) are one of the latest vehicles to capture investors’ attention.

The Business Development Company: An Introduction

BDCs are organizations that invest in small- and medium-sized enterprises that are in their early stages of development or require financial assistance to turn their fortunes around. BDCs typically lend to young and often distressed companies that struggle to qualify for financing given their current financial situation. Recipients of BDC funds usually carry the lowest-possible credit ratings or are not rated at all.

A typical BDC is organized like a closed-end investment fund, which is a publicly traded investment company that invests in a portfolio of entities. BDCs are usually public companies whose shares are traded on a major stock exchange, such as the Nasdaq or American Stock Exchange (AMX).

As the U.S. economic recovery continues to broaden, BDCs are said to occupy a “sweet spot” in the market for business loans. That’s because they can borrow at low rates and still make money on the spreads of above-market rates they charge less creditworthy borrowers. At the same time, the businesses themselves benefit from much-needed capital to fuel their expansion and, in some cases, rehabilitation. In this way, BDCs can be thought of as subprime lenders for small- and medium-sized enterprises.

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How BDCs Are Regulated

BDCs trace their origin to the 1980 Small Business Incentive Act, in which Congress recognized the need for private capital in the fast-growing middle market loan market. The rationale behind the establishment of the BDC was to allow regular investors to contribute to private capital formation more easily.

Fast forward to today and the middle market loan market represents roughly 200,000 private companies that collectively account for one-third of gross domestic product (GDP). These generally non-investment grade companies need access to financing when large financial institutions turn them away. The 2008 financial crisis widened the gap between growth capital and middle-market firms, thereby creating even bigger demand for BDCs.

Technically, a BDC is classified as a Regulated Investment Company (RIC), which refers to closed-end investment funds. Under a RIC formation, managers cannot withdraw money from the fund in the same way they can a mutual fund. In this vein, RICs are structured very much like Real Estate Investment Trusts (REITs).

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BDCs as Investment Assets

From the perspective of investors, BDCs have another crucial similarity with REITs. Namely, a BDC must pass through at least 90% of its profit to shareholders, which makes these assets highly attractive for inclusion in a dividend portfolio.

Investors now have access to 45 BDCs – up from just nine in 2004. The highest-yielding BDCs as of June 25, 2018, are:

  1. Garrison Capital Inc. (GARS )
  2. THL Credit, Inc. (TCRD )
  3. Capital Southwest Corporation (CSWC )
  4. KCAP Financial (KCAP)
  5. MVC Capital (MVC )

Each of these BDCs yield at least 12%.

However, sky-high yields don’t come without a price. BDCs tend to exhibit a higher cost structure, which often includes a base rate and a performance fee (the latter is usually 20% of net asset value growth). Since BDCs lend to subprime borrowers, there’s also a greater risk of the company failing or not being able to repay its loan. FINRA touched upon this several years ago when it warned that BDCs exhibit “significant market, credit and liquidity risks” due to low-cost financing. This structure runs “the risk of overleveraging their relatively illiquid portfolios,” FINRA said.

Prospective investors should also be aware of risks that emanate from so-called externally managed BDCs, which outnumber their internally managed counterparts. In the case of externally managed BDCs (the majority), management does not have to disclose its compensation information. Externally managed BDCs are also exposed to conflict of interest since management can guarantee itself higher income so long as it expands gross assets. For example, the fund’s managers can sell new shares or assume greater debt if it meets their definition of asset growth. However, these actions may not always present the best outcome for shareholders.

Against this backdrop, it’s fairly evident that BDCs are best suited for investors willing to accept higher risk for greater yield. Risk-averse investors seeking exposure to BDCs may find greater value (and safety) in exchange-traded funds (ETFs). Some of the leading BDC-focused ETFs include UBS E-TRACS 2x Leveraged Wells Fargo Business Development Company ETN (BDCL), VanEck Vectors BDC Income ETF (BIZD) and ETRACS Wells Fargo Business Development Company Index ETN (BDCZ).

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The Bottom Line

BDCs present yield-seeking investors with the opportunity for much higher returns than the current market average. But those returns carry significant risks tied to liquidity and asset structure. Investors who are compelled to go down this road are encouraged to hold BDCs in a diversified portfolio or through an exchange-traded fund or note.

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Jul 26, 2018