Overview of Business Development Company (BDC) Investments
A Business Development Company (“BDC”) is a form of investment company that invests in small and mid-sized businesses. Investors can buy shares in a BDC, and the money from their investments is used to fund the businesses. In turn, investors can profit from dividends paid on their investments, or, in some cases, the sale of their shares.
BDCs are a relatively new investment product, they were created in 1980 after Congress approved a series of amendments to the Investment Act of 1940. The creation of BDCs was meant to spur investment in smaller companies that couldn’t attract traditional forms of capital. BDCs have become increasingly popular in recent years, in part due to their ability to create strong returns on investment. However, BDCs are not without their risks and pitfalls.
Business Development Companies operate much in the same was as REITs (Real Estate Investment Trusts). BDCs pool investor money and use those funds as capital to invest in various businesses. The goal of a BDC is to invest in small and medium sized-businesses and help sustain and develop growth in those underlying businesses. When those businesses are profitable, the BDC can be a strong investment.
Additionally, certain BDCs offer a desirable tax structure for investors. A BDC can be formed as a regulated investment company (RIC). RICs are not subject to federal corporate income tax, so long as the companies return a high percentage of the profits to the investors. Typically, this means that BDCs are required to pay out 90% or more of their profits to the investors.
Companies who sponsor and sell BDCs often position them as the common investor’s access point to the world of venture capital. Indeed, this comparison is not far off, BDCs allow for unaccredited investors to invest in businesses that are not yet publically traded or open to general investment. However, much like venture capital, BDCs are exposed to the risks of investing in companies that are often not as large, profitable, or durable as traditional indexed stocks. Unfortunately for some investors, as is the case with venture capital, when investments go wrong with BDCs, they can go very wrong.
The risks associated with a Business Development Company depend greatly on the structure and underlying investments of the BDC in question. The main distinction between the riskier and safer classes of BDCs is their liquidity.
Many BDCs are set up much like closed-end investment funds and are public companies that are listed on the NYSE, NASDAQ, and other exchanges. These publically traded BDCs allow for a level of transparency and liquidity that makes them less risky investments than their privately-held counterparts. However, publically traded BDCs are, like any investment product, not without risk.
As previously mentioned, the value of a BDC depends entirely on the value and health of the underlying business investments. For example, many BDCs invest in oil and gas ventures that are unable to secure bank loans. In the current market, these smaller oil and gas companies are at great risk for bankruptcy. The failure of just one of a BDCs’ underlying assets can mean significant losses for investors.
Additionally, interest rates can play a large role in the profitability of BDC investments. BDCs are most effective when interest rates are higher. This is because smaller companies seek out lenders who can offer them lower or more flexible rates when interest rates increase. Unfortunately for BDC investors, interest rates in the US remain at historic lows, and a growing bear market threatens the likelihood of any future rate increases. As a result, fewer companies seek out BDC lenders, and BDCs lose negotiating leverage, resulting in lower payouts for investors.
In addition to publically traded BDCs, there is also another class of BDCs that are not listed on exchanges. These BDCs often carry much higher yields and can be a tempting investment option, however they are a much riskier investment than indexed BDCs. The first major component in the non-traded BDC’s risk profile is its lack of liquidity.
Without an open market to trade on, owners of non-traded BDCs can be stuck holding their investments for years, sometimes without ever getting the opportunity to sell. Additionally, the actual value of a BDC is not always clear or available. The SEC requires non-traded BDCs to be valued just once a quarter. Furthermore, this valuation is not a market-value, and thus not a reflection of what the BDC shares could be sold or redeemed for. Rather, the quarterly calculation is a “good-faith” valuation conducted by the BDCs board of directors and is based on the assets and overall financial well-being of the underlying companies. For these reasons, non-traded BDCs have not been deemed suitable for all investors.
Suitability standards generally require an investor to have either a net worth of at least $250,000, or a net worth and an annual gross income of at least US $70,000. These standards are a minimum threshold, proper discussion of liquidity, risk, and diversification needs should be discussed with a financial adviser before investing.
Aside from traded and non-traded Business Development Companies, there is a third category of BDCs that can present a unique set of risks to investors. While most BDCs are registered with the SEC and subject to regulation and reporting requirements, one subset of BDCs are not. Certain BDCs are offered through a Regulation E (Reg E) exemption of the Securities Act of 1933. This exemption precludes BDCs from having to conduct regular valuations or report their financial status if they meet a loose set of requirements. These requirements include an absence of past regulatory issues and a limit on the amount of money that can be solicited for investment. The exemption allows a company to raise up to $5 million in a 12-month period without registering with the SEC.
Unregistered BDCs are also more likely to be carrying non-secured debt in companies that have a higher risk of bankruptcy. Most BDCs seek to have their loans protected by receiving a property interest or equity in the companies they invest in. By doing this, the BDCs increase their chances of salvaging some of the investment’s value in the case of a bankruptcy.
Unfortunately for investors in unregistered BDCs, not only are they likely investing in weaker and less stable companies, they are most likely not adequately protected in the case of a bankruptcy. Investors in Business Development Companies should make certain that they are investing in BDCs that carry as few of these unnecessary risks as possible. Losses in unregistered BDCs can be catastrophic and extremely difficult to mitigate. Remember, the higher the purported return on a BDC, the riskier the underlying investments are.
Regardless of what kind of BDC you are being offered, there are several questions that you should ask. The first concerns the fees and commissions associated with the investment. Much like REITs, BDCs boast high returns, but the devil is often in the details when it comes to how much money you’re actually making. BDCs often charge both a management fee and a performance fee that is deducted from dividend payments.
The management fee is normally around 2%, however, the performance fee can often meet or exceed 20%. These fees are not common with most closed-end investment products, however, a special exception to the Investment Act’s prohibition against such fees is applied to the operators of BDCs. Additionally, these products are often a very profitable sale for brokers and investment advisors. It is not uncommon for a BDC to be sold with a commission of 10% or more. All of these additional costs should be taken into account when analyzing the profitability and suitability of such an investment.
In addition to a discussion on fees and costs, investors should also know that they are entitled to certain information about most BDCs prior to making an investment. The offering materials for a BDC and/or the adviser selling the product should share the following information with potential investors:
o A description of the offering’s objectives and its investment methodology
o The types of companies and securities in which it plans to invest
o The amount of capital the BDC seeks to raise, and how it plans to spend the money
o The liquidity of the BDC and the rules that govern redemption and sale
o If distributions are guaranteed in frequency or amount and the source of these payments
o The operating history of the BDC and any potential conflicts of interest.
Business Development Companies can be a good investment for the right investor, along with a diversified portfolio and sufficient due diligence. However, for many other investors, they can result in significant portfolio losses and financial harm. BDCs should only be recommended to those investors who are able to both weather substantial losses and those who are not in need of immediate liquidity. Investors should be particularly cautious of riskier non-public and non-traded BDCs.
AUTHOR: Daxton White
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.