A BDC (Business Development Company) is a closed-end investment company that pools the money it raises from investors to purchase the debt or equity of qualifying thinly traded or privately held companies.
This approach is attractive for small or mid-sized firms, which would otherwise have limited access to capital. And it offers individual investors access to a potentially lucrative market in which they otherwise would be unable to participate.
BDCs generally are public companies that are registered with the SEC and subject to the regulations that govern investment companies. There are two types of BDCs:
- Traded BDCs are listed on a national exchange or trade over-the-counter (OTC).
- Non-traded BDCs are sold through broker-dealers and financial advisors to investors who meet suitability standards based on their income, net worth, or the percentage of assets already committed to alternative investments.
The upfront fees associated with non-traded BDCs average approximately 11.5% to 15% of the purchase price. They cover commissions, management fees, and offering costs. In addition, annual asset-based management fees may apply during the BDC’s term.
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Debt and equity
Before a BDC is offered to investors, its sponsor decides whether the company will invest primarily in debt or equity. It must also decide whether to focus on companies in a particular industry or with specific characteristics, such as size or debt level. Debt BDCs, which are more common at present, are primarily income investments. The BDCs’ managers buy debt securities issued by its portfolio companies, anticipating regular interest payments that can be passed through to investors.
The managers may also sell some securities to realize capital gains that can be passed on to investors. Managers of a debt BDC choose a risk-return profile, which determines the types of debt it buys. If it selects unsecured debt, it will expect to realize more income than if it concentrates on the companies’ long-term secured debt.
But it will also run a greater risk that some of the companies may default. This would reduce the interest income and return of principal it was anticipating.
Equity BDCs focus on capital appreciation or growth in the market value of its portfolio companies. The companies are typically small and often fairly young. This means dividends are rare and distributions are uncommon.
But the managers anticipate that at least some of the companies will prosper and provide substantial capital gains during the program’s term, as a result of its exit strategy, or both. Equity BDCs may be riskier than debt BDCs. That’s the case in part because if a portfolio company fails, stockholders— in this case, the BDC — are unlikely to recover their principal, which goes first to secured bondholders. In addition, because the companies typically have limited reserves, they could be vulnerable in an economic downturn.
Finding an exit
Non-traded BDCs often have finite terms, of ten y-cars or maybe longer. The end-date, or liquidity event, depends on several factors including the managers’ exit strategy. There are generally three alternatives —
- Converting the non-traded BDC to a traded BDC and listing it on an exchange.
- Selling the entire portfolio or merging it with another BDC.
- Selling off the assets individually or in small lots.
Among the factors that influence the option the BDC chooses are whether traded BDCs are attracting investors, how appealing the portfolio is to potential buyers, and the overall state of the economy. None of those could have been accurately predicted when the BDC was offered initially.
The case for BDCs
Non-traded BDCs have several features that make them attractive to investors seeking income and increased diversification. BDCs must distribute at least 90% of their taxable income to shareholders each year to avoid federal corporate income taxes. And they typically distribute all of it, which allows them to avoid excise taxes. This has the potential to be a substantial annual amount, though, of course, there is no guarantee it will be.
In addition, the returns on a non-traded BDC are typically non-correlated with returns on traditional investments because they’re not subject to the same market pressures. So they can provide valuable diversification that may help to reduce portfolio risk. That diversification can be enhanced, at least to some extent, by investing in differently focused non-traded BDCs simultaneously.
Assessing the risks
Non-traded BDCs expose investors to potential risks. Chief among them is illiquidity. There is no secondary market for non-listed BDC shares. Even if the BDC offers a redemption program, it is likely to limit share backs and pay a discounted price for those it repurchases.
Potential defaults or limited growth of portfolio companies are also risks. The BDC may not be able to meet its obligations to lenders or investors if its cash flow drops, its investments lose value or both. Further, a BOC’s offering price must be at least equal to its net asset value (NAV), excluding commissions and discounts. This means investors may find that the value of their shares is diluted if the NAV falls after purchase.
There’s also the possibility that the BDC’s exit strategy will result in a disappointing profit, or none at all, either because the managers have misjudged the market, its portfolio is unattractive, or the economy is weak. This is a serious issue since total return depends on the combination of income and capital gains.
What Are BDCs And How To Invest In it? by Inna Rosputnia
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