Business development companies (BDCs for short) are less well known than traditional common stocks and bonds, but may add value as an investment portfolio diversifier, especially for income oriented investors. These pooled investment vehicles offer access to the private company debt market and usually offer attractive dividend yields and the chance for capital appreciation.
We have three learning objectives for this post:
- To understand what a business development company is and how they may benefit your investment and retirement income plan
- To learn the potential risks associated with investing in business development companies
- To identify tools to help analyze which BDCs are appropriate for you
BDCs are a form of registered investment company which file financial statements and are regulated by the Securities and Exchange Commission just like all mutual funds and publicly traded companies. When BDCs are formed they allow investors to become shareholders and enjoy the benefits of the investments made by the BDC on these investor’s behalf.
The main purpose of a BDC is defined in the federal code as to promote the growth of small, privately held businesses by making capital available through loans. In this case “small” is a relative term. The loans made are generally in the tens of millions of dollars so we are not talking about your favorite local restaurant or corner store. The companies that borrow from BDCs are privately held companies, usually with annual sales revenue in the range of tens of millions to many hundreds of millions annually.
These loans are usually structured with a floating interest rate that is tied to a benchmark rate. If interest rates rise over time, the interest rate paid to the BDC by the companies that borrowed the money will rise and the income received by investors will rise as well. This is in contrast to traditional corporate bonds which have a fixed interest rate that will not rise if rates go up. Of course, if interest rates drop, then the income received by the BDC will go down, but there are usually floors built into the rate structure that the rate will not drop below.
This all sounds wonderful for the BDC investor, right? So what’s the risk? When making loans the obvious risk is that the company that borrowed the money goes out of business or fails to make principal and interest payments on the loan. This could be the result of a problem at a particular company or could be more widespread if the economy enters a recession and businesses in general are having trouble paying the bills.
How do BDCs protect themselves against potential loan defaults? In most cases, the company that borrows the money puts up some form of collateral to secure the loan. This is similar to a mortgage on a home. If the homeowner fails to make the loan payments, the bank will eventually foreclose, be awarded the property in a court of law and then would sell the property to recover the original loaned funds. In the case of BDCs, the collateral could take many forms such as real estate, plant & equipment, patent rights, inventory, etc.
Of course securitizing the loan doesn’t remove all the risk as the value of the property and assets put up as collateral may be variable and if sold during a time of economic recession may have to be sold at lower than anticipated prices. It would be foolish to expect that all the loans will work out and be fully paid as to principal and interest, but if the BDC diversifies its loan portfolio across geographical regions and industries, a few bad loans won’t ruin the performance of the overall fund.
While the yields paid to investors in BDCs vary over time with the general level of interest rates, the general level will be higher than most other fixed income investments to compensate for the higher level of risk. Rates have historically been in a range from the high single digits (7% - 8%) to the low teens (11% - 13%). Most BDCs end up being listed on the stock exchange where the shares can be freely bought and sold by investors. The emotions of greed and fear may cause investors to bid up prices or panic and sell at low prices. Thus, the BDC investor should be prepared for their investment’s principal value to fluctuate significantly while they collect the high levels of income offered by the BDC.
One other aspect that needs to be paid attention to by the BDC investor is the relationship of “net investment income” (NII) to the dividend amount declared by the BDC board of directors. It is one thing to declare a dividend that looks attractive, but another to earn enough NII to cover the dividend distribution. If the level of the declared dividend exceeds the actual NII, then the investor is receiving back principal as part of their distribution. This is a less than desirable situation.
There are places where information on BDCs finances can be obtained. For those ready to dive into and understand financial statements, the BDCs quarterly and annual reports are available for free from the Securities & Exchange Commission website in the Filings and Forms section. Go to: www.sec.gov
For those wanting a prepared analysis of individual BDCs, you can pay a fee to obtain reports online from sources like BDCBuzz or Cliffwater BDCs. Links to these sites are listed below:
In addition, there are funds and exchange traded funds which provide a diversified portfolio holding shares in many different BDCs in one pooled investment. An example is:
VanEck Vectors BDC Income ETF – Symbol “BIZD”
In summary, business development companies are not without risks, but for the patient investor they are worthy of consideration as income producing investments as a part of an overall portfolio plan.
For help with detailed retirement income planning, contact us today at 941-778-1900 or visit integracapitaladvisors.com to schedule a time to learn more about how we help our clients achieve their financial goals.