What Is a Business Development Company (BDC)?
Created by the U.S. Congress in 1980, business development companies (BDCs) are specialized, closed-end funds designed to fuel economic growth by investing in small- to medium-sized enterprises and financially distressed businesses. These organizations not only provide the necessary capital to help emerging firms in their early phases but also assist struggling companies in restoring fiscal health.
Publicly traded on major stock exchanges, such as the AMEX and Nasdaq, BDCs present high-risk and high-reward opportunities for investors. They empower smaller, nonaccredited investors to participate in the growth of young and distressed companies, differentiating themselves from traditional venture capital funds.
Key Takeaways
- Business Development Companies (BDCs) are investment vehicles that provide funding to small, medium-sized, and financially distressed companies, aiming to help them grow and regain financial stability.
- BDCs are publicly traded on major stock exchanges, providing retail investors with an opportunity to invest in small growth companies, unlike venture capital funds that primarily cater to large institutions and wealthy individuals.
- To qualify as a BDC, a company must invest at least 70% of its assets in U.S. firms with market values under $250 million and offer managerial assistance to these businesses, as per the Investment Company Act of 1940.
- While BDCs offer the potential for high returns through dividends and capital appreciation, they also come with high risks, including interest-rate sensitivity and potential magnification of losses.
- Investors can purchase BDC stocks through brokers or gain exposure via exchange-traded funds such as the VanEck BDC Income ETF, but should be aware that dividends from BDCs are taxed as ordinary income.
Comprehending the Role and Structure of Business Development Companies (BDCs)
The U.S. Congress created business development companies in 1980 to fuel job growth and assist emerging U.S. businesses in raising funds. BDCs are closely involved in mentoring and developing the companies in their portfolios because it is in a BDC’s best interest to help them become successful.
BDCs invest in private companies and small public firms that have low trading volumes or are in financial distress. They raise capital through initial public offerings or by issuing corporate bonds and equities or forms of hybrid investment instruments to investors.
The raised capital is then used to provide funding for the struggling companies. BDCs can use different financial instruments to provide capital, but in general, most issue loans or purchase stocks or convertible securities from companies.
Some business development companies are publicly traded entities. Others are not publicly traded and are known as non-traded BDCs.
Criteria for Business Development Company (BDC) Qualification
To qualify as a BDC, a company must be registered in compliance with Section 54 of the Investment Company Act of 1940. Additionally, it must be a U.S.-based company with its securities registered with the Securities and Exchange Commission (SEC).
The BDC must invest at least 70% of its assets in private or public U.S. firms with market values of less than US$250 million. These companies are often young businesses seeking financing or firms suffering or emerging from financial difficulties. BDCs must also help manage the companies in their portfolio.
Fast Fact
Business development companies avoid corporate income taxes by distributing at least 90% of their income to shareholders.
Comparing Business Development Companies (BDCs) and Venture Capital
BDCs are similar to venture capital funds, but key differences exist. However, there are some key differences. One relates to the nature of the investors each seeks. Venture capital funds mainly serve large institutions and wealthy individuals through private placements. In contrast, BDCs allow smaller, non-accredited investors to invest in them, and by extension, in small growth companies.
Venture capital funds keep a limited number of investors and must meet specific asset-related tests to avoid being classified as regulated investment companies. BDC shares are traded on stock exchanges and are available to the public.
BDCs that decline to list on an exchange must follow the same regulations as listed BDCs. Relaxed rules on borrowing, related-party deals, and equity compensation make BDCs attractive to venture capitalists trying to avoid heavy regulations.
Pros and Cons of Investing in Business Development Companies (BDCs)
Pros
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High dividend yields
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Open to retail investors
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Liquid
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Diversity
Advantages Explained
- High dividend yields: Because BDCs are regulated investment companies (RICs), they must distribute over 90% of their profits to shareholders. That RIC status means they don’t pay corporate income tax on profits before distributing them to shareholders. The result is above-average dividend yields.
- Open to retail investors: BDCs expose investors to debt and equity investments in predominantly private companies—typically closed to retail investors.
- Liquid: BDCs trade on public exchanges, giving them a fair amount of liquidity and transparency.
- Diversity: BDC investments may diversify an investor’s portfolio with securities that can display substantially different returns from stocks and bonds.
Disadvantages Explained
- High risk: Although a BDC itself is liquid, many of its holdings are not. The portfolio holdings are primarily private firms or small, thinly traded public companies. BDCs invest aggressively in companies that offer both income now and capital appreciation later; as such, they register somewhat high on the risk scale.
- Sensitive to interest rate spikes: A rise in interest rates—making it more expensive to borrow funds—can impede a BDC’s profit margins.
- Illiquid or opaque holdings: Because most BDC holdings are typically invested in illiquid securities, a BDC’s portfolio has subjective fair-value estimates and may experience sudden and quick losses. In addition, the BDC-invested target companies usually have no track record or troubling ones.
- Magnify losses: Losses can be magnified because BDCs often employ leverage—that is, they borrow the money they invest or loan to their target companies. Leverage can improve the rate of return on investment (ROI), but it can also cause cash-flow problems if the leveraged asset declines in value.
- Dividends taxed as income: Dividends from BDCs are taxed as income because they don’t meet the criteria for qualified dividends.
Steps to Invest in Business Development Companies (BDCs)
- Choose a BDC: Research public BDCs trading on major exchanges and identify one that aligns with your investment goals.
- Open a Brokerage Account: Ensure you have an account with a broker that allows you to buy and sell stocks.
- Purchase BDC Shares: Use your brokerage account to purchase shares of your chosen BDC.
- Consider BDC ETFs: Explore exchange-traded funds, such as the VanEck BDC Income ETF, for broader exposure.
- Review Investment: Regularly review your BDC investments to assess performance and risk.
How Does a BDC Make Money?
Business development companies can make money in several different ways. One of the most common strategies is to purchase equity from the companies they provide funding for and sell it when its value appreciates.
If a BDC buys convertible bonds from a company it has invested in, it can receive yields from the bonds and later convert them to equity. Once converted, the equity can be held for appreciation or sold for capital gains.
Lending is another way BDCs make money. Similar to a consumer borrowing from a bank, a BDC charges interest on the loans it makes.
What Are the Benefits of a BDC?
Business development companies provide investors with higher yields and returns.
How Does a BDC Make Money?
BDCs make money by lending capital to and purchasing equity or bonds from the companies in their portfolio.
What Is BDC Lending?
Business development company lending is when a BDC lends capital to a company it has invested in.
The Bottom Line
Business development companies are firms that exist to assist smaller or financially struggling businesses. BDCs use fundraising techniques to raise capital for themselves from investors and then use that money to invest in these smaller businesses.
They were created by Congress in 1980 to help small businesses grow while attempting to shield them from predatory tactics sometimes used to take over struggling businesses.
BDCs typically offer higher returns than mutual and exchange-traded funds, but they also come with increased risk and volatility. If you’re considering BDCs, consulting a financial advisor can help assess if they fit your investing goals and risk tolerance.
