What are BDCs?
Business Development Companies or BDCs are defined as “investment companies, formed pursuant to the Small Business Investment Incentive Act of 1980, which make investments in mostly private US mid-market companies in the form of long term debt or equity capital.” BDCs have grown in popularity since the recent recession as the lack of traditional capital from commercial banks, other secured lenders and private equity funds has caused capital starved companies to consider alternative funding sources, like a BDC. As a financier of almost last resort borrowers, a BDC is similar in concept to the better known venture capital fund. A BDC allows individual investors, at low investment minimums, to invest in the same type of private companies as do large institutions, endowments and pension funds. As a regulated investment company, a BDC must be open to investment by all investors, while venture capital and private equity funds are often open only to qualified investors.
Since the enacting legislation, the main focus of BDCs has changed from being an investor in debt and equity deals to primarily a lender of several kinds of debt, including mezzanine debt and collateralized loan obligations or pools of leveraged loans. BDCs perform an important function in helping private mid-market companies finance their growth, and in doing so often provide managerial assistance to the borrower. Most companies looking to work with BDCs have credit ratings which are below investment grade or have no rating at all. BDCs can borrow at low interest rates and make money on the spread between those low rates and the above-market rates at which they loan to their borrowers. In their role as lenders to less credit-worthy companies, BDCs have become the latest version of the sub-prime lender, a role for which they are well paid often charging 10% to 12% or even 14% for a loan with a short to intermediate term (3-7 years). Typically the loans are negotiated with a floating rate which offers some protection should interest rates rise. In addition to the high interest rates, the BDC will also get a first-position lien on the assets of the company.
By regulation, BDCs cannot invest in foreign companies, must limit the size of each individual investment to under 5% of the total of the BDCs funds and must maintain an asset coverage ratio of 2 to 1 (meaning $2 of assets for every $1 of debt). As a regulated investment company, BDCs operate much like real estate investment trusts (REITs) in that they must distribute at least 90% of taxable ordinary income to their shareholders. Some examples of a few of the better known BDCs and their current dividend yields include Ares Capital Corporation (8.80%), BlackRock Kelso Corporation (9.90%) and Prospect Capital Corporation (13.20%). While these high yields look interesting, especially in the current low yield environment, investors in BDCs must take notice of the elevated risk which comes with these investments and proceed with caution. In bull markets, BDCs have the potential to perform well, however in risk-adverse markets BDCs will drop in price with stocks. Given their high-risk profiles, BDCs are best considered an alternative strategy limited to just a few percent of portfolio holdings.