Business development companies (BDCs) are publicly traded investment companies that provide capital and financial services to small and mid-sized businesses. They are typically structured as closed-end funds. This week let’s take a deeper dive into this class of investment.

BDC Basics

Congress created the structure for BDCs in 1980 via amendments to the Investment Company Act of 1940. The purpose of BDCs is to provide an alternative source of financing for small and medium-sized businesses that are unable to access traditional bank financing. BDCs are required to invest at least 70% of their assets in privately held companies valued at less than $250 million.

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BDCs are a unique type of investment vehicle that offers investors exposure to a diverse portfolio of small and medium-sized businesses, as well as the potential for high yields and capital appreciation.

A BDC makes money by charging interest on the loans they provide or by taking a share of ownership in the companies they invest in. They are similar to private equity firms in that they provide financing to businesses that are in need of capital. However, BDCs differ from private equity firms in several important ways.

Private equity firms typically invest in larger companies and are more focused on providing growth capital. A BDC typically focus on smaller companies that may be in need of financing for a variety of reasons. Those reasons include working capital, acquisitions, and restructuring.

They also differ from private equity firms in terms of their structure and regulatory requirements. BDCs are required to distribute at least 90% of their taxable income to investors in the form of dividends, which means that they often have higher dividend yields than other types of investment vehicles.

BDCs are also regulated by the SEC and are required to file regular reports with the agency, which provides investors with additional transparency and oversight.

Benefits for Investors

There are several reasons investors should consider adding a BDC to their portfolios.

The first is the potential for high yields. Because BDCs are required to distribute at least 90% of their taxable income to investors, they often have high dividend yields. In fact, many BDCs have dividend yields in excess of 10%. This can be attractive to income-oriented investors who are looking for sources of high yield.

A second benefit of investing in BDCs is the potential for capital appreciation. BDCs invest in a diverse portfolio of small and medium-sized businesses, which means that investors can potentially benefit from the growth and success of these companies. Additionally, BDCs often invest in debt securities that are secured by the assets of the underlying businesses, which can provide a level of downside protection.

Third, BDCs can provide diversification to a portfolio. BDCs invest in a variety of companies. They invest across different industries and sectors. This helps spread out the risks of investing in any one particular company or industry.

Fourth, BDCs can offer exposure to private markets. Because BDCs often invest in private companies, they can give investors access to opportunities that may not be available through traditional markets.

BDCs can be a good option for investors who are interested in supporting small and mid-sized businesses. By investing in a BDC, investors can help provide financing and support to companies that may not have access to traditional funding sources.

Assessing the Risks

However, investing in BDCs also carries risks. One of the main risks is credit risk. BDCs invest in privately held companies that may have limited operating histories or may be in distress. Additionally, BDCs often invest in debt securities that are rated below investment grade, which increases the risk of credit losses. Like a junk bond mutual fund, BDCs manage these risks by spreading out their bets.

Second, BDCs are also subject to regulatory risk. BDCs are heavily regulated by the SEC and are required to comply with a range of reporting and disclosure requirements. Changes in the regulatory environment could potentially impact the ability of BDCs to operate or could increase their compliance costs.

Despite these risks, investors should consider BDCs for their diversification, income, and exposure to private markets.

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