Business Development Companies (BDCs) are a special type of investment that combines attributes of publicly traded companies and closed-end investment vehicles, giving investors exposure to private equity- or venture capital-like investments.
BDCs are considered specialty finance companies and primarily make investments in the debt and/or equity of small to mid-size companies predominantly in the U.S. An example of investing in debt would be senior secured debt, subordinated debt, or unsecured debt. An example of investing in equity would be preferred stock or common stock. Some companies may offer two or more BDCs, one BDC for investing in their debt and another BDC for investing in their equity.
BDCs may be registered as Regulated Investment Companies (RIC), potentially giving investors a tax advantage. RICs must distribute 90% of their income to investors allowing the corporate entity to be exempt from federal taxes. Recent legislation increased the amount of leverage a BDC may take on to a 2-to-1 ratio; as a result, this can amplify losses in a poor economic environment. BDCs may be internally or externally managed with the majority of newly formed BDCs being externally managed. BDC managers will offer significant managerial assistance to the companies held in the portfolio.
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Benefits of BDCs
Potentially high yield
BDCs generally offer higher dividend yields than other common stocks due to their favorable tax structure.
BDCs are typically listed on a national exchange and provide investors considerable liquidity. These firms invest in private instruments that are not typically available to retail investors. BDCs allow investors to gain exposure to private equity-like investments without lockups or minimum investments.
Risks of BDCs
Portfolio and liquidity risk
BDCs hold illiquid investments in non-publicly traded companies. These loans and investments may not be considered investment grade and are often illiquid and not transparent.
Key personnel risk
The BDC's investment decisions are undertaken by a small team of managers. If part of the team leaves the firm, there may be an adverse effect on the company, including a loss of management expertise to the portfolio companies and financing relationships. The board of directors can also vote to replace the external manager.
Credit and interest rate risk
These investments can be highly sensitive to fluctuations in interest rates. BDCs must borrow money in order to lend to companies at higher rates. They accomplish this by using a variety of fixed-rate and floating-rate loans. Changes in interest rate policy can dramatically affect the margin between borrowing and lending costs and the amount the BDC is able to distribute.
BDCs have a concentration of assets held in small to mid-size developing and distressed companies. These companies can have similar attributes in regard to their ability to repay a loan and their ability to weather a prolonged economic downturn. Each BDC is invested in a variety of companies and cannot hold more than 25% of its assets in a single company.
High management fees
The costs associated with BDCs can be quite high and can be difficult to calculate. BDCs may charge management fees, incentive fees, as well as other fees associated with servicing loans. These fees may not be clearly disclosed and may detract from the total return.
Business development companies generally offer higher dividend yields than many other investment alternatives, but those higher yields come with greater risks. The debt securities that generally make up a BDC's investment portfolio are relatively illiquid and tend to have high credit risk, or the risk of default, leading to increased volatility and a greater likelihood of large price declines during a market downturn. BDCs should not be considered bond substitutes and should be considered part of the equities allocation of your overall portfolio, not fixed income.
Common types of BDCs
BDCs invest in several different types of non-public securities, which often include tiered investment structures.
Common stock is the bottom tier of corporate equity shares. Common stockholders' earnings on dividends vary and are subordinate to preferred stockholders. In the event of liquidation, common stockholders are last in line for asset distribution.
Preferred stock is an upper tier of corporate equity shares that grants stockholders higher claims to dividends and asset distribution.
Senior secured debt
Senior secured debt is a top-priority debt repayment secured by collateral. If a company is liquidated, senior debt is settled first, and if it's secured debt, collateral assets can be sold to cover the debt.
Subordinated or unsecured debt
Subordinated debt, such as junior debt, is collected after higher priority debt has been paid. Unsecured debt is not backed by any collateral, which presents a much higher level of risk to investors.
Your approach to investing in BDCs depends on what type of investor you are. BDCs aren't low-risk investments and therefore may not be appropriate for investors without a high level of risk tolerance. At Schwab, we provide the help you need to build a strong portfolio, whichever way you prefer to invest. You can buy and sell BDCs on your own with a Schwab One® brokerage account or call 877-566-0054 to talk to a Schwab representative about whether BDCs are right for you.
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