What is a BDC?
A BDC (Business Development Company) is a special type of investment that combines attributes of publicly traded companies and closed-end (private) investment vehicles. BDCs can provide exposure to investments similar to those associated with private equity or venture capital firms, including the potential for high yields but with added risk.
How do BDCs invest?
BDCs are specialty finance companies that invest primarily in the debt and equity of small to mid-sized U.S. companies. Their goal is to provide financing that helps these businesses grow.
Types of BDC investments:
- Debt investment types: Senior secured, subordinated, and unsecured debt
- Equity investment types: Preferred stock and common stock
Tax treatment and dividends of BDCs
BDCs may be registered as Regulated Investment Companies (RICs), which are not typically taxed at the entity level. 90% of the RIC's annual income must also be paid in dividends which, when combined with a structure that avoids double taxation, allows RIC-registered BDCs to typically pay out a higher dividend rate than common stock investments. Keep in mind that dividends received from BDC investments are taxed as regular income.
What are some potential benefits and risks of investing in BDCs?
Benefits of BDCs
Potential for higher yield
BDCs generally offer higher dividend yields than other common stocks due to their favorable tax structure.
Accessibility
BDCs are typically listed on national exchanges. These firms invest in private instruments not typically available to retail investors. BDCs allow investors to gain exposure to private equity-like investments without lockups or minimum investments.
Drawbacks of BDCs
Portfolio and diversification risk
While many BDCs are exchange-traded and considered liquid, they often concentrate assets in non-publicly traded companies, including small to mid-sized developing and distressed companies. These loans and investments may not be investment grade, are often illiquid and lack transparency, and may share risks in loan repayment and economic resilience. Each BDC invests across various companies but cannot hold more than 25% of its assets in one company.
Interest rate and financial structure risk
BDC investments can be highly sensitive to interest rate fluctuations, as the loans they provide to companies come from borrowed capital subject to higher interest rates and use a mix of fixed-rate and floating-rate loans. Additionally, interest rate policy changes can significantly affect borrowing-lending cost margins and BDC distribution capacity.
Management costs and risk
BDCs may charge management, incentive, loan-servicing, and other fees that can be quite high, difficult to calculate and may not be clearly disclosed. Additionally, their reliance on a small management team creates key personnel risk in the event someone leaves or needs to be replaced, adversely impacting the company.
Schwab's perspective on BDCs
We encourage investors interested in BDCs to consider their risk tolerance and to view these products as higher-yield, higher-risk investments that warrant careful evaluation and may not be appropriate for all investors. BDCs generally invest in illiquid debt securities with high credit risk, which can lead to increased volatility and potential large price drops during market downturns. BDCs are better suited as part of your equity allocation, not as a substitute for fixed income.
Common BDC investments
BDCs invest in several different types of non-public securities including tiered investment structures.
Common stock
- Bottom tier of corporate equity shares
- Earnings on dividends vary and are subordinate to preferred stockholders
- Last in line for asset distribution during liquidation
Preferred stock
- Upper tier of corporate equity shares
- Grants stockholders higher claims to dividends and asset distribution
Senior secured debt
- Top-priority debt repayment secured by collateral
- Settled first in the event of company liquidation
- Collateral assets can be sold to cover the debt
Subordinated or unsecured debt
- Collected after higher priority debt has been paid
- Not backed by any collateral
- Presents a higher level of risk to investors
How do I invest in BDCs?
You can buy and sell BDCs on your own with a Schwab One® Brokerage Account or call 888-245-6864 to talk to an experienced specialist about BDCs.
Frequently Asked Questions about BDCs (Business Development Companies)
The main difference between BDCs and traditional private equity firms is that BDCs are publicly traded, meaning individual investors can buy and sell shares on a stock exchange, while private equity funds are typically only accessible to institutional investors and high-net-worth individuals. BDCs also tend to focus on providing debt financing to small- and mid-market companies, whereas private equity firms tend to serve larger companies and play a more active management role where operational improvements can provide significant value.
Shares of BDC stocks can be purchased by investors using a brokerage account, just like any other publicly traded stock. Search for BDC companies by their ticker symbols and place an order to buy shares in your account. You can also invest in BDCs using exchange-traded funds (ETFs) that track a basket of BDC stocks.
BDCs make money by lending to and investing in small and mid-sized businesses. Their primary income source is interest from loans, often at high rates and sometimes floating, which benefits from rising interest rates. They also earn money from loan fees (e.g., origination, commitment, and prepayment) and may potentially generate capital gains by taking equity stakes in portfolio companies. BDCs use leverage to potentially amplify returns, borrowing at lower rates and lending at higher ones.
BDCs might be a good fit for income investors who consider them a part of a diversified equity allocation, understand their unique risks, and perform due diligence. They are not well suited for conservative or growth-focused investors or as a substitute for fixed income investments.