Business development companies are closed-end alternative investment funds that can allow retail investors to invest in privately owned small or medium-sized businesses.
What is a business development company?
A business development company (BDC) is a closed-end, alternative investment vehicle used to pool capital to fund small and/or medium-sized businesses. Shares of BDCs may be owned by any type of investor, including retail investors, and are sometimes—but not always—traded on major public exchanges.1
In an effort to meet the financing needs of small businesses across the country, Congress developed BDCs in the 1980s as part of an update to the Investment Company Act of 1940.2 Following the Global Financial Crisis in the late 2000s and as the corporate banking sector retrenched from lending to smaller businesses, BDCs flourished, with total assets surpassing $200 billion by the end of 2021.3 As a result of this more recent growth, BDCs are now more often associated with private credit or direct lending strategies.
Because they use a closed-end structure, BDCs may allow their investors a way to gain exposure to a set of more illiquid assets through a relatively more liquid vehicle than other types of traditional finite-life, drawdown private equity or private debt funds. As a result and also thanks to lower minimum investments and accreditation requirements as compared to most private funds, investors may have an opportunity to use BDCs to invest in private markets asset classes that have been historically inaccessible to them.
BDCs and their securities are regulated by the US Securities and Exchange Commission under the terms of the Investment Company Act of 1940 and the Investment Advisers Act of 1940 and must also fulfill the disclosure requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934.4
What investments make up a business development company?
Unlike mutual funds or other exchange-traded funds that invest in traditional assets, BDCs tend to focus on private markets. A BDC is required to invest a significant portion (at least 70%) of its portfolio in eligible assets like private companies—or smaller cap (less than $250 million in market capitalization) public companies—predominantly based in the United States.5 A BDC generally aims to fuel the growth of these smaller or middle market non-public companies.
BDCs may invest in either the debt or equity of these companies through investments akin to those negotiated by private equity or private credit funds that are limited in some cases to investors of higher accreditation. Debt investments a BDC makes may include senior secured loans, secured bonds, or unsecured, subordinated debt.6 Equity investments can include common or preferred stock.7
How do business development companies work?
BDCs generally aim to generate returns for their shareholders through the interest, fees, or capital appreciation from their portfolio companies. BDC managers may leverage their experience, resources, and network to influence the management and operations of its underlying portfolio companies, seeking to create additional value for its shareholders.
In some cases, BDCs may qualify as a regulated investment company (RIC), which may offer some tax advantages for shareholders.8 In particular, as an RIC, a BDC can seek to avoid double taxation and offer pass-through treatment of its income and long-term capital gains. Registered BDCs are required to distribute 90% of their taxable income to shareholders annually.9 Since these BDCs typically do not retain the bulk of their yearly earnings, their potential returns may fluctuate year over year.
What are the different types of BDCs?
BDCs may be characterized by whether they are traded on a public exchange; two main types are publicly traded and non-traded BDCs.
Publicly traded BDC – Publicly traded BDCs may be listed on major exchanges, such as NASDAQ; shares of a BDC typically trade at a premium or discount to the fund’s net asset value (NAV). While offering potentially greater liquidity, publicly traded BDCs may be more directly impacted by general trends in public equity markets and may have relatively higher correlations with stocks, especially small cap stocks, than other private markets funds.
Non-traded BDC – A non-traded BDC operates similarly to other closed-end private markets funds in that they are designed as long-term investments and may only provide limited liquidity after a certain period, generally five to seven years after the fund launches.10 However, some of these BDCs offer share repurchase programs to provide investors with interim liquidity.11 The BDC may also seek to provide its investors with liquidity by listing on a public exchange or by selling part or all of its portfolio.12 Other non-traded BDCs are designed with a perpetual life model.13 While non-traded BDCs may be more illiquid, they may encounter less pricing volatility than their publicly traded counterparts.
Though many offer a mix of underlying debt and equity investments, BDCs may also be classified by their focus on either debt or equity investing. Certain asset managers may offer separate BDCs for each to more specifically target either the income or capital appreciation goals of their prospective investors.14 As mentioned before, in recent years, BDCs have been more often associated with private debt—specifically private credit or direct lending strategies.
What are some costs and risks associated with BDCs?
Though they are available to most investors, BDCs remain complex and may carry many of the same risks associated with their underlying asset classes; advisors should be aware of the risks and costs related to these structures when making investment decisions. These risks may include:
Interest rate or credit risk – BDCs may use moderate leverage when lending to or investing in their portfolio companies, potentially leaving them vulnerable to interest rate fluctuations. Depending on their strategy, they may also be susceptible to the credit risk of their portfolio companies, which may be unable to pay back their debt obligations. Such credit risk may be especially high if a BDC invests in distressed or earlier-stage businesses.
High fees and tax rates – As actively managed strategies, BDCs may have relatively high management fees that can diminish the fund’s overall net returns. In addition, BDCs dividends may be treated as ordinary income, potentially impacting an investor’s tax obligations.15
Liquidity risk – A BDC invests in mostly non-traded companies that may not be easily valued or sold, which may affect the overall liquidity of the vehicle.
Diversification risk – BDCs tend to invest much of their portfolios in companies of a similar size, which may share similar cash flow profiles and be vulnerable to similar market shocks.16 Therefore, an advisor may consider the degree to which a specific fund is diversified across other dimensions.