What are BDCs?
Business Development Companies or BDCs are investment companies, formed pursuant to the Small Business Investment Incentive Act of 1980, which make investments in US mid-market companies in the form of long-term debt or equity capital. BDCs have grown in popularity over the last decade 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 last resort borrowers, a BDC is similar to the better-known venture capital fund. A publicly traded BDC allows individual investors 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 enabling 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. While BDCs are permitted to invest anywhere in the capital structure, the vast majority of recent BDC investment has been debt. In addition to helping mid-market companies finance their growth, BDCs are also required to provide managerial assistance to their portfolio companies, which assistance may include guidance and counsel on a variety of ongoing business issues like management, operations, personnel, finance, sales and marketing and the evaluation of acquisition and divestiture opportunities. 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 to the lender should interest rates rise. In most cases, the loan structure will provide the BDC with a first-position lien on the assets of the borrower.
By regulation, a BDC must invest at least 70% of its assets in private or public US firms with market values of less than $250 million, must limit the size of each individual investor to 5% of the fund and must maintain an asset coverage ratio of 2 to 1 (meaning $2 of assets for every $1 of debt). In April, in the early weeks of the coronavirus crisis, the SEC issued guidance allowing for a recalculated ratio so that BDCs will have more room to support their portfolio companies. 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 Apollo Investment Corporation (12.92%), Ares Capital Corporation (11.23%), and Prospect Capital Corporation (14.06%). Investors receive these rich yields in return for the elevated risk associated with these investments. In bull markets, BDCs have the potential to perform well, however in risk-adverse markets BDCs will perform more poorly than the broader market. Given their high-risk profiles, BDCs are best considered an alternative strategy limited to just a few percent of your portfolio holdings.