Business Development Companies (BDCs)
BDCs are open to all investors, including retail investors. BDCs pool money from investors and are organized to invest in two types of businesses: 1) small- and medium-sized companies in their initial development stages and 2) distressed companies that may be unable to raise money from other investors or to obtain traditional bank loans and are looking to balance their finances.
BDCs’ offerings of shares are similar to closed-end investment funds in that the shares are registered with the U.S. Securities and Exchange Commission (SEC). As such, BDCs are subject to regulation by the SEC. Investors own shares of the BDC, representing a pro-rata or proportional share of the investment.
SEC registration provides some investor protections such as disclosure about the BDC’s investments and certain restrictions on leverage use. However, because they are structured differently than ETFs, closed-end funds, or mutual funds, BDCs have more freedom to invest using debt and other leverage.
BDCs may be publicly-traded, non-traded, or structured as private BDCs.Key Characteristics of BDCs
Investing in BDCs has unique benefits and risks. Generally, a BDC must invest at least 70% of its assets in U.S. non-financial sector operating private companies or public companies with a market cap of less than $250 million. BDCs invest in debt and equity of small and medium-sized private companies or small public companies. The BDCs investments may include privately issued securities, distressed debt, and government securities. Sometimes BDCs may get involved in the management of the companies they invest in.Illiquid Investments
BDCs may provide higher returns than other types of funds. For example, their equity investments may have growth potential, and their debt investments may earn higher interest rates than other debt investments. However, with increase potential gain, also comes increase risk.
BDCs provide exposure to private companies that do not make public disclosures and whose shares do not regularly trade on national securities exchanges. The investments are often illiquid. An investor seeking to confirm the worth of a company or find information about the companies a BDC invests in may not be able to obtain this information. Some companies may also be at risk of defaulting on their debts or going out of business.Income Distributions v. Tax Payments
Most BDCs are required to distribute 90% of their taxable income to investors each year. Distributions can include revenue generated by the fund, such as dividends, interest income, or capital gains. Distributions can also include a return of capital. If the distributions include a return of capital, BDCs may not be as tax efficient as other investments.Exposure to Debt or Leverage
Compared to other types of funds, BDCs often use more leverage or debt to purchase their investments. The use of leverage can increase an investor’s returns but also an investor’s losses. It can also increase risk and add volatility to the BDC share price.
Higher interest rates can also reduce a BDCs’ profits.Premium v. Discount
BDC shares may have a market price that is higher or lower than the shares’ net asset value (NAV) of the fund’s underlying investments.
Shares sold at a premium sell at a price higher than the NAV, while shares sold at a discount sell at a price lower than the NAV. Depending on when the investor makes the investment, they may pay more or less than the NAV.
Investors who purchase shares at a discount may not be able to sell the shares other than at a discount.Higher Fees
BDCs often have higher fees than ETFs or mutual funds. A BDC’s high fees may reduce the value of the investment.
First, BDCs’ investment managers are often SEC-registered investment advisers with an advisory fee that equals 1.5% to 2% of the fund’s gross assets per year. Additionally, they may receive certain incentive fees, which may go up to 20% of any profits earned.
Second, management fees are generally calculated on gross assets, including leverage. Accordingly, BDC management fees charged to investors may be higher depending on the amount borrowed by a BDC.
Third, operating expenses may be higher than those of other types of funds. An investor who buys BDC shares in the initial offering will pay a commission or sales charge that will be a percent of the purchase price. This commission or sales charge is usually avoided by investors who purchase BDC shares on a securities market; however, they will still owe brokerage commissions.Elderly Investors
Though BDCs may be attractive to investors due to their high dividend yields, they are often considered high-risk investments with high sales commissions and unfavorable fee structures. FINRA has previously cautioned investors about the risks of non-traded or unlisted BDCs, which may be illiquid and offer investors limited opportunities to exit (i.e., periodic share repurchases at high discounts). BDCs are considered high-risk, speculative investments for elderly customers.