In 1980, the US Congress amended the Investment Company Act to create a new type of investment vehicle: a business development company (BDC). As the name suggests, BDCs help businesses develop by providing capital in exchange for an investment.
BDCs are structured as closed-end funds and invest primarily in small and midsized companies. By rule, BDCs must invest at least 70% of their portfolio in companies with less than a $250 million market capitalization. Companies of this size often have trouble getting financing from traditional sources like banks, so BDCs can connect investors with businesses they might not otherwise be able to invest in.
To make this more concrete, let’s look at a real-world BDC: Ares Capital Corporation (ticker: ARCC). Here are some highlights as of September 2022:
BDCs like ARCC serve two related purposes:
The assets in ARCC’s portfolio include the following:
These investment types are common components of BDCs other than ARCC.
Let’s look at a few specific investments in ARCC’s portfolio (as of September 2022):
ARCC (and other BDCs) can earn returns in several ways:
BDCs are also considered regulated investment companies eligible to claim Subchapter M. To qualify, at least 90% of a BDC’s net investment income must be passed through to investors. If the BDC meets this 90% requirement, the distributed returns aren’t taxable to the BDC. Instead, the tax obligation passes through to the investors who receive the distributions.
BDCs are typically registered under the Investment Company Act of 1940 and regulated by the Securities and Exchange Commission (SEC) as closed-end management companies. Many BDCs are listed on stock exchanges (ARCC is listed on NASDAQ), but some are unlisted and trade over-the-counter (OTC)*.
*Stock exchanges are centralized locations and platforms that allow investors to trade securities quickly and efficiently. A trade executed outside of stock exchanges occurs in the OTC market. Later in the Achievable materials, the secondary markets unit discusses these markets in further detail.
BDCs can be suitable for some investors, depending on their risk tolerance and overall profile. In general, these investments are best suited for aggressive investors with high risk tolerances.
We’ve previously discussed the risks of investing in small companies. During recessions, smaller businesses are often hit hardest and may be the first to go bankrupt. In stronger economic environments, those same businesses may have higher growth potential.
That high-risk, high-reward tradeoff often applies even more strongly to BDCs than to small-cap stocks. Small-cap companies typically have market capitalizations between $300 million and $2 billion, while BDCs are generally limited to investments in companies with $250 million or less in market cap. Bottom line: the smaller the business, the larger the risk and return profile tends to be.
BDCs offer both primary forms of return - capital appreciation (growth) and income.
Like stocks, BDCs trade on a per-share basis. If an investor buys shares at a low price and sells them later at a higher price, they realize a capital gain. While BDC market prices rise when shares are in demand, that demand is largely driven by the overall value and performance of the investments held in the BDC’s portfolio.
BDCs may also pay dividend income to shareholders when the portfolio generates income (especially from debt securities and preferred stock). As noted above, investors may expect higher-than-average yields. Investing in smaller companies is riskier, and that added risk can translate into higher return potential, including above-average dividend rates.
BDCs are risky because they invest in smaller businesses. Investors should expect market price volatility, since most BDCs have a beta above 1. The Russell 2000, which tracks the values of 2,000 small-cap stocks, is typically the benchmark index for this type of investment. With betas usually exceeding 1, BDCs tend to be even more volatile than the already-volatile small-cap market.
In general, the typical common stock risks apply to BDCs, often in amplified form. This includes:
Additionally, these risks apply to the debt securities held in BDC portfolios:
Liquidity risk* may also apply to a BDC, depending on how it trades. Two general categories exist - publicly listed BDCs and private unlisted BDCs.
Public listed BDCs are available to all investors, trade on stock exchanges (e.g., the NYSE), and are subject to the same regulatory oversight as publicly traded stocks. This type of BDC generally trades easily and avoids liquidity risk.
Private unlisted BDCs are typically made available only to sophisticated investors** through private placements*** and avoid much regulatory oversight. This type of BDC does not trade in the secondary market and is subject to significant liquidity risk.
*We’re discussing liquidity risk in terms of the BDC investment itself. The securities held in a BDC portfolio may also experience liquidity risk, further amplifying this risk.
**A sophisticated investor has market experience, expertise, and access to resources and capital. These are typically wealthy retail and institutional (large financial organization) investors.
***Private placements are private securities offerings made primarily to wealthy retail and institutional investors. We cover this type of offering in a future chapter.
BDC market prices typically decline when the risks listed above apply, potentially resulting in capital losses (investment losses; “buy high, sell low”).
Aggressive investors who are willing to accept high levels of risk are generally the best fit for BDC investments. Investors with short-term time horizons should typically avoid these investments. With a longer time horizon, an investor has more time to recover from losses that may occur during an economic recession (when many small businesses struggle).
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