Business development companies (BDCs)

BDC basics

The US Congress amended the Investment Company Act in 1980 to create a new type of investment vehicle - a business development company (BDC). As the name suggests, BDCs help companies develop further by providing them capital in return for an investment. Structured as closed-end funds, BDCs invest in small and midsized companies. In particular, BDCs must invest at least 70% of their portfolio in companies with less than a $250 million market capitalization. Businesses of this size commonly struggle to obtain financing through traditional sources like banks. BDCs help connect investors with companies they may not otherwise have access to.

Let’s explore a real-world BDC to understand them better. We’ll specifically analyze Ares Capital Corporation (ticker: ARCC). Here are some highlights of this BDC as of September 2022:

• $21 billion portfolio
• Invested in 450+ companies
• Diversified across multiple industries and regions

BDCs like ARCC accomplish two goals. First, the businesses they invest in receive funding to grow their operations. Second, the investments purchased by ARCC provide returns that are passed on to their shareholders. The assets in ARCC’s portfolio include the following:

• Secured debt
• Unsecured debt
• Preferred stock
• Common stock
• Warrants

These investment types are common components of BDCs other than ARCC.

Let’s analyze a few specific investments in ARCC’s portfolio (as of September 2022):

• SoundCloud Ltd. - Music distribution platform - ARCC owns 73,000+ common stock shares
• Convey Health Solutions - Healthcare workforce software - ARCC owns $2.7 million in secured bonds
• Pelican Products, Inc. - Case, cooler, flashlight, and travel gear manufacturer - ARCC owns $60 million in secured bonds
• OTG Management LLC - Airport restaurant operator - ARCC owns preferred stock, common stock, and warrants

ARCC and other BDCs make a return when debt securities pay interest, stocks pay dividends, or any investment results in a realized capital gain (the BDC manager buys an investment at a low price, then later sells at a higher price). Additionally, BDCs are considered regulated investment companies eligible to claim Subchapter M. At least 90% of a BDC’s net investment income must be passed through to investors to qualify. Once meeting the 90% requirement, any returns distributed to investors are not taxable to the BDC. Instead, the tax bill goes to investors receiving these 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.

Suitability

BDCs can be suitable for some investors depending on their risk tolerance and profile. In particular, these investments are best for aggressive investors with high risk tolerances. We’ve previously discussed the risks of investing in small companies. In recessions, smaller businesses are typically the hardest hit and the first to go bankrupt. On the other hand, they have the most growth potential (typically in healthy economic environments).

The high-risk, high-reward potential applies here, arguably even more than it does with small-cap companies. Small-cap companies maintain 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 & return profile.

Benefits

BDCs offer both primary forms of return - capital appreciation (growth) and income.

Just like stocks, BDCs trade on a per share basis. If an investor purchases shares at a low price and sells them later at a high price, they realize a capital gain. While BDC market prices rise when their shares are in demand, the overall value of the investments in the BDC portfolio drives demand.

BDCs also pay dividend income to shareholders as the portfolio receives income from investments (debt securities and preferred stock in particular). As we discussed above, investors can expect higher-than-average yields. Investing in small companies is risky, but more risk means higher return potential, resulting in above-average dividend rates.

Risks

BDCs are risky due to the small business investments in their portfolios. Investors should expect market price volatility, as most BDCs maintain 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 are even more volatile than the already volatile small-cap market.

Generally speaking, all the typical common stock risks apply to BDCs, often at an amplified level. This includes:

• Market risk
• Inflation risk (on a short-term basis)
• Financial risk
• Business risk
• Regulatory risk

Additionally, these risks apply to the debt securities held in BDC portfolios:

• Default risk
• Interest rate risk
• Inflation risk

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 is traded 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”).

Typical investor

Aggressive investors willing to expose themselves to high levels of risk are most suitable for BDC investments. Additionally, investors with short-term time horizons should avoid these investments. The longer the time horizon, the more time the investor has to recoup losses experienced in an economic recession (when most small businesses struggle).