What is a Business Development Company (BDC)?

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Definition:

A business development company (BDC) is an investment firm that typically invests in small and medium-sized companies to help them grow.

🤔 Understanding BDCs

A business development company (BDC) is an investment firm that invests in either small or distressed companies. BDCs are a high-risk investment option, but they can result in high-yield dividends. BDCs came about in the 1980s due to a piece of legislation Congress passed to help smaller companies. The law created a type of investment company known as business development companies. These BDCs, often publicly traded companies, primarily invest in either smaller companies to help them grow, or in distressed companies to help them get some stability. To be considered a BDC, these investment companies must invest at least 70% of their money into these small and medium companies. BDCs are more accessible than venture capital funds because anyone can invest in them. They are a popular investment option because of the high dividends they can yield — though, as always, higher yields tend to come with higher risks.

Example

Currently, one of the largest business development companies is Ares Capital Corporation (ARCC). Ares formed in 2004 and went on to acquire another BDC in 2017 to become the largest. With a market value of about $7.9B, Ares invests in hundreds of companies in industries such as consumer services, health care, and insurance. As of 2019, the company had an average yield of more than 8%.

Takeaway

A business development company is like a tutor that only works with those students who need the most help…

Some tutors might focus on helping already advanced students get even further ahead. Similarly, in the world of finance, some investment firms would prefer to put their money into larger companies. But you might also have a tutor who prefers to help struggling students. That’s what BDCs do — They help companies who are either small or struggling to grow.

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What is a business development company (BDC)?

A business development company (BDC) is an investment firm that puts money into small, medium, and distressed companies to help them grow. Congress paved the way for BDCs by passing the Small Business Investment Incentive Act of 1980. The act was an amendment to the Investment Company Act of 1940, which regulates investment companies.

Throughout the 1970s, the country saw an increase in the wealth and prominence of large businesses. Congress, to encourage entrepreneurs to continue starting businesses, allowed for the creation of BDCs in the 1980 law, which is often referred to as the BDC Act.

BDCs provide a way for emerging companies to get the capital they need to grow. These firms also offer a way for financially struggling companies to get their hands on funding when they otherwise might not be able to.

How do you qualify as a BDC?

To qualify as a business development company (BDC), a firm has to meet several requirements. First of all, the purpose of BDCs is to provide funding opportunities to small, medium-sized, and distressed businesses. To ensure that BDCs fulfill their mission, the government requires that they invest at least 70% of their money into qualifying assets (the term used for those companies they’re intended to help).

Next, BDCs must be based in the United States. BDCs fall under the supervision of the Securities and Exchange Commission (SEC). BDCs have to register with the SEC and comply with reporting requirements, including a quarterly summary of the investments they hold.

How do BDCs work?

Most business development companies (BDCs) choose to register as Regulated Investment Companies (RIC). RICs are regulated by the Investment Company Act of 1940. To qualify as an RIC, a firm has to meet specific income and diversification requirements.

First, they have to meet a 50% test, which says that more than 50% of their assets at the end of each quarter have to be in specific types of investments, including cash, government securities, or securities of other RICs.

RICs also have to meet a 25% diversification test, which says that no more than a quarter of their assets can be in securities from a single issuer or two issuers in the same trade.

In addition to the diversification requirements, investment companies also have to distribute at least 90% of their profits every year as dividends.

There are tax benefits for BDCs who meet the requirements of an RIC. As long as they distribute at least 90% of their profits, they don’t have to pay corporate income taxes on those earnings. This perk is beneficial for investors, as it means the government isn’t taking a cut of the profits before you get your share.

Another feature of BDCs is that they are closed-end companies. Closed-end companies offer a fixed number of shares at the time of their initial public offering (IPO). After that, they don’t continue to sell shares. Instead, an investor would have to purchase them in a stock market exchange.

Additionally, closed-end funds don’t have redeemable shares, meaning they don’t have to buy back shares from investors. They can choose to, but they don’t have to.

The final key feature of closed-end funds is that they can invest in more illiquid securities than other types of funds. A higher rate of illiquid securities is a commonality across many BDCs.

How does a BDC make money?

A BDC generally makes money in one of two ways.

First, some BDCs make money by investing in equity, meaning they purchase either preferred or common stock in their portfolio companies (meaning the companies in which they are investing).

Most BDCs, however, make their money by investing in debt securities. In this case, the company invests in secured and unsecured debt (secured debt is backed by collateral, meaning some sort of asset, while unsecured debt is not). Debt BDCs also invest in unsubordinated debt, which is the debt that borrowers must pay back first before paying off any other obligations.

BDCs that invest in debt securities rather than equity tend to take on lower risk. Because the company that you’ve invested in is contractually obligated to pay back its debtors, you have a lower risk of losing your principal investment.

What is the difference between BDCs and venture capital?

There are two primary differences between a business development company (BDC) and a venture capital firm. First, venture capital firms aren’t tied to the 70% rule that BDCs are. As a result, they have greater flexibility as to where they can invest their money.

The other critical difference between the two types of firms comes down to who can invest — Venture capital firms limit who can invest. In general, their investors include financial institutions, hedge funds, endowments, corporations, and very wealthy individuals. The average investor probably wouldn’t be able to get in on a venture capital fund.

Unlike venture capital funds, just about anyone can invest in BDCs. BDCs are publicly traded companies, meaning you can use your brokerage account or retirement account to invest in these companies just as you would any other publicly traded company.

Though anyone can invest in BDCs, there’s generally a limit to the number of people who can invest in any particular BDC. These firms are closed-end funds, which means they only sell a fixed number of shares in their initial public offering (IPO). After that, you can only purchase shares on the stock market when someone is selling them.

What are the pros and cons of investing in BDCs?

Let’s talk about some of the advantages of investing in a business development company (BDC). First, BDCs are an accessible investment. Unlike similar venture capital firms, it’s easy for the average investor to get their hands on shares of a BDC.

Another advantage of investing in BDCs is that they often yield higher-than-average dividends. A primary reason for this perk is that BDCs have a more favorable tax structure than many corporations, where they don’t have to pay corporate income taxes on any profits that they distribute to shareholders.

Despite their advantages, BDCs aren’t without their risks. First, BDCs primarily focus on companies that are either small or medium-sized or companies that are struggling financially. In other words, they invest in companies that either haven’t had the chance to prove themselves yet, or companies that perhaps haven’t adequately managed the money they already have. As a result, there’s always the risk that these companies won’t perform as the BDC expects. Because BDCs usually invest in companies with similar characteristics, they also often have less diversification than other investment funds.

It’s also critical to remember that you’re putting your money at risk anytime you invest it in the stock market. No investment opportunity comes with any guarantee of return. Unless you’re investing in government-backed security, there’s an inherent level of risk.

In addition to the risk, there are other disadvantages as well. BDCs tend to include high fees, which will decrease the return you get. BDCs may charge loan servicing fees if they deal in debt securities. They also often charge incentive fees and management fees.

Are BDCs a good investment?

Ultimately, it depends on your risk tolerance and the type of business development company (BDC) in which you’re considering investing.

First, remember that this type of investment is not without its risk. This increased risk comes from the nature of the firms they invest in, the frequent lack of diversification in their portfolios, and the sensitivity to fluctuating interest rates.

Another thing to consider before investing in BDCs is that, like any other type of investment or fund, not all BDCs are created equal. Some BDCs will include higher management fees than others. There will also be varying rates of return from one BDC to the next, so it would be worthwhile to research your options before jumping in.

All investment carries risk. Always keep investing objectives in mind.

How does one invest in BDCs?

Anyone with a brokerage account can put their money in a business development company (BDC). Investing in BDCs works the same as investing in other types of stocks and ETFs . BDCs are publicly traded firms with a ticker symbol and shares available on the stock market.

There are a few different ways you can go about investing in BDCs. First, you can invest directly in a particular company by purchasing shares in that firm.

You can also invest in BDCs by investing in an exchange-traded fund (ETF). ETFs buy into assets of a particular type of company. Some kinds of ETFs focus on investing in firms in a specific industry. Others are specifically BDC ETFs, meaning they specialize in buying into BDCs.

BDC mutual funds and ETFs create a more diversified portfolio than just buying shares of a particular company. Spreading investments across multiple firms ensures that if one company goes under, the entire investment isn’t lost. Of course you are only investing in BDC companies so that does limit diversification.

If you want to get started with investing in BDCs, you can log into your brokerage account or speak with a financial advisor. All investment carries risk; always keep investment objectives in mind.

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