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Income-hungry investors often seek unconventional opportunities for higher yields. A lesser-known type of investment called a business development company (BDC) may help satiate their appetite.
BDCs tend to offer outsized dividend yields—often 5% to 14% or more. Some outperforming BDCs may occasionally offer dividend increases, too, making them attractive investments for income seekers and retirees, especially in today’s low-interest environment. BDCs’ higher yields also come with increased risks, though, so it’s worth doing some research before adding them to your portfolio.
What Is a Business Development Company?
A business development company invests money in privately owned, small- and medium-sized companies. Generally the businesses are facing challenges and need help to grow or get back on track, and they may not be able to obtain financing through traditional means, like bank loans or bond issues.
BDCs aim to generate income and capital gains when the companies they invest in are sold, much like venture capital or private equity funds. Business development companies are attractive choices because almost anyone can invest in them. That’s because they are public companies, traded on major stock exchanges. Venture capital and private equity are only available to accredited investors with large net worths.
Business development companies were created by Congress in 1980 to jumpstart America’s sputtering economy by helping fledgling small businesses raise money to scale and create jobs. Today, there are 47 publicly traded BDCs with a combined market capitalization of more than $49 billion as of April 2021, according to Closed-End Fund Advisors, which tracks BDC data and research.
How Does a BDC Work?
A BDC is regulated under the Investment Act of 1940 and the Securities and Exchange Commission (SEC). As Regulated Investment Companies, BDCs aren’t considered taxable entities. In exchange for this favorable tax treatment, however, a BDC must distribute at least 90% of its taxable income to shareholders as ordinary dividends each year.
Since they retain very little of their earnings, BDCs don’t pay corporate taxes. They’re taxed only once—at the shareholder level, not at the corporate or individual levels. In this way, BDCs are similar to Real Estate Investment Trusts (REITs), which own and often operate income-producing real estate like office buildings and shopping malls. With both BDCs and REITs, this means you as an investor end up paying the taxes on your investments’ earnings.
In addition, to meet federal regulations, BDCs’ portfolio company holdings must adhere to specific diversification requirements. For example, at least 70% of a BDC’s assets must be invested in U.S. public or private companies with market capitalizations under $250 million. What’s more, no single investment can account for more than 25% of its holdings.
Advantages of BDC Investing
In addition to their higher-than-average dividend yields, BDCs come with many advantages:
•Access to private companies. You get access to private market investments, which can otherwise be unavailable or hard to access for regular investors. BDCs offer easy exposure to a potentially vibrant part of the market that would be very challenging to access otherwise.
•Enhanced liquidity. Even if retail investors find a way to buy into private companies, they face another problem: Getting their money out. Companies that are not publicly traded are generally highly illiquid investments. You might have to wait years for a liquidation event, or you could possibly sell for a loss on the secondary market if you’re really in a bind. Publicly traded BDCs give you excellent liquidity, and you avoid locking your money up for extended periods.
•More transparency. As highly regulated public companies, BDCs are required by law to provide their investors with extensive information about their financial health. Private companies aren’t required to tell their direct investors much of anything about their finances. This can help you ensure your investing dollars are being spent wisely.
Risks of BDC Investing
While they come with many advantages, BDCs are not without their risks:
•Relatively short track records. Although the BDC format was pioneered in the 1980s, the majority have only existed since the early 2000s. Their histories are still relatively short, giving would-be investors limited information to consider when weighing the options.
•Large debt exposure. BDCs rely heavily on debt when they invest in their portfolio companies, which are privately held or thinly traded, making them largely illiquid. An economic downturn like the one we experienced due to the Covid-19 pandemic could cause the portfolio companies to go out of business and possibly default on their loans.
•Interest rate sensitivity. BDCs are sensitive to interest rate spikes, which can make it more expensive for them to borrow money, hindering their profit margins and ability to invest.
•Higher tax rates.While BDCs themselves get away from Uncle Sam tax free, you don’t. In fact, you’ll probably end up paying more on your BDC dividends than other dividends in your portfolio because BDC dividends are taxed at ordinary income rates, or the normal rate you pay on income like your paycheck. For example, a single person with an annual income of $50,000 would be taxed 22% on any BDC dividends earned in 2021. By contrast, “qualified dividends” from other types of income investments, like stocks and bonds, may be taxed at lower capital gains rates—15% in this example.
How to Invest in Business Development Companies
You can buy and sell BDCs just like you would a stock or exchange-traded fund (ETF). Each has its own unique ticker symbol, and you can purchase shares in a brokerage account or individual retirement account (IRA).
If you’re new to BDC investing, or simply want easy diversification, you may opt for an ETF that invests in many BDCs for you.
For instance, the VanEck Vectors BDC Income ETF (BIZD), tracks some of the larger, better-known players in the BDC space, including Ares Capital (ARCC), Main Street Capital (MAIN) and Prospect Capital (PSEC). All are publicly traded companies with current dividend yields between 5% and north of 8%. BIZD delivers an 8.5% dividend yield as of late April 2021.
Exchange Traded Options
Exchange-traded notes (ETNs) are another option. ETNs are similar to ETFs, except they’re more like bonds. ETNs are unsecured notes issued by institutions that can be held to maturity or bought and sold at will. One risk of an ETN is that its issuing institution could receive a credit downgrade, which could cause a decline in the value of the ETN’s shares unrelated to the underlying product it tracks.
Investors wishing to purchase a basket of BDCs vs. individual securities may find ETFs and ETNs offer the best of all worlds. Still, they aren’t a panacea, cautions Duane Batcheler, an author and research analyst who provides research for BDC investors at BDCBuzz.com.
“BDCs are still a niche sector,” he says. “There are a few [ETFs/ETNs], but they continually underperform, paying much lower distributions due to fees and poor allocation. Often, the top five or six allocations account for 50% of the fund and are usually BDCs with limited dividend and price appreciation potential.”
Should You Invest in a BDC?
Tax Implications of BDC Investing
As with any investment, it’s important to do your homework so you can make an informed decision. According to Batcheler, BDCs are worth considering for tax-advantaged accounts, like IRAs because of their potential long-term returns.
“Investors can benefit from the compounding returns on aggressive income-producing [instruments like BDCs],” says Batcheler. As long as you keep them in a tax-advantaged account, you won’t owe annual taxes on any income they produce. “That means these returns [could be] compounding and growing your portfolio faster, assuming you choose carefully.”
BDCs aren’t for everyone, however. More conservative investors may not be able to stomach the risks. But for income-oriented investors willing to do their research and recognize that the risks are a trade-off for higher dividend yields, BDCs may be an appetizing addition to a well-diversified portfolio.
