A prolonged period of low interest rates has made it difficult for investors to find investments that provide a high level of current income. At the same time, in the face of sweeping regulatory changes, many banks have reduced or eliminated lending to private U.S. middle market companies. Business development companies (BDCs) have emerged as both an alternative source of income and diversification for investors and a timely source of capital for private U.S. middle market companies.
BDCs facilitate the flow of capital from individual investors to U.S. middle market companies. BDCs were created by Congress in 1980, but it was in the years following the 2008 financial crisis—a period of rapid consolidation in the banking industry—that they experienced their greatest period of growth. By pooling investments from individual investors, BDCs help provide many middle market companies with the capital necessary to operate and grow their businesses. A BDC must invest at least 70% of its assets in private U.S. companies or public companies with a market capitalization of less than $250 million.
BDCs are regulated under certain provisions of the Investment Company Act of 1940, which provide limited regulatory protections. BDCs are required to:
- Maintain an independent board of directors and custodian, which holds and safeguards the BDC’s assets similar to how an escrow account functions
- Disclose financial performance through regular filings with the U.S. Securities and Exchange Commission (SEC)
- Provide the value of its investments on a quarterly basis
Role in a portfolio
BDCs may help investors achieve a range of investment objectives based on the types of securities in which they invest. BDCs that invest primarily in a company’s debt (senior secured loans and bonds) may serve as an alternative source of income. Senior secured loans are typically the first to be repaid in the event a company defaults on its obligations, ahead of subordinated debt and equity holders. Subordinated (high yield) bonds have historically had lower recovery rates in the event of default than senior secured loans, due to their lower priority for repayment.
BDCs that invest predominantly in equity securities may assume a higher degree of risk as compared to BDCs that invest primarily in senior parts of the corporate capital structure. In exchange for assuming a higher level of risk, equity-focused BDCs may provide a higher level of return and growth. Investors should carefully consider a BDC’s investment objectives and asset allocation to ensure they are properly aligned.
BDCs typically invest in below-investment-grade companies, which means that they may, among other things, experience higher default rates and may be more illiquid and difficult to value compared to investment-grade companies. A BDC’s yield and total return potential should be weighed against the level of risk assumed within the portfolio.
An investment in a BDC can involve significant costs. Investors should consider a BDC’s fees as well as liquidity, or the frequency with which an investor may buy or sell their shares. Public BDCs trade on a national securities exchange and typically provide investors with liquidity on a daily basis. Shares of publicly traded BDCs are subject to the daily volatility of the public markets.
A private BDC does not trade on a national securities exchange and is designed as a long-term investment, generally providing investors with limited liquidity five to seven years following its launch. Private BDCs seek to provide liquidity through a listing on a national securities exchange or through a sale or merger of its portfolio. In addition, the share price of a private BDC is typically based on the value of the fund’s investments while public BDC shares can trade at a premium or discount to net asset value.
Investors need a clear understanding of the risks and benefits of BDCs to make well-informed decisions on how to best incorporate them to construct diversified portfolios. Working with a financial advisor, investors should take these primary considerations into account before investing.