Business Development Company (BDC)
Get a better understanding of what BDCs are and considerations for incorporating them into your investing or trading strategy.
What is a BDC?
A BDC is a special type of investment that combines attributes of publicly traded companies and closed-end (private) investment vehicles.
BDCs can provide exposure to investments similar to those associated with private equity or venture capital firms, including the potential for high yields but with added risk.
BDCs are considered specialty finance companies that invest primarily in different types of debt and/or equity of small- to mid-size U.S. companies:
- Debt investment types: Senior secured, subordinated, unsecured
- Equity investment types: Preferred stock, common stock
Some companies may offer two (or more) BDCs, one for investing in their debt and another for investing in their equity. BDC managers will offer significant managerial assistance to the companies held in the portfolio.
BDCs may be registered as Regulated Investment Companies (RICs), which are not typically taxed at the entity level. 90% of the RIC’s annual income must also be paid in dividends which, when combined with a structure that avoids double taxation, allows RIC-registered BDCs to typically pay out a higher dividend rate than common stock investments. Keep in mind that dividends received from BDC investments are taxed as regular income.
Benefits and drawbacks of BDCs
Benefits of BDCs
Potential for higher yield
BDCs generally offer higher dividend yields than other common stocks due to their favorable tax structure.
Accessibility
BDCs are typically listed on national exchanges. These firms invest in private instruments not typically available to retail investors. BDCs allow investors to gain exposure to private equity-like investments without lockups or minimum investments.
Drawbacks of BDCs
Portfolio and liquidity risk
While many BDCs are exchange-traded and considered liquid, BDCs hold illiquid investments in non-publicly traded companies. These loans and investments may not be investment grade and are often illiquid and lack transparency.
Credit and interest rate fluctuations
BDC investments can be highly sensitive to interest rate fluctuations. BDCs must borrow money to lend to companies at higher rates. They use a mix of fixed-rate and floating-rate loans. Interest rate policy changes can significantly affect borrowing-lending cost margins and BDC distribution capacity.
Management fees
Costs associated with BDC investments can be quite high and challenging to calculate. The BDC may charge management, incentive, loan-servicing, and other fees that may not be clearly disclosed and reduce the investment’s total return.
Key personnel risk
BDC investment decisions rely on a small management team. If part of the team leaves, it can adversely impact the company, causing potential management expertise loss. The board can vote to replace the external manager if needed.
Diversification risk
BDCs often concentrate assets in small to mid-size developing and distressed companies. Such companies may share risks in loan repayment and economic resilience. Each BDC invests across various companies but cannot hold more than 25% of its assets in one company.
Publicly Traded Business Development Companies (BDCs): Investor Bulletin
The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to provide investors information about business development companies, or BDCs, that are traded on national securities exchanges. It is important to understand them before investing. Learn more about BDCs whose shares are not traded on national securities exchanges at Non-Publicly Traded Business Development Companies (BDCs): Investor Bulletin.
What are BDCs?
BDCs are a type of closed-end investment fund. They are a way for retail investors to invest money in small and medium-sized private companies and, to a lesser extent, other investments, including public companies. BDCs typically invest in companies that are in the early stages of development or are financially distressed. BDCs are sometimes compared to venture capital funds or private equity funds, which provide exposure to private, often illiquid, investments and may provide assistance to the companies they invest in. Some BDCs are focused on investing in private credit loans, which generally means they lend money directly to businesses or purchase syndicated loans. Syndicated loans are loans to businesses generally originated by a bank and sold in several pieces to other investors.
BDCs are complex and have certain unique risks. BDCs also may be structured in different ways. One way that BDCs can differ is in whether their shares are traded on national securities exchanges. This Investor Bulletin discusses features of BDCs generally, with a particular focus on BDCs whose shares can be bought and sold on national securities exchanges, or “publicly traded” BDCs.
BDCs are not registered with the SEC as investment companies. However, BDCs are subject to many protective provisions of the Investment Company Act, such as governance requirements, compliance and recordkeeping provisions, and prohibitions on certain conflicts of interest.
How are publicly traded BDCs similar to other SEC-regulated investment funds?
In some ways, publicly traded BDCs are similar to other SEC-regulated investment funds – like mutual funds, other closed-end funds, and exchange-traded funds (ETFs):
- They pool money from many investors and invest that money.
- All types of investors, including retail investors, can own shares.
- Investors own shares representing a pro rata or proportional part of the BDC.
- Their offerings of shares are registered with the SEC, and they are regulated by the SEC.
- Their investment managers may be investment advisers that are registered with the SEC.
Publicly traded BDCs are also similar to other closed-end funds and ETFs in that their shares are typically bought and sold on national securities exchanges at market prices.
How are BDCs different from other SEC-regulated investment funds?
As a technical matter, BDCs are not registered investment companies. However, they elect to be subject to many of the regulations applicable to registered investment companies.
The main difference between BDCs and other SEC-regulated investment funds is the type of companies they invest in. BDCs invest in debt and equity of small and medium-sized private, or some small public, companies. The companies BDCs invest in are typically in their early stages of development, or are distressed companies that may not be able to obtain bank loans or raise money from other investors. Sometimes BDCs may help manage the companies they invest in.
BDCs are sometimes compared to venture capital funds or private equity funds, which provide exposure to private, often illiquid, investments and may provide assistance to the companies they invest in. However, unlike venture capital funds and private equity funds, publicly traded BDCs are open to all investors, including retail investors.
In addition, BDCs have more leeway than other closed-end funds, mutual funds, and ETFs to invest using debt and other leverage.
These differences create potential benefits and risks unique to BDCs.
What are some potential risks and benefits of investing in BDCs?
As with any investment, you could lose money investing in a BDC.
Investment Risks. BDCs invest in small and medium-sized companies that are developing and/or financially distressed. Many are private companies that don’t make public disclosures, and the shares of the companies do not regularly trade on a national securities exchange.
- What this means for you: BDCs’ equity investments have potential for growth and their debt investments may earn higher interest rates than those of other debt investments, so BDCs may seek to achieve a higher return than other types of funds. But there are risks in owning shares or loaning money to small- and medium-sized companies that are different from, and in some ways more significant than, investments in larger public companies. These smaller companies may be more likely to go out of business or default on their debts. Also, it can be difficult to find information about the companies BDCs invest in and to know for sure what they are worth. The value the BDC assigns to a particular investment may differ materially from the value it ultimately receives for the investment. The BDC’s valuation process (especially for private investments and private companies) requires an exercise of judgment such that the values assigned to particular investments may be uncertain and may fluctuate over short periods of time.
Different Investing Opportunities. At least 70% of a BDC’s total assets must be invested in certain types of investments, including certain privately issued securities, distressed debt, and government securities.
- What this means for you: BDCs can offer a different investing opportunity for retail investors than is offered by typical mutual funds, ETFs, or other closed-end funds. Investing in a wider range of assets can be a good tool for portfolio diversification and may mean that a BDC follows movements of the stock market less closely. But these investments can expose you to the risks described in this Investor Bulletin.
Exposure to Leverage or Debt. BDCs can and often do use more leverage or debt than other types of funds to purchase their investments. For example, under certain conditions BDCs may borrow up to $2 for every $1 of investor equity.
- What this means for you: BDCs’ use of leverage can increase your return but can also increase your losses. It can also increase risk and can make the price of BDC shares more volatile. In addition, it can be more expensive for BDCs to borrow to invest if interest rates go up. Higher interest rates can also reduce BDCs’ profits.
Higher Fees. BDCs often have higher fees than other investment funds, like mutual funds or ETFs. Typically BDCs that are managed by an investment adviser have an advisory fee, which is generally equal to 1.5% – 2% of the fund’s gross assets annually, plus certain incentive fees generally up to 20% of any profits earned. Because management fees are typically calculated on gross assets, which would include leverage, the actual management fee charged to investors may be higher than if the BDC were unleveraged, depending on the amount borrowed by a particular BDC. Also, BDCs’ operating expenses may be higher than those of other types of funds. In addition, if an investor buys publicly traded BDC shares in the initial offering, the investor will pay a sales charge or commission that will be a certain percent of the purchase price. If an investor purchases publicly traded BDC shares on a securities market, the only transaction fees the investor pays are typical brokerage commissions.
- What this means for you: These fees reduce the value of your investment. If you buy publicly traded BDC shares in the initial offering, you will likely pay higher fees than if you were to buy the shares of the same fund later on a securities exchange. In addition, typically the price of publicly traded BDC shares immediately decreases after an initial offering, and the shares sell at a discount. If you buy or sell publicly traded BDC shares on a securities exchange, you will pay a typical brokerage commission, but not any sales loads or purchase or redemption fees.
Paying a Premium or Discount. The market price for publicly traded BDC shares may be greater or less than the shares’ net asset value (NAV). Shares that sell at a price higher than the NAV are said to be sold at a premium, and shares that sell at a price lower than the NAV are said to be sold at a discount. Publicly traded BDC shares may sometimes trade at a discount, but may sometimes sell at a premium.
- What this means for you: Trading at market price means that, when purchasing shares, you may pay more or less for publicly traded BDC shares than the current value of the fund’s underlying investments. Similarly, when selling shares, you may receive more or less than the current value of the fund’s underlying investments. This pricing creates an additional layer of risk and opportunity when owning publicly traded BDC shares. If you purchase shares at a premium, you are paying more than the current value of the underlying investments. If you purchase shares at a discount, you are paying less than the current value of the underlying investments, but you may not be able to sell the shares other than at a discount.
Potentially large distributions. BDCs’ distributions can include income generated by the fund – interest income, dividends, and/or capital gains – but can also include a return of capital. Because of their tax structure, most BDCs (that have elected a certain tax status) must distribute 90% of their taxable income to their investors each year.
- What this means for you: BDCs may pay large distributions. If the distributions include a return of capital, BDCs may not be as tax-efficient as other investments. In addition, a return of capital means you are getting back some of your principal, which is the money you originally invested. A distribution that includes a return of capital reduces the BDC’s asset base (the money the BDC has available to invest) and may make it harder for the BDC to make money in the future. It also means that the value of your remaining investment in the BDC may decline. When a distribution includes a return of capital, the BDC is required to send you a written notice.
Before you invest in a BDC
- Carefully read all of the fund’s available information, including its registration statement, prospectus, and any recent 10-Ks, 10-Qs, and 8-Ks. You can get this information by looking at the fund’s filings on the SEC’s EDGAR database, from your investment professional, or directly from the fund.
- Understand the fees and expenses you will pay for the fund, including up-front fees to purchase shares of the BDC along with longer term management fees and performance fees, and compare them to other investment options. A fund with high costs must perform better than a lower cost fund to generate the same returns for you.
- Be sure that the fund’s investment strategy is consistent with your goals.
- Ask Questions:
- What kind of companies does the BDC invest in?
- What kind of loans does the BDC make? Are they higher quality loans or lower-rated loans?
- What are the most significant risks of an investment in the BDC?
- How much debt has the BDC taken on to make its investments?
- Has the BDC consistently paid distributions to its investors?
- What ongoing fees and expenses are my investment dollars subject to? Do the fees change depending on the investment performance of the BDC?
- Will my initial investment be reduced by an up-front fee to invest in the BDC?
Additional Information
This bulletin represents the views of the staff of the Office of Investor Education and Advocacy. It is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”). The Commission has neither approved nor disapproved its content. This bulletin, like all staff statements, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.
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