Business Development Companies (BDCs) are another special type of investment, like real estate investment trusts (REITs) or Master Limited Partnerships (MLPs), the companies are in the United States and are publicly traded on stock exchanges.
They often have high dividend yields approaching 10% or more. Hence, these stocks are attractive to retirees and others seeking income. But they have much more significant risks because they invest in private companies and other illiquid assets with leverage. Additionally, owning them may cause tax implications.
Canadian retail investors can invest in publicly traded BDCs but should understand the risks.
What Are BDCs?
Publicly traded BDCs are specialty finance companies. They are a kind of closed-end investment fund traded on public stock exchanges like the Nasdaq or New York Stock Exchange (NYSE). Thus, Canadian retail investors can buy or sell the shares with access to U.S. exchanges.
They mainly invest in debt or equity of small-to-medium-sized companies in the United States. BDCs also issue loans and invest in convertible securities. A BDC must invest at least 70% of assets in U.S. companies with market values of less than $250 million.
Hence, most of the investments are in privately held or lightly traded public companies seeking financing to grow. Sometimes the companies are under duress. Consequently, the assets are illiquid, creating risk.
The investment money is raised and pooled from retail and institutional investors and other sources. Because BDCs are publicly traded, the shares are registered with the U.S. Securities and Exchange Commission (SEC). Thus, they are regulated by the SEC. In addition, the investment managers may also be registered with the SEC.
BDCs traded on U.S. exchanges differ from privately held ones in Canada. Most of these are accessible only to high-net-worth and accredited investors. Similarly, the Business Development Bank of Canada is usually called a BDC but is a government-owned entity.
Benefits of BDCs
The four main benefits of BDCs are high dividend yields, access, liquidity, and diversification.
High Dividend Yields
BDCs have high dividend yields because they must pass 90% of their profits to shareholders. As a result, they don’t pay corporate income taxes. Instead, profits are distributed as dividends and capital gains distributions.
As a result, BDCs typically pay dividend yields greater than most corporations. However, because they allocate a significant percentage of profits to investors, BDCs may cut their dividends during economic duress, like the COVID-19 pandemic.
Access is another advantage. BDCs let retail investors gain exposure to private equity-type investments. They also provide exposure to investment in privately held companies.
Moreover, the BDCs are liquid because they are publicly traded, unlike usual private equity investments with lock-up periods. Also, no minimum investment is required except the share price. An investor can buy a single share or as many as they like.
Lastly, an investment in BDCs can diversify a portfolio. BDCs do not perform similarly to stocks, bonds, REITs, or MLPs. They are essentially an alternative investment.
Disadvantages of BDCs
BDCs also have a downside because of their risks. Some of their main disadvantages are illiquid portfolio holdings, concentration, interest rates, and fees. Besides these cons, Canadian investors may be subject to different taxation on the distributions.
Illiquid Portfolio Holdings
A significant downside is the holdings are illiquid. Although a BDC may be publicly traded, the portfolio holdings, whether equity, debt, or loans, are usually not. Moreover, the securities are valued not on exchanges but through estimates.
As a result, the valuation can change quickly. Investors in stocks and bonds can sell their holdings on an exchange. But a BDC’s portfolio is based on investments in private companies and cannot be quickly sold.
Because a BDC invests in s small-to-medium-sized private companies, its holdings are concentrated. Many of these companies have similar attributes with similar challenges. Hence, they may struggle during a recession. Even though a BDC cannot place more than 25% of its assets in one company, concentration is still a concern.
Business Development Companies borrow money to make their investments. Like a bank, they borrow at lower rates and lend at higher rates. If interest rates fluctuate, the difference between the two rates, or the net interest margin, may decrease. In turn, this change affects the ability to pay distributions.
BDCs often have higher fees than most other investments. For instance, ETFs, or index funds, often have low expense ratios. Today, even stocks have low brokerage fees.
However, BDCs have private equity-like costs. The management earns about 1.5% to 2% of total assets. In addition, the structure often includes incentive fees that can reach 20% of profits.
Examples of BDCs
BDCs have a relatively short track record. The three largest ones are Ares Capital (ARCC), Main Street Capital (MAIN), and Capital Southwest (CSWC).
Ares Capital is a BDC that operates throughout the United States. It focuses on middle-market companies investing in debt, warrants, loans, and equity. This BDC investment is concentrated with more than 50% of total assets in the top four industries. It has 21.9% of its assets in Software & Services, followed by 10.8% in Health Care Services. It also has 10.1% in Ivy Hill Asset Management and another 9.5% in Commercial & Professional Services.
Ares Capital is publicly traded on the Nasdaq. It is currently yielding about 10.9%.
Main Street Capital
Main Street Capital is headquartered in Houston, Texas. The BDC specializes in equity capital for lower-middle market companies across America. It is currently invested in 194 companies with approximately $6.4 billion of capital under management. This BDC is more diversified, with the top five industries taking up ~29% of total assets. The breakdown is 8% of assets in Internet Software & Services, 7% in Commercial Services & Supplies, 5% in Distributors, 5% in Leisure Equipment & Products, and 4% in Professional Services.
Main Street Capital is publicly traded on the NYSE. It currently yields ~6.8%.
Capital Southwest is headquartered in Dallas, Texas. It focuses on credit, private equity, and venture capital for middle-market companies. The BDC has a longer history. It was formed in 1961 and changed to a BDC structure in 1988. The firm has $1.2 billion spread across roughly 81 companies. The top five industries represent nearly half of the total assets. It has 12% in Media & Marketing, 11% in Business Services, 10% in Healthcare Services, 8% in Consumer Services, and another 8% in Consumer Products & Retail.
Capital Southwest is publicly traded on the NASDAQ. The dividend yield is around 12.3%.
The Bottom Line
BDCs can provide excellent dividend yields, diversification, and exposure to private companies. However, they have higher risks investors need to understand. In addition, BDCs differ because their underlying investments and leverage vary.
Furthermore, they are not substitutes for stocks, bonds, REITs, or MLPs. The bottom line is BDCs are not for everyone.