Business development companies (BDCs) are hot on Wall Street for their impressive yields. Most yield 7-10% per year in the form of quarterly dividends to investors.
It’s no question why BDCs are so hot in a low-yield environment, but investors need to know more before putting their money on the line.
Business Development Companies Are REITs for Businesses
BDCs are very much like private equity funds, except that BDCs are publicly-traded. A business development company buys, improves, and sells companies to make a profit. BDCs are also involved in high-risk debt financing to smaller companies.
A business development company is not taxed because it trades like a fund. In order to maintain their tax advantages, business development companies have to pay out 90% of their earnings in the form of dividends. This is also required of REITs, which have to pay the same 90% of earnings to avoid corporate taxation.
Where a REIT holds real estate and loans on real estate, a business development company holds many smaller companies, and loans to small businesses.
What You Should Know About BDCs
Here are the five most important things to know about business development companies:
- They are high-risk – Risk and reward are very much related. High dividend yields come from earnings from illiquid businesses in their portfolio, and high-risk debt issues the company holds.
- They rely on leverage – Many BDCs improve earnings by borrowing large amounts of money at a low rate in the short-term to invest in illiquid companies. This means that a business development company will typically outperform when the economy is doing well, and significantly underperform when the economy performs poorly.
- Dividends are non-qualified – You will pay ordinary income taxes on dividends paid out by a business development company. Therefore, the most tax efficient way to hold a BDC is through a tax-exempt retirement plan like a 401k or IRA.
- BDCs are difficult to value – A business development company may own more than 100 companies at any one time. These assets can be difficult to value, and you have to rely on management’s assessment of what their holdings are worth. Like any other closed-end fund, the management team is required to publish the fund’s “net asset value,” or the value that it ascribes to its investment portfolio.
- BDCs have irregular income – The debt instruments BDCs hold provide regular income. However, the businesses that BDCs own do not. Therefore, BDCs that are invested primarily in equity, rather than debt, will have less consistent income and less consistent dividends.
Should You Invest in BDCs?
I find business development companies to be a spectacular investment for investors willing to tolerate the risks in exchange for beefed up dividends. In adhering to typical asset allocation models, investors should treat business development companies as stock, not as a bond.
To show just how volatile the industry can be, here is a chart of a popular BDC, Ares Capital Corporation (ARCC):
The company rewarded investors with an average of 8% in consistent dividends each year, as well as a 14% gain in the stock from late 2004-2012. However, the company is extremely volatile. From 2005 to 2009, the company lost nearly 80% of its value. The stock later recovered, but those who had to raise cash at the bottom sold at a tremendous loss to their original investment. The company rewarded investors with market-beating returns if shareholders were willing to ride out the highs and lows.
If you have a long term investment horizon, BDCs can be a winning investment, but they should make up only a small portion of a portfolio.