Business Development Company: What You Should Know

Income-hungry investors frequently pursue unorthodox yield-enhancing options. A lesser-known kind of investment known as a business development company (BDC) might help satisfy their need. Typically, BDCs give 5% to 14% or greater dividend rates. Moreover, some outperforming BDCs may also periodically boost their dividends. Thus, this makes them attractive investments for income-seekers and retirees, particularly in the current low-interest climate. Nevertheless, before adding BDCs to your portfolio, it is necessary to gain more understanding because of the higher risks associated with higher returns.

What Exactly Is a Business Development Company?

A business development company (BDC) invests in privately held small to medium-sized businesses. Typically, the companies are suffering difficulties and want assistance to develop or get back on track. However, they may not secure finance through conventional sources, such as bank loans or bond issuance.

In addition, BDCs seek to produce income and capital gains from the sale of the companies they have invested in, similar to venture capital and private equity funds. Significantly, almost everyone can invest in business development businesses, which makes them a desirable option. They are public corporations that are traded on major stock markets. Private equity and venture financing are only available to accredited investors with substantial net worth. Significantly, congress established business development corporations in 1980 to stimulate the faltering American economy by assisting budding smaller companies in raising capital for expansion and employment creation. 

Working Principles of Business Development Companies

The Investment Act of 1940 and the Securities and Exchange Commission (SEC) regulate business development companies. As Regulated Investment Companies, they are exempt from taxation. In exchange for this beneficial tax classification, a BDC must annually pay at least 90% of its taxable profits as regular dividends to its stockholders.

In addition, since they keep relatively little of their revenues, business development companies don’t pay corporate taxes. They are taxed once, at the shareholder level, and not again at the corporate or individual levels. BDCs are comparable to Real Estate Investment Trusts (REITs), which hold and frequently operate income-producing real estates such as office buildings and retail malls. In the case of BDCs and REITs, this implies that you, as an investor, must pay taxes on your investments’ profits.

Furthermore, portfolio company holdings of BDCs must conform to particular diversification standards to comply with federal rules. For instance, at least 70% of a BDC’s assets must be invested in public or private U.S. enterprises with market capitalizations of less than $250 million. Significantly, no single investment can account for more than 25 percent of the portfolio.

Business Development Company vs. Venture Capital

If business development companies sound like venture capital funds, that is because they are. However, there are still important distinctions. One refers to the type of investors sought by each. Through private placements, venture capital funds are typically accessible to major organizations and rich people. Smaller, non-accredited investors can invest in BDCs and, by extension, in small growth companies.

Additionally, venture capital funds maintain a limited number of investors to avoid classification as regulated investment corporations and must pass certain asset-related standards. In contrast, BDC shares are often traded on stock markets and are always available to the public as investments.

Business development companies that choose not to list on an exchange must adhere to the same rules as listed BDCs. However, less severe requirements for borrowing, dealings with related parties, and equity-based remuneration make the BDC an attractive form of incorporation for venture capitalists wary about investment company regulation.

Tips for Investing in Business Development Companies

Generally, business development companies can be purchased and sold similarly to stocks and exchange-traded funds (ETFs). Each has a distinct ticker symbol, and shares can be purchased in a brokerage or individual retirement account (IRA).

If you are new to investing in BDCs or just like easy diversification, you may choose an ETF that invests in many BDCs on your behalf. For example, the VanEck Vectors BDC Income ETF (BIZD) tracks some of the largest and best-known BDC companies, such as Ares Capital (ARCC), Main Street Capital (MAIN), and Prospect Capital (PSEC). All are publicly listed companies with dividend yields ranging between 5 and 8 percent. BIZD has a dividend yield of 8.5% as of the end of April 2021.

Tax Consequences of Investing in Business Development Companies

As with any investment, it is essential to conduct research before making a choice. Due to their potential for long-term profits, Batcheler argues that BDCs should be considered for tax-advantaged accounts such as IRAs. As long as they remain in a tax-advantaged account, you will not be required to pay yearly taxes on any income they generate. Therefore, if you pick wisely, these profits might be compounding and expanding your portfolio quicker.

However, BDCs are not for everyone. Conservative investors may not be able to tolerate the hazards involved. BDCs may be an attractive addition to a well-diversified portfolio for income-focused investors ready to conduct homework and acknowledge the risks as a trade-off for greater dividend payouts.

Exchange Traded Options

Exchange-traded notes (ETNs) offer an additional alternative. ETNs are comparable to ETFs, although they more closely resemble bonds. ETNs are institution-issued, unsecured notes that can be held until maturity or traded at will. One risk associated with an ETN is that its issuing institution might suffer a credit downgrade, which could result in an unconnected drop in the value of the ETFs shares. Additionally, ETFs and ETNs may offer the best of both worlds to investors who prefer to acquire a basket of BDCs rather than individual stocks. 

Benefits of a Business Development Company Investing

In addition to their above-average dividend rates, business development companies offer the following benefits:

Greater transparency

As highly regulated public corporations, business development companies are required by law to give significant financial information to their investors. Private corporations are not obligated to provide significant financial information to their direct investors. This might assist you in ensuring that your investment funds are used appropriately.

Greater liquidity

Even if investors discover a means to participate in private enterprises, they face a second obstacle: withdrawing their funds. Non-publicly traded companies are typically very illiquid investments. You may have to wait several years for a liquidation event or be forced to sell at a loss on the secondary market. Publicly traded BDCs provide exceptional liquidity and prevent you from tying up your funds for lengthy periods.

Access to the private sector

You can access private market investments that may be inaccessible or difficult for normal investors. BDCs provide simple access to a potentially robust segment of the market that would be difficult to access.

Risks of a Business Development Company Investing

Despite its numerous benefits, business development companies still have risks as follows:

Higher tax rates

While business development companies themselves escape Uncle Sam without paying taxes, you do not. BDC dividends are taxed at regular income rates, the same as your wage. Thus, you may pay more than other dividends in your portfolio. For instance, a single individual with a $50,000 yearly income would be taxed 22% on any BDC dividends in 2021. In contrast, in this case, qualified dividends from other income assets, such as stocks and bonds, may be subject to lower capital gains tax rates — 15%.

Rate of interest sensitivity

BDCs are susceptible to interest rate spikes, which can make it more expensive for them to borrow money. Thus, this diminishes their profit margins and investment capacity.

Large debt exposure

When investing in their portfolio companies, which are often privately held or thinly traded, BDCs rely significantly on debt, rendering them mainly illiquid. An economic collapse like the one brought on by the Covid-19 outbreak might lead portfolio companies to fail and perhaps default on their debts.

Comparatively short track recordings

Even though the BDC concept was created in the 1980s, most BDCs have only been formed since the early 2000s. Their histories are still quite brief, providing investors with minimal data to examine when assessing the alternatives.

Conclusion

To conclude, it depends on your risk tolerance and the business development company you are choosing. This investment is risky. This heightened risk comes from the businesses they invest in, their lack of portfolio diversification, and their vulnerability to shifting interest rates. As with any investment or fund, not all BDCs are equal. BDCs have varying management costs. Different BDCs provide different rates of return. Thus, it is very important to do your research before investing.

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Source: Forbes