In this low interest rate environment many people are looking for opportunities to collect higher payouts. Business Development Companies (BDC) are a rather rapidly expanding area that may well be worth considering but only with the understanding that higher returns only comes with higher risks.
A BDC is similar to the better known venture capital or private equity fund in that it is created in order to help small up-and-coming privately owned companies grow beyond the initial stages of development. One way the BDC is different from the venture capital fund is that BDCs accept smaller investors from the general public, which essentially allows investors to participate in an industry previously not open to the small investor, i.e. private equity. That is one reason why BDCs have been growing in popularity.
A BDC is a usually a publicly traded company, regulated under the 1940 Investment Company Act. In order for the BDC to qualify as a “regulated investment company,” it is required to meet some legal criteria:
- • Pay dividends to shareholders in an amount no less than 90% of taxable income.
- • A minimum of 90% of the BDC’s taxable income (gross, per annum) must come from interest, dividends and/or realized capital gains derived from its own investment portfolio.
- • Additional tax incentives are available to the BDC if it makes distributions and dividends of at least 98% of ordinary income and capital gains, respectively.
- • BDCs which opt not to trade publically are required to meet additional requirements as directed by the Financial Industry Regulatory Authority or FINRA.
What do BDCs do?
BDCs often make short-term uncollateralized loans in amounts, which range from as little as $2 million and up to $50 million. Moreover, the BDC is required to provide managerial assistance to those smaller or mid-sized companies; it’s not just a matter of “here’s your money, take good care of it” but “here’s your money, now let us show you how to make the most of it.” Later, when their client’s company goes public, the BDC often takes equity interests in them.
A BDC’s own expansion relies on a financing combination more debt (by borrowing) and equity (by selling more shares), however, it should be noted that they are required to have a total debt to total equity ratio which is less than 1:1.
Because the BDC’s performance is dependent upon the overall health of the U.S. economy, there may be reason for concern as interest rates look to begin rising. Analysts point out that rising interest rates are actually an indication that the economy is improving, but they also note that the BDCs may be shielded to some extent from interest rate increases. They typically structure their assets so that about 60% of them are floating rate investments, suggesting that as interest rates rise then so will investment rates. Conversely, BDCs often structure most of their liabilities on a fixed rate basis, so rising interest rates will generally have little effect on them.
There are currently about 30 BDCs and annual payouts can range from 5% to over 11%. Those with some of the higher payouts include: Prospect Capitol (PSEC), Pennant Park Investment Corp (PNNT), Fifth Street Finance Corp (FSC), TICC Capital Corp (TICC) and Medley Capital (MCC).
If you consider investing in BDC you would be well advised to diversify by owing 8 to 12.
Options to Owning Individual BDC Stocks
As with any investment option the financial services companies like to be involved. Wellsfargo has created 2 mutual funds that allow investors to participate in BDC without owning individual stocks. Over the past several years, BDCs in general have outperformed the financial sector index. One recent analysis shows the Wells Fargo BDC (WFBDC) achieving an annual return over a five year period far in excess of the Financial Sector Index (XLF).
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While BDCs do not occupy a very large sector, the strong performance of the collective group had drawn the attention of Swiss banking giant UBS which launched a pair of Exchange Traded Notes (ETN) to track the index two years ago while an Exchange Traded Fund (ETF) launched by Market Vectors become operational earlier this year.
If interest rates do eventually rise as the Federal Reserve has long forewarned investors, there are several BDCs which experts believe could weather a rate hike including Hercules Technology Growth, Inc. (HTGC), Pennant Park Floating Rate Capital, Ltd. (PFLT), Ares Capital Corp. (ARCC), Medley Capital BDC (MCC) and Golub Capital BDC, Inc. (GBDC).
Though no investment is risk-free, investors might want to consider adding several BDCs or a BDC ETF to their own portfolio to help increase dividends while further diversifying risk.