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What is a BDC?

Introduction

A business development company is a special type of closed-end fund that invests in and helps small- and medium-size companies grow in the initial stages of their development. A company must be registered in compliance with Section 54 of the Investment Company Act of 1940 to qualify as a BDC. The U.S. Congress created BDCs in 1980 to assist emerging U.S. businesses in raising funds and fuel job growth. BDCs are closely involved with operating and providing advice to their portfolio companies, and many BDCs make investments in private companies or sometimes small public firms that have low trading volumes.

There are currently 49 BDCs that are traded on U.S. stock exchanges, with a total market capitalization of $99,095,163,319. See our list of BDCs.

BDCs are organized as pass-through tax structures, which means that BDCs must distribute at least 90 percent of taxable income as dividends to investors to avoid taxation at the fund level. So BDCs tend to appeal to dividend investors looking for dividend yield, especially during low interest rate periods when bonds don't generate much yield. As of today, the average dividend yield of the 48 BDCs in our database is 10.85%.

Effective March 21, 2014, S&P Dow Jones removed BDCs from its broad U.S. indexes. Russell followed suit soon thereafter. So BDCs are now almost never included in a U.S. stock index, as they are viewed as an investment fund rather than a stock.

BDC investments

BDCs can make either debt or equity investments in their portfolio companies. Each BDC is somewhat unique, in that they can pursue all kinds of different investment strategies. You need to study the website of a BDC carefully to understand the nature of their investments. That being said, most BDCs tend to have more debt investments than equity investments. WILBDC, the Wilshire Business Development Company Index, only includes BDCs that have at least 75% of their portfolio consisting of debt investments, and as of December 31, 2018, WILBDC had 35 BDCs as components.

Most of the debt held by a BDC would probably be categorized as "below investment grade" or "high yield" debt, as BDCs typically invest in businesses that have limited access to capital. So as a general rule, you should think of a BDC as an investment fund that largely holds junk bonds, but each BDC tends to have its own unique business model.

Most BDCs make loans to businesses that contain floating interest rates, which means that the typical loan portfolio of a BDC may not be as affected by rising interest rates. In fact, a BDC's income may go up as interest rates rise, as they are able to increase the average interest rate on their loan portfolio.

Keep in mind that since most of a BDC's loan portfolio consists of "below investment grade" loans, a BDC's loan portfolio is affected by the general state of the economy. BDCs are making risky investments in small and medium-sized businesses, so it is unclear to what degree a BDC's investment portfolio will be impacted by the next economic downturn.

Since BDCs are making debt and equity investments in mostly privately held businesses or sometimes thinly traded public businesses, it is sometimes unclear if the net asset value, or NAV, of a BDC really reflects the value of the fund. BDCs often have to value their investments using estimates that may or may not be accurate.

BDCs use leverage

BDCs typically use leverage to enhance returns to common stockholders. As a closed-end fund, BDCs are allowed to issue either preferred stock or they issue debt at a fund level. But the amount of leverage that a BDC can use is limited by law. BDCs originally were required to have 200% asset coverage (total assets/total debt). For example, a BDC with $100,000,000 in total assets can borrow up to $50,000,000 (and they would have $50,000,000 in equity).

On stoxray.com, we calculate the "leverage factor" of securities. Our leverage factor is simply total assets divided by total equity. So BDCs were originally allowed to have a maximum leverage factor of 2.0 ($100,000,000/$50,000,000).

The Small Business Credit Availability Act, or the SBCAA, which was signed into law in March 2018, decreased the minimum asset coverage ratio in Section 61(a) of the 1940 Act for business development companies from 200% to 150%, subject to either stockholder approval or approval of both a majority of the board of directors and a majority of directors who are not interested persons. So a BDC with $100,000,000 in assets can borrow $67,000,000 and would have $33,000,000 in equity. In our terminology, a BDC can now have a maximum leverage factor of 3.0 ($100,000,000/$33,000,000).

Please note that our leverage factor calculation doesn't perfectly match the "asset coverage" calculation that BDCs are required to follow. Section 18(h) of the Act defines asset coverage of a class of senior security representing an indebtedness of an issuer as "the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer." In other words: (total assets - total liabilities excluding outstanding debt)/outstanding debt.

So in many respects, a BDC operates like a bank: a BDC borrows money at a fund level, at interest rates as low as possible. The BDC then makes either debt or equity investments in small businesses, with the goal of obtaining a return on those investments that is greater than the interest rate on the BDC's debt.

BDCs have to use leverage partly to offset their high management fees. As an investment fund, a BDC is run by an investment firm that acts as the fund's manager. The BDC pays management fees to the investment firm that is managing the BDC. Often, the management fees include both a fixed management fee as well as some type of incentive based management fee tied to the BDC's performance. So even though a BDC is an investment fund, a BDC has higher management fees than most investment funds. A BDC typically has management fees equal to 2 or 3% of assets. These fees are necessary because of the complex nature of the business operation of a BDC.

BDCs borrow money in lots of different ways, including issuing notes that are traded on a stock exchange. There are currently 17 exchange traded debt issued by BDCs.

BDC dividend yields often aren't real

The above charts show that BDCs often perform about the same as corporate high yield bonds, on a total return basis (market price change plus dividends). How can that be, when BDCs often have dividend yields of 8% or 9%, at a time when corporate bond yields are 5% or 6%? Part of the reason is that BDC dividend yields, including the dividend yields on this website, aren't real, because they often include "dividends" that are actually a return of capital. Similarly to the practice of many closed-end funds, BDCs often adopt what is called a "managed dividends" policy. The BDC will declare at the start of the year that they are going to pay a dividend of $1.00 per share per quarter, before even knowing what their income is going to be. At the end of the year, if the BDC actually only earns $3.00 per share, then $1.00 of the total dividends for the year will end up being a return of capital. This "true-up" only happens at the end of the year.

Unfortunately, we don't have good data in our database that splits out BDC dividends between real dividends and dividends that are return of capital. But BDC dividends that are a return of capital can be significant. For example, if you look at Ares Capital Corporation's balance sheet as of 9/30/2020 (see page 3 of their SEC Form 10-Q), you find that stockholders' equity includes $697 million of "accumulated overdistributed earnings".

ETFs that buy BDCs

There are now 3 ETFs and ETNs that either buy BDCs or track an index of BDCs. Why would an ETF buy a BDC? In other words, why would one investment fund type buy another investment fund type?

The primary appeal of a BDC to an ETF investor is that BDCs usually employ leverage to magnify their returns, as explained above. So if you are an ETF investor, and you are looking for an ETF with a high dividend yield, you can buy an ETF that is buying BDCs, since BDCs have dividend rates.

Here are the 4 ETFs that buy BDCs or track an index of BDCs:

Name	Symbol	Last price	Currency
VanEck Vectors BDC Income	ARCX:BIZD	16.72	USD
ETRACS Quarterly Pay 1.5X Leveraged MVIS BDC Index ETN due June 10, 2050	ARCX:BDCX	31.62	USD
Putnam ETF Trust Putnam BDC Income ETF	ARCX:PBDC	34.49	USD
Ubs Wel Frg Bsdv	ARCX:BDCZ	19.16	USD

The SEC considers BDCs to be a type of "investment fund" for purposes of disclosing fees. So an ETF that owns BDCs has to include in its fee disclosures the underlying fees of the BDC (that the manager of the BDC charges to the BDC itself). So BIZD, an ETF that tracks the Market Vectors US Business Development Companies Index, has to disclose a fee of over 9%, even though almost all of that is not really a fee that BIZD is paying. Most ETFs use the phrase "acquired fund fees" when disclosing the fees associated with the underlying BDCs that the ETF is investing in.

Keep in mind that BDCs might be attractive to investors who are worried about rising U.S. interest rates. Most BDCs issue loans to businesses that are floating interest rate loans. So the value of the loan portfolios of most BDCs should not be as impacted by rising U.S. interest rates as the value of the bonds in the bond ETF. See our educational article ETFs for rising interest rates.