A BDC, or Business Development Company, is an investment that gives ordinary investors a way to participate in the rarified world of venture capital.
Business development companies are a special type of Regulated Investment Company, or RIC, that primarily make loans to small and medium-sized businesses. To qualify as an RIC, a BDC must invest at least 70% of its assets in private (or public but thinly traded) U.S. companies, and has to provide “significant managerial assistance” to their portfolio companies. That can mean consulting, managerial guidance, or even taking seats on the company’s board. And while BDCs primarily exist to make loans to their portfolio companies, many also make equity investments, which can translate into big payoffs when they exit the position. Successful BDCs will look to invest in companies that have good growth potential and where their investment and guidance can be helpful.
BDCs also have to distribute at least 90% of their taxable income to shareholders as dividends, a requirement that makes them great high yield investments. (They get even better tax treatment if they distribute 98% or more of both ordinary income and capital gains to shareholders.)
Picking The Best BDC For Your Portfolio
Yield is obviously going to be an important criterion when choosing the right BDC for your portfolio, but you’ll want to look at a host of other factors to figure out which BDCs fit your risk tolerance and appetite for growth.
Here are three questions to ask yourself before investing in a BDC:
1. What Kind of Companies Do They Invest In?
BDCs that make loans to primarily more mature businesses with positive cash flows will be safer, while BDCs that make more speculative loans to smaller businesses will be riskier—but they may also have more growth potential, especially if they take equity positions in a lot of their portfolio companies.
Also check how diversified their portfolio is. If most of their portfolio companies are in one industry, the BDC could take a big hit from a downturn in that sector. Laws regulating BDCs require that they have no more than 25% of their assets in any one loan or equity position, but BDCs can still vary widely in how diversified they are. Check how many different companies the BDC is invested in, and how big their positions tend to be. Just as with your own portfolio, too much concentration can be risky.
2. What Kind of Loans Do They Make?
Looking at a BDC’s filings should give you a sense of how risky or safe their loan portfolio is. Some BDCs mostly make higher quality loans that have a better chance of getting paid back, while others will make more speculative loans that have higher interest rates but also carry a greater chance of default. You can check the interest rates on the loans for a sense of the borrower’s creditworthiness. If the BDC is able to charge higher interest rates than its peers, it’s probably making riskier investments.
You can also look at the type of loans the BDC is making for a sense of how well protected their investments are. Senior secured debt is the most secure type of loan, with strong protections for the lender, but many BDCs will also make unsecured, junior or mezzanine loans, which are lower in the capital structure. You can also check to see if the debt is fixed or floating rate, and what sort of security the BDC has if the company defaults on the loan.
3. What Does Their Balance Sheet Look Like?
BDCs have to take on a lot of debt themselves, so they can then lend that capital at higher rates. Luckily for you, that means bankers have already looked at this company’s balance sheet and assessed their financial health, so you can take a shortcut by looking at what kind of interest rates the BDC is paying on their own debt. That will give you a general idea of how risky bankers think this company is. Also find out if the rates are fixed at that level or if they’re floating rate, which can expose the BDC to more interest rate risk. You may also want to compare the BDC’s debt-to-equity ratio to the industry average to see if this BDC has more or less financial flexibility than its peers. Some BDCs, like Main Street Capital, may even have a borrower rating from one of the big ratings agencies.
The good news on this point is that the regulations governing BDCs say that they have to cover every dollar of debt with two dollars of assets, so there’s a limit to how much debt they can take on. If the BDC’s asset to liability ratio is already near two, they’ve just about maxed out their borrowing, while a BDC with a lower ratio probably has more financial flexibility (and can probably borrow at lower rates).
Of course, I also look at the usual dividend safety and growth factors when assessing BDCs. As with any other company, a BDC with a long and stable dividend history is likely to have a more reliable, consistent income stream, indicating that it makes loans that get repaid. A history of rising dividends is even better, as it indicates that the BDC consistently makes good investments that reward investors.
We also want to see cash flow covering dividends, as usual. For BDCs, I use Net Investment Income as the best measure of real cash flow. NII should consistently cover the dividend by at least 100%. Note that Net Investment Income is not the same thing as taxable income. NII is equal to the company’s total investment income minus expenses (base management fee, incentive fee, interest expense) plus any gain on extinguishment of debt. Taxable income is usually equal to net ordinary income plus realized net short-term capital gains in excess of realized net long-term capital losses, if any, and does not include unrealized appreciation or depreciation. The two numbers may also differ because of differences in when income and expenses are recognized, and dividends may include some taxable income earned in a different reporting period.
We can also look at the stock’s past performance, compared to the S&P or the rest of the BDC sector, to get an idea of how well the BDC’s investments perform. A BDC that primarily makes successful investments in successful companies should see that reflected in its stock price over time.
You can also compare the stock’s performance to the trend in its Net Asset Value, or NAV. Since BDCs invest in private or thinly-traded companies, their NAVs are very rough estimates of the value of their investments, made by the BDC’s board and audit committee (and signed off on by their CPA). Checking to see if the stock is trading at a significant premium or discount to the NAV can give you some idea of what investors think of the estimate. If the stock is trading at a significant discount to the NAV, investors may not be as confident about the company’s investments as the board. Conversely, if the stock is trading at a significant premium to the NAV, investors might think more highly of the BDC and its portfolio than the board, or they may be placing a premium on the company because they expect its assets to increase in value or they expect the company will make more good deals in the future.
In late February, S&P sent shockwaves through the BDC sector when it decided to remove Business Development Companies from its indexes, effective March 31. After the S&P decision, Russell followed suit, announcing that it would remove BDCs from all its indexes in late June.
The reasoning is not a strike against BDCs, rather, it had to do with the way that BDCs report certain fees. These fees aren’t charged directly to investors, but the way they are reported can make it look like funds that hold BDCs have higher fees than they actually do. S&P and Russell didn’t want this happening in the ETFs based on their major indexes, so they decided to eliminate the problem by removing BDCs from the indexes altogether.
Shortly after the announcements, Barron’s reported: “Since an estimated 8% of all BDC shares are held by funds benchmarked to the indexes, such as iShares Russell 2000 ETF (IWM), ‘it will take weeks’ worth of trading volume for index funds to sell those positions,’ says Bryce Rowe, an analyst at Robert W. Baird.”
Sure enough, in the 11 weeks after S&P announcement, the main ETFs tracking the BDC market both fell over 8% (the S&P 500 was up 3% over the same period). Even after they were removed from the S&P indexes March 31 and from the Russell indexes in late June, BDCs remained weak into the fall, with most hitting new lows in October. I was waiting to see some strength return to the sector before adding MAIN to our portfolio, and believe now is that time.
Lastly, note that the tax rate on dividends you receive from a BDC depends on how the BDC earned those dividends. The company should let you know how it generated the dividends at the end of the year. Most dividends paid from the BDC’s investment income will be classified as ordinary income, but some may qualify for the capital gains rate (if the BDC recognized a capital gain on an asset held long-term) or the dividend tax rate (if the BDC received dividends from a qualified company). Some BDCs may also classify part of their distributions as return of capital, if they were not made out of current earnings, although this can be a warning sign that NII is not completely covering the dividend.