Investing in a business development company is a high-risk, high-reward proposition for income investors. But there are ways to mitigate the risks with BDC investment.
Looking for more ways to earn income from your investments now that the market appears to be at an uncertain crossroads? Try investing in a business development company.
Business development companies (a.k.a. BDCs) are similar to venture capital funds, except that they are publicly traded on stock exchanges so that anyone—not just millionaires—can enjoy the benefits of a BDC investment. They provide financing to small- and mid-size companies that are often underserved by banks and other traditional lenders. Often this financing includes “mezzanine loans” that pay high interest rates and come with or can be converted into equity in the target company.
Business Development Company Pros and Cons
A BDC investment is a good hedge against bubbling market uncertainty. BDCs typically borrow funds at much lower interest rates than those paid by the smaller companies, so investors reap the rewards of the spread—although it does make a BDC investment fairly interest rate-sensitive (which could come into play if the Fed cuts interest rates again soon).
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On the bright side, business development companies can have very high yields—frequently in the double digits—but those payouts often reflect the high risk of lending to speculative, development-stage companies. BDCs that make loans primarily to 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.
Looking at a business development company’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.
BDCs also 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 its financial health, so you can take a shortcut by looking at what kind of interest rates the business development company is paying on its 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 a floating rate, which can expose the business development company 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 may even be rated by one of the big ratings agencies.
Tax Advantages of a BDC Investment
One other bonus: when you invest in business development companies, there can be tax advantages. Some BDCs pay distributions that are taxed at ordinary income tax rates, but others consistently designate a portion of their distributions as Return of Capital, which aren’t taxed until you sell your shares.
Some BDCs may also designate some of their distributions as qualified dividends, which are taxed at a lower 15% dividend tax rate. How the distributions are treated depends on how the BDC earned the income. Interest the BDC earned from loans and preferred stock is taxed at your normal income tax rate, for example, while qualified dividend income from preferred stock will be taxed at the 15% rate.
Tax benefits aside, business development companies are an often overlooked method of income investing—and a great place to find high yields, sometimes as high as 15%. In the current market climate, high yields can be a nice buffer against frequent share-price fluctuations.
For a full list of business development companies, and which ones have the highest yields, click here.
Investment analyst and Chief Analyst of Cabot Wealth Daily, Chris Preston brings you all the latest from the investing world. Sign up to get updates and breaking news delivered FREE to your inbox. Get unlimited access to our library of complimentary investing reports.Sign up now!
What is your opinion of business development companies? Do you think they have a place in most portfolios? Let us know in the comments.
*This post has been updated from an original version, published in 2017.