Business Development Corporations: A Brief Summary
An area of investing that has been increasing in popularity over the past number of years is the business development corporation (BDC). Many of you may be invested in them, but some of you may not be familiar with them. As banks have retreated from making loans to middle market companies, a competitive industry of BDCs has grown in the marketplace. A main reason their popularity has risen over the past few years is because of the healthy dividends they tend to pay – yields of upwards of 10%. There are publicly traded BDCs and privately held BDCs that investors may consider.
What is a BDC?
A business development corporation is a type of fund that invests in small and medium-sized businesses. The investments are typically first and second lien senior secured loans and, at times, mezzanine debt (subordinated debt, only senior to common shares of the company), issued by middle market companies.Middle market companies taking advantage of BDCs are typically those with annual revenue between $5 million and $250 million.
Beyond this debt interest in middle market companies, some BDCs also take equity interests in their client companies. This can help boost the return on their investments. Some of these equity interests begin as warrants in the company, which enables the BDC to purchase the stock in the company at a fixed price or exercise price. If the exercise price is below the current market price of the equity when exercised, there is a potential profit to be made, which would be taxed at a capital gains tax rate when the security is sold.
BDCs are also interesting in that they may have a tax advantage. When a corporation is paying a dividend that dividend is typically taxed twice: first, when the corporation pays taxes on the income it generates to pay the dividends to shareholders; and second, the shareholder is taxed when they receive the dividend. BDCs, on the other hand, are corporations that don’t have to pay income taxes on the interest they distribute as long as they distribute at least 90% of taxable income to shareholders, along with some other requirements.
Some things to consider before investing in a BDC?
- Many BDCs add debt to the money they are investing in middle market companies. BDCs with high debt to equity ratios tend to be more volatile, especially when interest rates are on the rise.This is some of the interest rate risk that BDCs can be prone to.
- Some BDCs source their own loans to middle market companies, some rely on third party companies to source opportunities. The management fees of internally managed firms average 30% of income, whereas those using third party companies average management fees of about 45% of income, according to a Seeking Alpha survey.
- Most loans given by BDCs are variable rate loans to middle market companies, so they should fare well in a rising interest rate environment. The question is whether the leverage the BDC is using is variable rate or fixed rate, so there can be an impact to the BDC in a rising interest rate environment based on the amount and type of leverage utilized.
- BDCs have the opportunity to access US Small Business Administration low interest loans which would reduce their costs, depending on the industry sector parameters of each small company with which they are working.
- First and second senior secured debt is seen as the least risky debt of a company when compared to mezzanine debt. An investor needs to understand the portion of secured debt to subordinated mezzanine debt within a BDC. The more mezzanine debt, the riskier the BDC is.
- I have touched on leverage risk, interest rate risk, and investment risk with BDCs in this piece. Other types of risks to be aware of with BDCs are the following:credit risk, market risk, and liquidity risk. Credit risk is the risk of default on a debt should the borrower fail to make their payments. Market risk is the risk of loss from different market conditions and adverse circumstances. Liquidity risk is the risk that an asset cannot be liquidated or traded quickly enough in the market place without impacting prices.
BDCs suffered badly in the economic recession of 2008 and 2009. Many of the firms they work with could not service their debts. BDC share prices plummeted as they cut their dividends. It is vital to do your homework before investing in any product. BDCs are no exception.
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- This article should not be construed as personalized investment advice or as an offer to buy or sell the securities mentioned herein. A professional advisor should be consulted before implementing any of the strategies presented. All investments and investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's investment portfolio.
Gene C. Sulzberger is president of Sulzberger Capital Advisors, a registered investment advisor, in Miami, Florida. He works with U.S. and international clients, helping them meet their wealth management goals. Gene is a CERTIFIED FINANCIAL PLANNER™ and a registered trust and estate practitioner (TEP). He is also an attorney who previously practiced law in the area of trust and estate planning. He has over 20 years of experience in financial services and financial planning. Gene can be reached at (305) 573-4900 or firstname.lastname@example.org.