Business Development Corporations (BDCs)

Business Development Companies (BDCs) represent a distinct category of closed-end investment funds which we can buy on the US stock market, offering an avenue for retail investors to allocate capital into small and medium-sized private firms and, to a lesser extent, diverse investment opportunities, such as small publicly traded companies. BDCs exhibit a degree of complexity, accompanied by particularized risks.  Investing in Business Development Companies (BDCs) offers potential benefits such as attractive dividend yields, portfolio diversification through exposure to private middle-market companies, and access to private equity-like investments, providing opportunities for capital appreciation as well as access to professional management who are experts in the sector. Additionally, if the companies in a BDC’s portfolio thrive, investors may enjoy capital gains. Nevertheless, it’s crucial to be aware of the associated risks, including potential capital loss, sensitivity to interest rate fluctuations, market price volatility, regulatory complexities, and limited transparency due to the private nature of many portfolio companies. Therefore, investors should carefully evaluate their goals, risk tolerance, and research the particular BDC under consideration before considering an investment.

This article focuses on publicly traded BDCs, those whose shares can be traded on US national securities exchanges like the NYSE, NASDAQ or AMEX.

In certain respects, BDCs share similarities with various investment funds, including mutual funds, other closed-end funds, and exchange-traded funds (ETFs):

1. Pooling of Funds: BDCs aggregate capital from a multitude of investors and deploy those resources to earn income.
2. Inclusive Ownership: Individuals from all walks of investment life, including retail investors, have the capacity to buy shares in BDCs.  These investments are diffcult for retail investors to access directly.
3. Proportional Ownership: Investors hold shares that represent a proportionate stake within the BDC.
4. Regulatory Oversight: BDCs offer shares that adhere to the Securities and Exchange Commission (SEC) regulations, and BDCs themselves operate under SEC governance.
5. Managed by SEC-Registered Advisers: BDCs frequently have professional investment managers who are registered as investment advisers with the SEC.

Publicly traded BDCs, in some respects, share similarities with other closed-end funds (CEFs) and ETFs, as their shares are typically traded on national securities exchanges at prevailing market prices.  Prices adjust constantly depending on stock market supply and demand.

In a technical sense, BDCs do not qualify as registered investment companies but may voluntarily elect to comply with a substantial portion of the regulatory framework applicable to registered investment companies. The key differentiator between BDCs and other SEC-regulated investment vehicles is the nature of their investments. BDCs specialize in investing in the debt and equity of small and medium-sized private companies, occasionally extending their reach to select small public enterprises. These companies in BDC portfolios are generally either in their initial stages of development or are struggling entities that face challenges in securing traditional bank loans or attracting investments from other sources. BDCs sometimes play an active role in managing the companies they invest in. BDCs are occasionally likened to venture capital funds or private equity funds, as they offer exposure to private, often illiquid, investments and may provide operational support to their portfolio companies. However, BDCs are accessible to all investors, including retail investors.  Moreover, BDCs have more flexibility in utilizing debt and other financial leverage as compared to CEFs and ETFs.

These distinctions give rise to potential advantages and risks that are distinct to BDCs.  Just like any investment, there is a potential for losses when investing in a BDC.   Some of these are as follows:

Investment Risks: BDCs specialize in investing in small and medium-sized companies, many of which are in developmental stages or facing financial distress. Most of these are private firms that do not disclose financial information publicly, and their shares are not regularly traded on national securities exchanges.  BDCs’ investments in equities offer growth potential, and their debt investments can yield higher interest rates compared to other debt instruments, potentially aiming for higher returns. However, these equity and debt investments also come with elevated risks. Investing in smaller companies poses different and sometimes greater risks than investing in larger public companies. Smaller firms are more susceptible to business failures or defaults on their debts. Furthermore, it can be challenging to access comprehensive information about the companies BDCs invest in, making it difficult to ascertain their true value.

Diverse Investment Opportunities: BDCs are mandated to allocate at least 70% of their total assets into specific types of investments, including privately issued securities, distressed debt, and government securities.  BDCs provide an alternative investment opportunity for retail investors compared to traditional mutual funds, ETFs, or other closed-end funds. Expanding the array of assets can facilitate portfolio diversification, potentially reducing sensitivity to stock market fluctuations. However, these investments carry unique risks, as elucidated in this Investor Bulletin.

Exposure to Leverage or Debt: BDCs often employ more leverage or debt than other fund types when acquiring investments.  The use of leverage by BDCs can amplify both returns and losses. It heightens the level of risk and can lead to greater volatility in the price of BDC shares. Additionally, if interest rates rise, borrowing costs for BDCs can escalate, potentially diminishing profits.

Paying a Premium or Discount: BDC shares may trade at a price above or below their net asset value (NAV). Shares trading above NAV are considered at a premium, while those below NAV are at a discount. BDC shares may fluctuate between premium and discount pricing.  What this means for you: Market prices for BDC shares may deviate from the actual value of the underlying investments, introducing an extra layer of risk and opportunity when owning BDC shares. Purchasing shares at a premium means paying more than the underlying investments’ current value, while acquiring shares at a discount means paying less. However, selling shares bought at a discount may also incur a lower selling price.

Potential for Large Distributions: BDC distributions may encompass income generated by the fund, including interest income, dividends, and capital gains, as well as a return of capital. Due to their tax structure, most BDCs (having chosen a specific tax status) must distribute 90% of their taxable income to investors annually.  BDCs may deliver substantial distributions, but if these distributions include a return of capital, they may not be as tax-efficient as other investments. A return of capital implies a return of your initial investment, which diminishes the BDC’s asset base available for future investment, potentially affecting future profitability and the value of your remaining investment. When a distribution includes a return of capital, the BDC is obligated to provide written notice.

Higher Fees: BDCs often entail higher fees compared to other investment funds such as mutual funds or ETFs. Typically, BDCs managed by investment advisers charge an advisory fee, generally ranging from 1.5% to 2% of the fund’s gross assets annually, along with incentive fees of up to 20% of profits earned. As management fees are typically calculated based on gross assets, including leverage, the actual fee charged to investors may be higher depending on the amount borrowed by a particular BDC. BDCs may also incur higher operating expenses than other fund types. Additionally, investors purchasing BDC shares in an initial offering may incur sales charges or commissions as a percentage of the purchase price.  These fees reduce the overall value of your investment. If you acquire BDC shares in an initial offering, you are likely to pay higher fees than if you purchase shares of the same fund later on a securities exchange. Typically, BDC share prices decrease immediately after an initial offering, often trading at a discount. When buying or selling BDC shares on a securities exchange, you will incur standard brokerage commissions, but not sales loads or purchase/redemption fees.

Irrespective of whether we acquire shares during an initial public offering (IPO) or buy them on a stock exchange, we will bear the BDC’s operating expenses indirectly, as these fees, including management fees, distribution fees, and shareholder services fees, are subtracted from the BDC’s assets. Thoroughly review all available information related to the fund, including its registration statement, prospectus, and any recent 10-Ks, 10-Qs, and 8-Ks. We can access this data by examining the fund’s filings on the SEC’s EDGAR database, Comprehend the fees and expenses associated with your investment in the fund and assess how they compare to alternative investment choices.

Ensure that the fund’s investment strategy aligns with your financial objectives.   

Here are some Inquiries to pose to ourselves before investing.

1. What types of companies does the BDC allocate its investments to?
2. What kinds of loans does the BDC extend? Are these loans of high quality or lower-rated?
3. To what extent has the BDC leveraged its investments by taking on debt?
4. Does the BDC possess a track record of consistent distributions to its investors? A lengthy and stable history of distributions can signify the BDC’s ability to meet its obligations and generate returns for investors.
5. Which fees and expenses are applicable to my investment capital?

Also be aware that in a recession, BDC’s are typically hit hard and some may face liquidation if the underlying investments in the BDC’s fail.  Let there be little doubt:  These are higher risk investments and there is no free lunch.  However current economic conditions look robust and at the most we are expecting a mild recession later in 2024 or 2025, and the larger BDC’s should be able to survive them.

A list of leading publicly traded BDC’s available on the US stock market is attached as Appendix 1.  

You will note the high dividends paid by these BDC’s.  This is obviously an attraction for retail investors.  However caution should be exercised as dividend yield alone may be misleading and we should consider a myriad of quantitative and qualitative factors before investing. 

Case Study: Ares Capital Corporation, (ARCC, Financial)

For example looking at Ares Capital Corporation, (ARCC, Financial) the BDC is very large (market cap of over $10 billion) with a relatively high financial strength score of 4 in relation to other BDC’s.  It provides mainly debt financing to small to medium size private companies, so through it we can access a market which is not readily available to retail investors.  Ares Capital Corporation (ARCC) was founded in April 2004 and is sponsored by Ares Management, L.P. It went public with an initial public offering (IPO) shortly after its establishment, raising capital to finance its investment activities. Over the years, ARCC has focused on providing financing solutions to middle-market companies, building a diverse portfolio of investments in private and public firms across various industries. It has consistently paid dividends to shareholders and expanded its operations through investments, acquisitions, and partnerships. ARCC has grown to become one of the largest and most prominent BDCs in the United States.   It also has the distinction of surviving the Great Finacial crisis.

Its PE ratio is 11.85 which is slightly higher than its ten year average PE Ratio (Shiller PE Ratio) of 9.09.  This may indicate that it maybe somewhat over-valued.  The price to tangible book value is 1.05.  That means its trading close to its net asset value.  Dividend yield of 9.56% is very good, however the ARCC payout ratio is more than its earnings at 1.14.  Similarly dividend is not covered by free cash flow but that appears to be consistent.

Overall while the dividend yield is very good we are probably taking our fair share of risk in earning this high yield and we should explore the risk of a dividend cut if this state of affairs continues.  However insiders have been buying the stock on the open market which is usually a good indication of value.  Insiders typically do not buy if the stock is not good value.  Given all this I would give serious consideration to ARCC, but I would watch economic conditions carefully.

Appendix 1.

Exchange	NAS	NYSE	NYSE	NYSE	NAS	NAS	NYSE	NYSE	NAS	NYSE	NAS	NAS
Symbol	(ARCC, Financial)	(FSK)	(OBDC)	(MAIN)	(GBDC)	(PSEC)	(TSLX)	(GSBD)	(OCSL)	(BBDC)	(MFIC)	(GLAD)
Current Price	19.57	20.63	13.53	40.28	14.28	5.99	20.20	14.44	20.20	8.90	13.62	9.95
Company	Ares Capital Corp	FS KKR Capital Corp	Blue Owl Capital Corp	Main Street Capital Corp	Golub Capital BDC Inc	Prospect Capital Corp	Sixth Street Specialty Lending Inc	Goldman Sachs BDC Inc	Oaktree Specialty Lending Corp	Barings BDC Inc	MidCap Financial Investment Corp	Gladstone Capital Corp
Revenue ($M)	1021.00	322.00	927.72	431.41	187.24	-52.59	229.34	101.55	93.24	97.79	85.80	49.61
Market Cap ($M)	10908	5778	5273	3320	2422	2420	1762	1582	1557	948	889	384
Financial Strength	4	3	2	4	3	5	2	3	3	2	3	3
PE Ratio	11.86	20.63	6.24	9.09	14.72	At Loss	8.87	17.19	16.83	10.85	12.16	10.36
Forward PE Ratio	8.62	6.64	7.22	10.11	8.08	0.00	9.37	0.00	8.15	7.22	7.99	8.22
Price-to-Tangible-Book	1.05	0.84	0.89	1.45	0.96	0.65	1.20	0.99	1.03	0.78	0.90	1.07
Price-to-Operating-Cash-Flow	22.97	2.86	7.72	0.00	8.40	0.00	0.00	10.70	36.79	13.57	3.77	0.00
Debt-to-Equity	1.10	1.18	1.18	0.90	1.25	0.69	1.11	1.22	1.15	1.24	1.50	1.01
Debt-to-EBITDA	N/A	25.34	7.58	N/A	N/A	N/A	7.08	19.25	18.66	15.26	N/A	7.29
WACC %	6.01	6.40	6.21	7.78	5.06	7.08	7.29	6.37	6.61	5.68	6.27	8.10
ROE %	9.10	3.95	14.59	16.75	6.52	-2.60	13.88	5.76	6.28	7.26	7.31	10.49
ROA %	4.02	1.72	6.36	8.31	2.89	-1.31	6.49	2.47	2.87	3.24	2.86	5.21
Dividend Yield %	9.56	12.75	7.54	6.60	9.52	12.02	5.05	12.47	10.64	11.24	10.65	9.12
Dividend Payout Ratio	1.14	2.60	0.61	0.69	1.33	0.00	0.83	2.14	1.75	1.18	1.69	0.91
Shiller PE Ratio	9.09	5.47	0.00	12.66	10.86	6.20	8.41	9.46	21.38	13.08	13.38	9.63