In 1980 an amendment to the Investment Company Act of 1940 permitted publicly traded investment companies to register as Business Development Companies (BDC). BDCs are similar to Private Equity Companies and Venture Capital funds in that they invest in startup entities as well as established small and mid-sized businesses. The key difference with a BDC is they allow average investors to make investments that have historically only been available to very wealthy investors.

BDCs are given preferential tax treatment and registered as pass-thru entities similar to REITs, allowing them to avoid double taxation. In order to qualify as a BDC, the company must pass on 90% of its taxable income to shareholders as dividends, although most pass thru nearly 98% to avoid any form of corporate tax. As a result of this incentive, the average dividend rate across the publicly traded BDC market is in excess of 7% annually.

BDC’s primarily serve as a financing resource for privately held small and mid-size companies. They offer debt financing and often take a partial equity stake in the company. They may even serve in a consultative role in the management of the company, not unlike a private equity firm. BDCs are typically structured similarly to closed end funds where investors exchange shares on an exchange with each other rather than directly with a fund manager. This allows the management team access to a permanent source of capital rather as opposed to having to constantly redeem shares back to shareholders every time they sell securities. Simultaneously this allows investors the liquidity to sell shares on an exchange with daily intra-day liquidity that does not disrupt the management team’s investment strategy.

There are numerous BDCs that have been trading on public exchanges for several decades with a high degree of success. Historically they have served as a component in several of the major market indices. Yet, a 2014 legislative change has required that market indices and mutual funds holding BDC’s report the internal cost of the management of the BDC as an additional expense calculated in the expense ratio of the index or actively managed mutual fund. In reality this is not an expense borne directly by the shareholder, and would be similar to a mutual fund holding stock in IBM and reporting that company’s operating expenses as part of the expense ratio of the fund. As a result of this accounting change, organizations like S&P opted to remove all BDCs from all of their U.S. indices. When interviewed about the decision, S&P made it clear that this was not a reflection on the investment benefits of BDCs…but rather that they simply grew tired of explaining why the internal expense ratios appeared to suddenly increase. Since these holdings made up a small percentage of the index itself, it was simply easier to remove the holdings than comply with the new accounting requirements.

BDCs still however may present a strong investment opportunity for a number of investors seeking higher dividends for cash flow. Yet it should be noted that BDCs are by nature volatile and should be only be placed in a portfolio with the expectation of considerable risk and allocated on a percentage basis accordingly. The cash flow is not the only component of a BDC that may appear attractive to an investor. The BDC marketplace has had an overall degree of volatility higher than that of the S&P 500 Index, yet has had correlated price movements with the S&P only approximately 0.80% of the time. Their failure to move in lockstep with the broad market may offer some benefits for a number of investment portfolios by reducing overall volatility. As a result of the recent legislative changes forcing BDCs out of most major market indices, both Wells Fargo and Van Eck Global have recently created ETFs that incorporate various BDCs into a diversified index fund designed to track the marketplace. While they are still subject to the same accounting requirements that artificially inflate the cost of the index, investors who wish to gain widespread diversified access may continue to do so. Alternatively, they can still buy various BDCs individually.

As with all investments, it is important to evaluate an investment in BDCs based not just on the merits of the holding…but also how it is likely to impact overall portfolio volatility and work in conjunction with the additional investments across a comprehensive investment strategy.

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