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Business Development Co

 Business Development Companies

by Dave Dyer

 

This unique class of investment vehicles, which has only been in existence since 1980, is still largely unrecognized despite the fact that Business Development Companies (BDCs) seem to combine three elements that current investors crave: high yields, low volatility, and the potential for capital appreciation.

 

A BDC is a Regulated Investment Company (RIC), just like a Real Estate Investment Trust (REIT).  Like a REIT, the BDC must pay out at least 90% of its pre-tax profits in dividends to shareholders. They are traded on the various public markets just like a REIT. The main difference between a BDC and a REIT is in the underlying assets.  While a REIT holds real estate or real estate loans, the BDC owns equity positions in small companies or loans to small companies.  But the BDC is not like a mutual fund or closed end fund that owns shares of other public companies.  The companies in the BDC portfolio are all small private companies that are not traded.

 

The BDC operates somewhat like an old-fashioned bank. They issue shares to raise capital and then they fund small companies either with loans or equity positions. These small companies are currently having a hard time getting funding from the major banks, so there is a ready market for the capital. There are probably millions of small private companies in America right now, and this is a good way to get capital to them.

 

A BDC is more like a private equity firm or a venture capital fund, but, because they are publically traded, there is no requirement for investors to meet financial qualifications.

 

Here are some of the advantages of BDCs:

 

·         The dividends are large, up to 11%, and they tend to grow.

·         Large, consistent dividends will tend to lower volatility.  A stock that pays a large dividend is less likely to have a big drop.

·         Dividends from corporations are taxed twice; once as corporate profits and then as dividend income to the shareholder. Dividends from BDCs are paid from pre-tax profits and are only taxed once at the shareholder level.  This can result in larger dividends.

·         When new shares are issued by the BDC, the money is invested, and the dividends increase. For this reason, new shares do not typically dilute the stock price as they usually do when a company has a secondary offering.

·         Because they are limited to 50% leverage, they are much less risky than banks which can use more leverage.

·         You get the advantage of professional management and asset selection as you would in a mutual fund. The managers of the BDC try to select the best investments and often partner with their clients by providing business guidance.

·         BDCs are better than mutual funds when you consider their tax efficiency. Mutual funds distribute capital gains annually, but you don't take your capital gains in a BDC until you sell your shares.

·         Some BDCs will specialize in a market such as energy, medical, or technology, so you can focus or diversify as you please.

·         Since the companies in the BDC's portfolio are not public and not traded, you can expect the BDC to be less volatile. The companies have no market value that will fluctuate as market conditions change or business events occur. This should make it easier to hold them on a long-term basis.

·         BDCs are more convenient than Master Limited Partnerships (MLPs) because the tax reporting requirements do not include the complex K-1 forms. The income from a BDC is reported as a normal dividend.

·         BDCs are much more liquid than a traditional private equity investment that may tie up investment capital for years. The BDC can be sold in the market at any time like any other stock.

·         Small companies are where much of the innovation happens in our economy so there is a chance for a BDC to own some big winners.

As with any investment, there are also some risks and warning signs. Here are some that you should understand:

·         If a BDC announces a decline in their dividend, they are probably having some problems. Perhaps some of their companies have defaulted on loans or gone out of business.  Poor management decisions will show up quickly as declining dividends.

·         In some market cycles, the small companies in a BDC are out of favor and viewed as too risky. A shift in market sentiment to risk avoidance can harm the share price of the BDC even if the dividend is stable.

·         A change in the favorable tax treatment of dividends could make BDCs less desirable, although most of their dividends are non-qualified.

·         Rising interest rates could make other income investments relatively more attractive.

 

 

 

 

 

 

Copyright © 2012 by Dave Dyer