What is a Business Development Company (BDC)?

A business development company (BDC) is a firm whose sole purpose is to invest in small and medium businesses, as well as distressed companies. It helps to develop and grow small and medium-sized businesses at their early stage of development until they become financially independent. BDC also helps distressed companies regain their financial strength.

Business development companies are similar to closed-end investment funds. Many of these companies are also public companies that have their shares trade on major stock exchanges like the American Stock Exchange (AMEX), Nasdaq, etc. BDC investments are high-risk investments that also offer high dividend yields.

BDC Explained

In 1980, the U.S. Congress created business development companies to drive job growth and provide assistance to small- and medium-sized businesses in raising funds. Business development companies also provide advice about the operations of the companies listed in their portfolios.

Many business development companies invest in private companies and sometimes small public companies that have low trading volumes and high potentials to grow. BDCs also provide permanent funding to these businesses through a variety of sources including equity, debt, and hybrid financial instruments.

For a company to qualify as a business development company (BDC), it must be duly registered in the Investment Company Act of 1940 in compliance with Section 54. The company must also be a domestic company that has its securities registered with the Securities and Exchange Commission (SEC).

The BDC must also have at least 70% of its assets in private or public U.S. firms with market values of less than $250 million. It is expected that all investments must be done in small- and medium-sized companies or distressed companies that are having financial difficulties. The company must also be able to provide managerial assistance to the companies listed in its portfolio.

BDCs vs. Venture Capital

Business development companies are quite similar to venture capital funds in the sense of what they do. Although there are slight differences between both organizations in the sense of the kind of investments they make.

Venture capital funds are more concerned with large institutions and wealthy clients through private placements. Whereas, business development companies allow smaller and nonaccredited investors to invest in them, by extension the businesses in their portfolios.

Venture capital funds also keep a limited number of investors and must constantly meet certain requirements to avoid being misclassified as regulated investment companies. On the other hand, shares of business development companies typically trade on stock exchanges and are always available as investments for the public.

It is not compulsory for all BDCs to be listed on an exchange as non-listed BDCs still have to follow the same regulations as listed BDCs.

The Advantages of BDC Investment

Business development companies give investors access to debt and equity investments in predominantly private companies that are typically closed to investments.

BDCs are regulated investment companies (RICs), therefore, it is required of them to distribute more than 90% of their profits to shareholders. As RICs, they don’t need to pay corporate income tax on profits before distributing to shareholders. Investors that receive dividends will pay taxes on them at the tax rate for ordinary income.

BDC investments are capable of diversifying investors’ portfolios with securities that can bring substantial returns from stocks and bonds. Trading publicly on stock exchanges means that BDCs possess liquidity and transparency.

The Disadvantages of BDC Investments

Many BDCs holdings are not liquid although the companies are liquid. BDCs portfolio holdings mostly consist if private firms and small slightly-traded public companies. BDC’s portfolio has subjective fair value estimates since most of its investments are in illiquid securities, which may cause quick losses.

These losses can escalate because BDCs often borrow the money they loan to their target companies (leverage). Leverage has the potential to improve the rate of ROI (return on investment), but can also cause cash-flow disruptions if the leveraged assets lose value.

BDC-invested target companies hardly have any bad track records. However, there is always a possibility that they could default on loans. BDC profit margins can also be affected by a rise in interest rates, making it more expensive to borrow funds.