Over the past few years, Business Development Companies, or BDCs, have proven very popular with yield-starved income investors.
Given their sky-high yields, this is understandable. But it’s important for dividend investors to realize that this isn’t a “set it and forget it” industry (1), which means that successful long-term investing in BDCs requires being very selective about who you entrust with your hard earned money.
Read on to find out just why these specialty finance stocks offer such juicy yields, but more importantly: who should invest in BDCs, what metrics matter the most to protect your capital, and what risks dividend lovers need to be aware of. These are especially important topics for conservative investors who are living off dividends in retirement.
What is a BDC?
BDCs trace their origin to the 1980 Small Business Incentive Act, which amended the 1940 Investment Company Act; itself an answer to the 1929 stock market crash that heralded the Great Depression.
While the Investment Company Act resulted in much needed changes to the transparency of investment firms, the rise of BDCs was because Congress recognized the need for private capital to raise funds more easily from regular investors in order to serve the vast middle market loan market.
The middle market loan market consists of about 200,000 private businesses in the US that make up about 33% of GDP. These are small companies, generally non-investment grade, and so large banks are less likely to lend them growth capital.
This is especially true since the financial crisis, thanks to the passage of far stricter banking regulations such as Dodd-Frank, and Basel III. These laws require banks to hold more, higher quality assets on their balance sheets to ensure that another economic downturn or financial crisis won’t threaten the global financial system. BDCs help fill the gap by providing debt and equity financing to middle market companies.
A BDC is technically a Regulated Investment Company (RIC), which is a closed end investment fund (meaning investors can’t withdraw money from the fund like they can a mutual fund) structured similarly to a Real Estate Investment Trust or REIT (2).
Specifically, the BDC can avoid paying corporate taxes if it distributes 90% of taxable income in the form of dividends. Because of this requirement BDCs, like REITs or Master Limited Partnerships, or MLPs, retain very little earnings and require raising external capital from debt and equity markets in order to grow.
In addition, thanks to their beneficial tax status, BDCs are limited by law to holding at least 70% of assets in private US companies, and a debt/equity ratio of no higher than 1.0, meaning $1 in debt for every $1 in assets. However, upcoming legislation could raise this to maximum leverage (debt to equity) to 2:1.