What Is a Business Development Company (BDC)?

A business development company (BDC) is an organization that invests in small- and medium-sized companies as well as distressed companies. A BDC helps these firms grow in the initial stages of their development. With distressed businesses, the BDC helps the companies regain sound financial footing. Similar to closed-end investment funds, many BDCs are public companies whose shares trade on major stock exchanges, such as the American Stock Exchange (AMEX), Nasdaq, and others. As investments, they are high-risk but offer higher rewards.

Understanding Business Development Companies (BDCs)

The U.S. Congress created business development companies in 1980 to fuel job growth and assist emerging U.S. businesses in raising funds. BDCs are closely involved in mentoring and developing the companies in their portfolios because it is in a BDC's best interest to help them become successful. BDCs invest in private companies and small public firms that have low trading volumes or are in financial distress. They raise capital through initial public offerings or by issuing corporate bonds and equities or forms of hybrid investment instruments to investors. The raised capital is then used to provide funding for the struggling companies. BDCs can use different financial instruments to provide capital, but in general, most issue loans or purchase stocks or convertible securities from the companies.

Some business development companies are publicly traded entities. Others are not publicly traded and are known as non-traded BDCs.

Qualifying as a BDC

To qualify as a BDC, a company must be registered in compliance with Section 54 of the Investment Company Act of 1940. In addition, it must be a domestic company whose class of securities is registered with the Securities and Exchange Commission (SEC).

The BDC must invest at least 70% of its assets in private or public U.S. firms with market values of less than US$250 million. These companies are often young businesses seeking financing or firms suffering or emerging from financial difficulties. Also, the BDC must provide managerial assistance to the companies in its portfolio.

BDCs vs. Venture Capital

If BDCs sound similar to venture capital funds, they are. However, there are some key differences. One relates to the nature of the investors each seeks. Venture capital funds are primarily available to large institutions and wealthy individuals through private placements. In contrast, BDCs allow smaller, nonaccredited investors to invest in them, and by extension, in small growth companies.

Venture capital funds keep a limited number of investors and must meet specific asset-related tests to avoid being classified as regulated investment companies. On the other hand, BDC shares are typically traded on stock exchanges and are constantly available as investments for the public. BDCs that decline to list on an exchange must follow the same regulations as listed BDCs. However, less stringent provisions for the amount of borrowing, related-party transactions, and equity-based compensation make the BDC an appealing form of incorporation to venture capitalists who were previously unwilling to assume the burdensome regulation of an investment company.

Advantages and Disavantages of BDC Investment

Advantages Explained

• High dividend yields: Because BDCs are regulated investment companies (RICs), they must distribute over 90% of their profits to shareholders. That RIC status means they don't pay corporate income tax on profits before distributing them to shareholders. The result is above-average dividend yields.
• Open to retail investors: BDCs expose investors to debt and equity investments in predominantly private companies—typically closed to retail investors.
• Liquid: BDCs trade on public exchanges, giving them a fair amount of liquidity and transparency.
• Diversity: BDC investments may diversify an investor's portfolio with securities that can display substantially different returns from stocks and bonds.

Disadvantages Explained

• High risk: Although a BDC itself is liquid, many of its holdings are not. The portfolio holdings are primarily private firms or small, thinly-traded public companies. BDCs invest aggressively in companies that offer both income now and capital appreciation later; as such, they register somewhat high on the risk scale.
• Sensitive to interest rate spikes: A rise in interest rates—making it more expensive to borrow funds—can impede a BDC's profit margins.
• Illiquid or opaque holdings: Because most BDC holdings are typically invested in illiquid securities, a BDC's portfolio has subjective fair-value estimates and may experience sudden and quick losses. In addition, the BDC-invested target companies typically have no track records or troubling ones.
• Magnify losses: Losses can be magnified because BDCs often employ leverage—that is, they borrow the money they invest or loan to their target companies. Leverage can improve the rate of return on investment (ROI), but it can also cause cash-flow problems if the leveraged asset declines in value.
  
• Dividends taxed as income: Dividends from BDCs are taxed as income because they don't meet the criteria for qualified dividends.

How to Invest in a BDC

A business development company is a publicly traded firm with stocks trading on public exchanges, so you can purchase stocks through your broker.

Some BDC stocks are included in exchange-traded funds and mutual funds. For example, the VanEck BDC Income ETF is offered through many brokers and is available to retail investors.

How Does a BDC Make Money?

Business development companies can make money in several different ways. One of the most common is to purchase equity from the companies they provide funding for and sell it when it appreciates. If a BDC buys convertible bonds from a company it has invested in, it can receive yields from the bonds and later convert them to equity. Once converted, the equity can be held for appreciation or sold for capital gains. Lending is another way BDCs make money. Similar to a consumer borrowing from a bank, a BDC charges interest on the loans it makes.

The Bottom Line

Business development companies are firms that exist to assist smaller or financially struggling businesses. BDCs use fundraising techniques to raise capital for themselves from investors and then use that money to invest in these smaller businesses. They were created by Congress in 1980 to help small businesses grow while attempting to shield them from predatory tactics sometimes used to take over struggling businesses.

BDCs generally have higher returns than mutual funds and exchange-traded funds, but with these returns comes an equal increase in risk and volatility. If you're considering investing in BDCs, it helps to talk to a professional financial advisor to determine if they meet your investing goals and risk tolerance.