The Ins and Outs of Business Development Companies

If you’re a regular Investing Daily reader, you know we frequently cover tax-advantaged, high-yielding investments like real estate investment trusts (REITs) and master limited partnerships (MLPs).

Today we’re going to throw another acronym to the mix: the BDC, or business development company.

A Bird’s Eye View of BDCs

On the surface, BDCs appear similar to venture capital firms or private equity funds, but there are a number of key differences, which we’ll look at more closely in a moment.

First, an overview: BDCs were created in 1980, when Congress passed an amendment to the Investment Companies Act of 1940. The goal: to give small- and mid-sized businesses an easier way to raise money.

“BDCs lend money, take equity stakes in companies and serve firms that can’t find capital through other means,” wrote Investing Daily analyst Khoa Nguyen in a March article.

But here’s the twist: unlike private equity funds or VC firms, which are usually limited to “accredited” investors—meaning those with a high income or a net worth exceeding $1 million—anyone can invest in BDCs. Many trade on the major exchanges, and there are also ETFs dedicated to them (more on that below).

Like REITs and MLPs, BDCs’ main draw is high yields, to the tune of nearly 9% on average. To put that in perspective, the average S&P 500 stock yields just under 2%, while the benchmark Alerian MLP Index boasts a 6% yield.

As well, the fact that BDCs are open to average investors means they must meet certain other standards, according to Investing Daily’s Jim Fink. “Because of this, investors in BDCs are afforded statutory safeguards that require the BDC to diversify its investment portfolio, limit its debt-to-equity ratio to 1 or less and revalue its private investments every quarter,” he wrote in an April 2012 article.

Like the enterprises they invest in, the BDC market is small, consisting of only about 30 companies with a combined market cap of around $30 billion. Compare that to MLPs, at about $520 billion, and REITs, at roughly $900 billion.

Making the Grade

Here’s something else that will sound familiar if you invest in REITs: like those investments, BDCs don’t pay tax at the corporate level, provided they pay out to shareholders at least 90% of their taxable net income each year.

That eliminates the double taxation most corporations must contend with (i.e., corporate tax at the corporation level and income tax at the investor level). And with less money going to the government, BDCs are left with more to hand out to investors in the form of dividends. 

To qualify as a BDC, at least 70% of a company’s investments must be in certain types of eligible assets, including companies that: (a) are based in the US (b) don’t have any of their securities listed on a public exchange, or (c) have securities listed on a public exchange but have a market cap of less than $250 million. (That’s generally regarded as the cutoff between small- and micro-cap stocks).

In addition, BDCs must get 90% of their gross annual income from dividends, interest and realized capital gains on securities. They’re also required to assist the management teams of the companies in which they invest.

Two Ways to Invest

There are a couple different ways to invest in BDCs. The most direct one is to buy shares in these companies. For that, you could look to the four we cover in our Personal Finance advisory.

Among them is Ares Capital Corp. (NasdaqGS: ARCC). Ares is externally managed by Ares Capital Management LLC, a subsidiary of Ares Management LP (NYSE: ARES), a leading international finance firm that manages about $87 billion of assets.

Ares Capital, which mainly focuses on mid-sized companies, is well diversified: as of March 31, 2015, it had investments in 201 firms ranging from industrial equipment suppliers to renewable power producers and health care companies. It ended the first quarter with total assets of about $8.9 billion.

The stock currently yields 9.5%. It’s up 2.7% so far this year, and over the long run its share price has been relatively stable: it fell sharply during the financial crisis, along with most stocks, but in the years before and after, it’s mainly moved in a range between $15 and $20. (Shares currently trade around $16.)

Another option is to invest in BDCs is through an exchange traded fund such as the Market Vectors BDC Income ETF (NYSE: BIZD). The fund invests in 28 BDCs—the largest being Ares, at 14.7% of the portfolio—and boasts an 8.4% yield. However, it also boasts a hefty 9.17% expense ratio, compared to an industry average of around 0.65%.

“Still, if you like the idea of BDCs but are reluctant to invest in them, the fund is a good way to enter the market,” writes Nguyen.

Buy These 3 “Hidden Market” Stocks Now

Personal Finance chief strategist Jim Pearce has just rushed out his three favorite “hidden market” stocks—one BDC, one REIT and one MLP—in a new free report.

Your broker will never tell you about these three income wonders, which crank out payouts of 6.6%, 9.9% … even 12.8% like clockwork! Get the names of all three when you click here.