BDCs: Private Equity for the Masses

To many investors, investing in private equity—or privately held companies—is the sole domain of venture capital firms and private equity funds.  To play in that game, you typically have to be an “accredited” investor (i.e., have a high income or a net worth exceeding $1 million).

But there’s a way for the rest of us to join this club, too, and it’s just as easy as buying stocks: the business development company, or BDC.

On its surface, the role of the BDC is similar to that of a venture capital firm: to extend financing to small and mid-sized companies that would otherwise have trouble accessing it on their own. They do that by both lending money and taking equity stakes in client companies.

But what sets BDCs apart is that the average Joe can invest in them: many trade on the major exchanges, and there are also BDC-focused ETFs.

BDCs can also help diversify your investments, because you’re not likely to be familiar with the private or thinly traded public companies in which they invest, so there shouldn’t be any overlap with the other stocks or funds you hold.

A Solid Choice for Income

At this point, you may be wondering what investing in privately held and start-up companies has to do with income investing.

Here’s where that comes into play: BDCs typically choose to be treated as regulated investment companies (RICs). As such, they’re pass-through investments, much like real estate investment trusts (REITs) and master limited partnerships (MLPs). That means they don’t pay income tax at the corporate level, provided they pay out to shareholders at least 90% of their taxable net income each year.

That gets rid of the double taxation most corporations have to deal with (i.e., corporate tax at the corporation level and income tax at the investor level). With less cash going to the government, BDCs have more to give to investors in the form of dividends.

Add it all up and you get an asset class that boasts growth potential and dividend yields higher than you’ll find just about anywhere else: the benchmark S&P BDC index currently yields around 9.2%. To put that in perspective, the Alerian MLP Index boasts a 7.0% yield, while the S&P United States REIT Index yields 4.3%. The average S&P 500 stock trails well behind with a yield of just 2.0%.

As is the case with REITs, BDCs’ dividends are taxed as ordinary income and require filing a Form 1099.

Safeguards Help Limit Risk

BDCs were created in 1980, when Congress passed an amendment to the Investment Companies Act of 1940. The goal: to encourage the flow of private equity capital to private businesses.

Like the enterprises in which they invest, 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.

But it’s a fast-growing group: according to S&P Indices, the number of listed BDCs jumped 78% in the five years ended Dec. 31, 2013.

To be sure, investing mainly in start-up and development-stage companies entails higher risk. To help mitigate that risk, BDCs typically invest across a large number of firms and a range of industries.

Take for example, the BDC we already have our Aggressive Portfolio, Ares Capital Corp., which we profiled in our March issue of GIE. Ares currently yields more than 9%.

Also consider Main Street Capital Corp. (NYSE: MAIN), which has investments in 194 companies and about $3 billion in capital under management.  It is a member of our Personal Finance Maximum Income for Retirees portfolio.  It yields about 7.4%.

The largest portion of its portfolio is in the media sector (8%), followed by IT services (7%), hotels, restaurants and leisure (6%), specialty retail (5%) and health care providers and services (5%).

The fact that BDCs are open to average investors means they must meet certain statutory standards—and that includes sufficient diversification. For example, a BDC must hold at least half of its portfolio in investments that each represent less than 5% of the total portfolio. What’s more, no single investment can be greater than 25% of the total portfolio.

In addition, BDCs must limit their debt-to-equity ratio to 1 or less and revalue their private investments every quarter.

What Makes a BDC?

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 their portfolio companies. A BDC may be either internally managed or run by an outside advisory firm—something that could result in higher costs for the company.

In the end, the choice of whether or not to invest in a particular BDC comes back to management—and whether you’re confident the team in charge can make the right calls and value the BDC’s portfolio accurately.  We feel confident in Ares and Main Street Capital, and you may wish to explore more BDCs by looking at our Personal Finance Max Income portfolio, if you’re a subscriber.