What is a BDC?

Introduction

A business development company is a special type of closed-end fund that invests in and helps small- and medium-size companies grow in the initial stages of their development. A company must be registered in compliance with Section 54 of the Investment Company Act of 1940 to qualify as a BDC. The U.S. Congress created BDCs in 1980 to assist emerging U.S. businesses in raising funds and fuel job growth. BDCs are closely involved with operating and providing advice to their portfolio companies, and many BDCs make investments in private companies or sometimes small public firms that have low trading volumes.

There are currently 51 BDCs that are traded on U.S. stock exchanges, with a total market capitalization of $31,627,033,415. See our list of BDCs.

BDCs are organized as pass-through tax structures, which means that BDCs must distribute at least 90 percent of taxable income as dividends to investors to avoid taxation at the fund level. So BDCs tend to appeal to dividend investors looking for dividend yield, especially during low interest rate periods when bonds don't generate much yield. As of today, the average dividend yield of the 51 BDCs in our database is 11.76%.

Effective March 21, 2014, S&P Dow Jones removed BDCs from its broad U.S. indexes. Russell followed suit soon thereafter. So BDCs are now almost never included in a U.S. stock index, as they are viewed as an investment fund rather than a stock.

BDC investments

BDCs can make either debt or equity investments in their portfolio companies. Each BDC is somewhat unique, in that they can pursue all kinds of different investment strategies. You need to study the website of a BDC carefully to understand the nature of their investments. That being said, most BDCs tend to have more debt investments than equity investments. WILBDC, the Wilshire Business Development Company Index, only includes BDCs that have at least 75% of their portfolio consisting of debt investments, and as of December 31, 2018, WILBDC had 35 BDCs as components.

Most of the debt held by a BDC would probably be categorized as "below investment grade" or "high yield" debt, as BDCs typically invest in businesses that have limited access to capital. So as a general rule, you should think of a BDC as an investment fund that largely holds junk bonds, but each BDC tends to have its own unique business model.

Most BDCs make loans to businesses that contain floating interest rates, which means that the typical loan portfolio of a BDC may not be as affected by rising interest rates. In fact, a BDC's income may go up as interest rates rise, as they are able to increase the average interest rate on their loan portfolio.

Keep in mind that since most of a BDC's loan portfolio consists of "below investment grade" loans, a BDC's loan portfolio is affected by the general state of the economy. BDCs are making risky investments in small and medium-sized businesses, so it is unclear to what degree a BDC's investment portfolio will be impacted by the next economic downturn.

Since BDCs are making debt and equity investments in mostly privately held businesses or sometimes thinly traded public businesses, it is sometimes unclear if the net asset value, or NAV, of a BDC really reflects the value of the fund. BDCs often have to value their investments using estimates that may or may not be accurate.

BDCs use leverage

BDCs typically use leverage to enhance returns to common stockholders. As a closed-end fund, BDCs are allowed to issue either preferred stock or they issue debt at a fund level. But the amount of leverage that a BDC can use is limited by law. BDCs originally were required to have 200% asset coverage (total assets/total debt). For example, a BDC with $100,000,000 in total assets can borrow up to $50,000,000 (and they would have $50,000,000 in equity).

On StockMarketMBA.com, we calculate the "leverage factor" of securities. Our leverage factor is simply total assets divided by total equity. So BDCs were originally allowed to have a maximum leverage factor of 2.0 ($100,000,000/$50,000,000).

The Small Business Credit Availability Act, or the SBCAA, which was signed into law in March 2018, decreased the minimum asset coverage ratio in Section 61(a) of the 1940 Act for business development companies from 200% to 150%, subject to either stockholder approval or approval of both a majority of the board of directors and a majority of directors who are not interested persons. So a BDC with $100,000,000 in assets can borrow $67,000,000 and would have $33,000,000 in equity. In our terminology, a BDC can now have a maximum leverage factor of 3.0 ($100,000,000/$33,000,000).

On a nightly basis, we calculate the leverage factor of every BDC using the BDC's most recent financial statements. Here is a summary of the current leverage factors of BDCs:

Leverage Factor RangeCount
1 to 1.53
1.51 to 2.014
2.1 to 2.516
2.5+16
Unknown2

Please note that our leverage factor calculation doesn't perfectly match the "asset coverage" calculation that BDCs are required to follow. Section 18(h) of the Act defines asset coverage of a class of senior security representing an indebtedness of an issuer as "the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer." In other words: (total assets - total liabilities excluding outstanding debt)/outstanding debt.

So in many respects, a BDC operates like a bank: a BDC borrows money at a fund level, at interest rates as low as possible. The BDC then makes either debt or equity investments in small businesses, with the goal of obtaining a return on those investments that is greater than the interest rate on the BDC's debt.

BDCs have to use leverage partly to offset their high management fees. As an investment fund, a BDC is run by an investment firm that acts as the fund's manager. The BDC pays management fees to the investment firm that is managing the BDC. Often, the management fees include both a fixed management fee as well as some type of incentive based management fee tied to the BDC's performance. So even though a BDC is an investment fund, a BDC has higher management fees than most investment funds. A BDC typically has management fees equal to 2 or 3% of assets. These fees are necessary because of the complex nature of the business operation of a BDC.

BDCs borrow money in lots of different ways, including issuing notes that are traded on a stock exchange. There are currently 41 exchange traded debt issued by BDCs. See our Exchange traded debt screener to see the list.

How do BDCs perform?

Given their unique structure, will BDC's act more like a stock or a bond? In other words, how do BDC's perform compared to a "regular stock"?

Let's look at the market price performance of WILBDC, the Wilshire BDC Index, one of the oldest BDC indexes, compared to SPY, the SPDR S&P 500 ETF, which tracks the S&P 500 Index:


Obviously, WILBDC has not performed very well in terms of market prices. However, if you factor in the high dividend yields of most BDCs, and look at the total return indexes, the performance looks much better. Let's compare the WILBDC total return index compared to the S&P 500 Total Return Index:


So BDCs perform somewhat like a bond and somewhat like a stock. They don't appreciate as much as a stock, but they usually have higher dividend yields.

ETFs that buy BDCs

There are now 3 ETFs and ETNs that either buy BDCs or track an index of BDCs. Why would an ETF buy a BDC? In other words, why would one investment fund type buy another investment fund type?

The primary appeal of a BDC to an ETF investor is that BDCs usually employ leverage to magnify their returns, as explained above. So if you are an ETF investor, and you are looking for an ETF with a high dividend yield, you can buy an ETF that is buying BDCs, since BDCs have dividend rates.

Here are the 3 ETFs that buy BDCs or track an index of BDCs:

SymbolDescriptionInception DateLeverage FactorCurrent YieldActions
BDCSETRACS Wells Fargo Business Development Companies ETN04/27/20111.0012.35%Analyze
BIZDMarket Vectors BDC Income ETF02/11/20131.0012.71%Analyze
BDCZETRACS Wells Fargo Business Development Company Index Series B ETN 10/09/20151.0012.34%Analyze

The SEC considers BDCs to be a type of "investment fund" for purposes of disclosing fees. So an ETF that owns BDCs has to include in its fee disclosures the underlying fees of the BDC (that the manager of the BDC charges to the BDC itself). So BIZD, an ETF that tracks the Market Vectors US Business Development Companies Index, has to disclose a fee of over 9%, even though almost all of that is not really a fee that BIZD is paying. Most ETFs use the phrase "acquired fund fees" when disclosing the fees associated with the underlying BDCs that the ETF is investing in.

Keep in mind that BDCs might be attractive to investors who are worried about rising U.S. interest rates. Most BDCs issue loans to businesses that are floating interest rate loans. So the value of the loan portfolios of most BDCs should not be as impacted by rising U.S. interest rates as the value of the bonds in the bond ETF. See our educational article ETFs for rising interest rates.


All data is a live query from our database. The wording was last updated: 06/26/2020.

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