A lifeline for struggling small businesses.
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Business development companies (BDCs) are investment entities that focus on supporting smaller private enterprises. By providing both funding and managerial assistance, a BDC aims to encourage entrepreneurship and deliver returns for investors. If youâre considering adding BDCs to your portfolio, understanding how they function, how they compare to other structures, and their associated risks can help you make informed decisions.
Key Points
- Business development companies are closed-end funds often structured as corporations.
- BDCs can be publicly traded on major exchanges or offered privately to accredited investors.
- Key risks of investing in BDCs include market price fluctuations and limited liquidity.
What are business development companies and how do they work?
A business development company is a closed-end investment fund that primarily invests in small and midsize private enterprises, including those facing financial challenges. Business development companies are regulated under the Investment Company Act of 1940, which provides clear rules for what constitutes a BDC.
How closed-end funds differ from open-end funds
Closed-end funds issue a fixed number of shares, which trade on stock exchanges like company stocks. Prices fluctuate based on market demand. Open-end funds, such as mutual funds, continuously issue and redeem shares at net asset value (NAV), which is directly tied to the fundâs underlying assets. Closed-end funds often invest in less liquid assets, such as private companies, while open-end funds prioritize liquidity and accessibility.
The law requires business development companies to invest at least 70% of their assets in private U.S. enterprises or small, publicly traded U.S. companies (those with market values of less than $250 million). The remaining 30% may be invested in other types of assets, such as shares in a venture capital fund or the stock of a large publicly traded company.
Business development companies must explicitly identify as BDCs but are frequently structured as corporations, issuing shares that (if publicly available) are registered as traditional securities. Shares of publicly traded business development companies are widely accessible through major stock exchanges, while shares in privately issued BDCs are available only to accredited investors.
The leadership of a business development company has a fiduciary duty to shareholders and a legal obligation, as defined by the Investment Company Act, to provide âsignificant managerial assistanceâ to the small companies they support. Many BDCs qualify as regulated investment companies, distributing more than 90% of their taxable income to shareholders annually.
Some BDCs also utilize pass-through investment structures, a design shared with limited liability companies (LLCs). These structures avoid corporate income tax by passing profits and losses directly to shareholders or members, offering potential tax advantages compared to traditional corporations. Although uncommon, a BDC may operate as an LLC, combining the pass-through benefits of this structure with its focused investment mandate.
Business development companies also stand out because they may issue a combination of common stock, debt, stock warrants, and stock options. Although not widely recognized by name, BDCs play a significant role in the market. For example, BlackRock Capital Investment Corporationâa subsidiary of BlackRock, Inc. (BLK)âoperates as a BDC, combining equity and debt investments to support middle-market companies.
How business development companies compare to other structures
Because business development companies usually invest in early-stage or financially distressed companies, BDCs are frequently compared to venture capital or private equity funds. Explore how business development companies stack up against a variety of investment and business structures:
| Structure | Similarities with BDCs | Key differences |
|---|
| Closed-end fund | BDCs are a specific type of closed-end fund with particular investment requirements. | Closed-end funds, unlike BDCs, may invest without restriction in various types of assets. |
| Venture capital (VC) fund | Both frequently invest in early-stage companies with high growth potential. | Publicly traded BDCs are open to all investors, whereas investing in VC funds is typically restricted to private placements. |
| Private equity fund | Both commonly invest in midsize, financially distressed companies. | BDCs are bound by regulatory restrictions on capital allocation, while PE funds have much more investing flexibility. |
| Private credit fund | Both lend to private companies, providing access to credit for enterprises that may struggle to get bank financing. | Private credit funds typically have long lockup periods, making them much more illiquid than the shares of publicly traded BDCs. |
| Limited liability company (LLC) | Both entities can use pass-through structures to avoid corporate income tax. | LLCs are generally private, versatile business entities, while BDCs have a specific investment mandate and can be publicly traded. |
| Corporation | Many BDCs are structured as corporations, benefiting from the ability to raise capital by issuing equities or debt. | Corporations are highly versatile, often public business structuresâand not usually pass-through entities like BDCs. |
5 risks to know before investing in a BDC
Investing in business development companies can provide opportunities to benefit from the growth of promising companies, but it comes with risks:
Investing in public vs. private BDCs
Public and private business development companies differ in liquidity and investment potential. Public BDCs, traded on major exchanges, offer the most liquidity and allow quick transactions. Private BDCs are much less liquid, but may provide superior returns by focusing on specialized industries or exclusive investment opportunities. Incorporating both public and private BDCs into your portfolio can help diversify risk and access a broader range of investment strategies.
- Market price fluctuations. Shares in a publicly traded BDC may trade at a discount to its net asset value (NAV), which represents the total value of the companyâs underlying investments minus its liabilities. This discrepancy arises from broader market conditions and can significantly affect your returns.
- Limited liquidity in private BDCs. Shares in a private business development company may not be easily traded or sold, making them generally illiquid investments. Shareholder agreements for private BDCs typically lack any type of buyback clause, meaning that investors depend on BDC leadership to create a liquidity event such as going public, merging with another company, or being sold.
- Elevated default risk for distressed debt investments. Many BDCs invest in financially distressed companies, which can offer high potential returns but also carry a high risk of default. Default risk increases during economic downturns, potentially reducing the BDCâs NAV and, in turn, its share price.
- Risks of leveraged portfolios. Some BDCs use borrowed funds to amplify their investments. Although leverage can boost returns in favorable markets, it magnifies losses when investments underperform, directly impacting the BDCâs NAV and share price.
- High fees affect returns. BDC management often collects both a fixed fee (based on assets under management) and incentives based on financial performance. These fees can significantly reduce investor returns, especially when the company underperforms or its NAV declines.
The bottom line
Investing in a business development company allows you to participate in the growth of small and midsize companies while potentially earning strong dividends. If these benefits align with your investment goals, start by evaluating your risk tolerance and researching specific companies. Focus on their track records, fee structures, and the quality of their portfolio investments. By understanding the opportunities and risks, you can make an informed decision about whether BDCs are the right fit for your portfolio.
This article was most recently revised and updated by Allie Grace GarnettThis article was most recently revised and updated by David Schepp
