A Closer Look at Business Development Companies

Business development companies, or BDCs, represent a distinct category of closed-end investment funds which we can buy on the U.S. stock market, offering an avenue for retail investors to allocate capital into small and medium-sized private firms and, to a lesser extent, diverse investment opportunities, such as small publicly traded companies. According to Investopedia, BDCs exhibit a degree of complexity, accompanied by particularized risks. Investing in these companies offer benefits such as attractive dividend yields, portfolio diversification through exposure to private middle-market companies and access to private equity-like investments, providing opportunities for capital appreciation as well as access to professional management who are experts in the sector. Additionally, if the companies in a BDC's portfolio thrive, investors may enjoy capital gains.

Nevertheless, it is crucial to be aware of the associated risks, including potential capital loss, sensitivity to interest rate fluctuations, market price volatility, regulatory complexities and limited transparency due to the private nature of many portfolio companies. Therefore, investors should carefully evaluate their goals, risk tolerance and research the particular BDC under consideration before considering an investment.

In certain respects, the Securities and Exchange Commission notes BDCs share similarities with various investment funds, including mutual funds, other closed-end funds and exchange-traded funds. These similarities include:

1. Pooling of funds: BDCs aggregate capital from a multitude of investors and deploy those resources to earn income.
2. Inclusive ownership: Individuals from all walks of investment life, including retail investors, have the capacity to buy shares of BDCs. These investments are diffcult for retail investors to access directly.
3. Proportional ownership: Investors hold shares that represent a proportionate stake within the BDC.
4. Regulatory oversight: BDCs offer shares that adhere to the Securities and Exchange Commission regulations, while BDCs themselves operate under SEC governance.
5. Managed by SEC-registered advisors: BDCs frequently have professional investment managers who are registered as investment advisers with the SEC.

Publicly traded BDCs, in some respects, also share similarities with other closed-end funds and ETFs, as their shares are typically traded on national securities exchanges at prevailing market prices. Prices adjust constantly depending on stock market supply and demand.

In a technical sense, the SEC also says BDCs do not qualify as registered investment companies, but may voluntarily elect to comply with a substantial portion of the regulatory framework applicable to registered investment companies. The key differentiator between BDCs and other SEC-regulated investment vehicles is the nature of their investments. BDCs specialize in investing in the debt and equity of small and medium-sized private companies, occasionally extending their reach to select small public enterprises. The companies in BDC portfolios are generally either in their initial stages of development or are struggling entities that face challenges in securing traditional bank loans or attracting investments from other sources. They are also occasionally likened to venture capital funds or private equity funds, as they offer exposure to private, often illiquid, investments and may provide operational support to their portfolio companies. However, BDCs are accessible to all investors, including retail investors. Moreover, BDCs have more flexibility in utilizing debt and other financial leverage as compared to CEFs and ETFs.

These distinctions give rise to potential advantages and risks that are distinct to BDCs. Just like any investment, there is a potential for losses when investing.

The first is investment risk.BDCs specialize in investing in small and medium-sized companies, many of which are in developmental stages or facing financial distress. Many are also private companies that do not disclose financial information publicly, and their shares are not regularly traded on national securities exchanges.

There are also diverse investment opportunities. BDCs are mandated to allocate at least 70% of their total assets into specific types of investments, including privately issued securities, distressed debt and government securities. Expanding the array of assets can facilitate portfolio diversification, potentially reducing sensitivity to stock market fluctuations.

Further, BDCs often employ more leverage or debt than other fund types when acquiring investments. The use of leverage can amplify both returns and losses, heightening the level of risk and potential volatility in the price of shares.

Next, BDC shares may trade at a price above or below their net asset value. Shares trading above NAV are considered at a premium, while those below NAV are at a discount. BDC shares may fluctuate between premium and discounted pricing.

There is also potential for large distributions. BDC distributions may encompass income generated by the fund, including interest income, dividends and capital gains, as well as a return of capital. Due to their tax structure, most BDCs must distribute 90% of their taxable income to investors annually. BDCs may deliver substantial distributions, but if these distributions include a return of capital, they may not be as tax-efficient as other investments.

Finally, BDCs often entail higher fees compared to other investment funds. Typically, the investment advisors charge an advisory fee, generally ranging from 1.5% to 2% of the fund's gross assets annually, along with incentive fees of up to 20% of profits earned. As management fees are typically calculated based on gross assets, including leverage, the actual fee charged to investors may be higher depending on the amount borrowed by a particular BDC. BDCs may also incur higher operating expenses than other fund types. Irrespective of whether investors acquire shares during an initial public offering or buy them on a stock exchange, they will bear the BDC's operating expenses indirectly as these fees are subtracted from its assets.

Also be aware that in a recession, BDC's are typically hit hard and some may face liquidation if the underlying investments in the BDC fail. Let there be little doubt: These are higher-risk investments and there is no free lunch. However,current economic conditions look robust and at the most we are expecting a mild recession later in 2024 or 2025, so the larger BDCs should be able to survive them.

You will note the high dividends paid by these BDCs. This is obviously an attraction for retail investors. However, caution should be exercised as dividend yield alone may be misleading and we should consider a myriad of quantitative and qualitative factors before investing.

Case study: Ares Capital

For example, looking at Ares Capital Corp. (ARCC, Financial), the BDC is very large (market cap of over $10 billion) with a relatively high financial strength score of 4 out of 10 in relation to other BDCs. It provides mainly debt financing to small to medium-size private companies, so through it we can access a market that is not readily available to retail investors.

Founded in April 2004, it is sponsored by Ares Management L.P. It went public shortly after its establishment, raising capital to finance its investment activities. Over the years, Ares has focused on providing financing solutions to middle-market companies, building a diverse portfolio of investments in private and public companies across various industries. It has consistently paid dividends to shareholders and expanded its operations through investments, acquisitions and partnerships. Having survived the Global Financial Crisis, it has grown to become one of the largest and most prominent BDCs in the United States.

Its price-earnings ratio of 11.85 is slightly higher than its 10-year average of 9.09. This may indicate that it maybe somewhat overvalued. The price-to-tangible book value is 1.05. That means its trading close to its net asset value. The dividend yield of 9.56% is very good, but the payout ratio is more than its earnings at 1.14. Similarly, the dividend is not covered by free cash flow, but that appears to be consistent.

Overall, while the dividend yield is very good, investors are probably taking their fair share of risk in earning this high yield and should explore the risk of a dividend cut if this state of affairs continues. However, insiders have been buying the stock on the open market, which is usually a good indication of value. Insiders typically do not buy if the stock is not good value. Given all this, I would give serious consideration to Ares Capital, but would watch economic conditions carefully.