Written By Yasin Ebrahim
Business development companies, or BDCs, have become a popular investment choice for income-seeking investors due to their reputation for providing attractive dividend-like returns. These companies fill the middle-market funding gap left by traditional banks, leading to significant growth in the BDC sector. According to a recent Jefferies report, total assets under management for BDCs have increased from $12 billion in 2000 to over $260 billion by 2023.
What Are Business Development Companies?
BDCs are investment companies that typically focus on investing in the middle market industry, specifically smaller private companies generating around $5 million to $100 million in EBITDA. BDCs primarily provide debt funding through senior secured loans, but they may also have a more diverse investment strategy.
These companies receive coupon payments on debt and various fees from borrowers, which are then distributed to investors. While debt funding is their main focus, BDCs can also invest in equity capital. BDCs are required to distribute around 90% of their investment income to investors, usually in the form of dividends.
The origin of BDCs dates back to the 1980s, following the financial crisis of the late 1970s. Increased regulation and compliance forced banks to tighten lending standards, leaving middle-market companies struggling to access debt capital. In response, Congress created the Small Business Incentive Act of 1980 to encourage private equity firms to provide debt capital to these companies.
As bank lending decreases, smaller companies are staying private for longer and relying more on debt capital to fund their growth.
Private Vs. Public: Liquidity Matters
Not all BDCs are the same in terms of liquidity. Publicly traded BDCs, which trade on public stock exchanges like Nasdaq, are more liquid compared to private BDCs, which have less liquidity and mirror typical private equity fund structures. Perpetual BDCs fall in between, offering redemption windows for investors.
Buying stock in a publicly traded BDC allows investors to gain exposure to the underlying assets and receive income generated from those assets.
High Returns From Plugging the Middle-Market Funding Gap
BDCs typically generate distributions or dividend yields ranging from high-single digits to mid-teens income, making them an attractive option for investors seeking income. The returns from BDCs’ underlying assets, primarily senior secured loans, can range from high single digits to mid-teens gross yields.
BDCs are able to offer these attractive returns through leverage and fees. Leveraging their equity allows BDCs to borrow at lower rates and lend at higher rates to generate higher yields. Fees charged to borrowers also contribute significantly to their returns.
Internally managed BDCs can generate additional income by managing third-party capital, charging management fees and incentive fees on other pools of capital.
While the high dividend income is appealing, investors should always consider the risks associated with any asset class.
Understanding the Risks: What Every BDC Investor Should Know
When investing in debt instruments, managing credit risk is crucial. BDCs may invest across various companies with varying risk levels, from venture-backed startups to late-stage firms. It is important for investors to be aware of these risks.
Proactive management approaches can help identify potential problems and manage risks effectively.
For publicly traded BDCs, valuations are a significant risk. Economic changes can impact valuations, affecting the stock of the BDCs even if the ability to collect on the loan remains intact.
However, for investors focused on generating income, fluctuations in valuations may not be as concerning as for those trying to time the market.
Risk To BDCs From Lower Interest Rates or Recession?
As the Fed initiates a rate-cutting cycle, investors are concerned about the impact on income derived from loans managed by BDCs. While falling rates may affect the yield on debt investments, lower borrowing costs can help cushion the impact on margins.
Most BDC base dividends are not at significant risk from Fed rate cuts, according to Jefferies.
There are numerous factors that can help BDCs maintain dividend coverage, such as increasing originations and refinancing fees, as well as improving credit performance, as highlighted by Jefferies.
In anticipation of further rate cuts, S&P Global reported a slight decrease in the leveraged loan Index default rate this year, which could potentially remain around 1.50% through June 2025. This indicates that lower interest rates may not have a significant impact on BDCs, but it is important for investors to carefully evaluate individual BDCs and understand their underlying assets and performance in various economic and interest rate environments.
The ability of BDCs to source high-quality investment opportunities can give them a competitive advantage as the number of funds within the industry continues to grow. Deal origination is crucial for putting valuable assets on the balance sheet and enhancing market access.
When considering investing in BDCs, due diligence is key. Investors should focus on the management team’s experience and understanding of the market. Assessing the strength of a BDC’s portfolio, its ability to generate income to cover dividends, and its growth over time is essential for evaluating dividend yield.
Despite fluctuations in economic and interest rate cycles, BDCs provide access to private credit opportunities and the potential to build income, making them a resilient asset class with continued growth prospects. Capital is expected to continue flowing into BDCs, with companies maintaining high enterprise value and cutting costs to drive future activity and success.