Business development companies (BDCs) are closed-end investment companies that invest in small and mid-sized businesses in the United States. Similar to venture capital funds, BDCs invest shareholders’ money to generate investment income and turn a profit. BDCs differ from VC funds in that they are open to the public in contrast to many private funds which are only open to wealthy investors.
BDCs enable non-accredited investors to purchase shares in the open market, pooling their money toward investments in private companies and startups. In turn, companies have permanent finances to kickstart growth in early stages of development.
A History of BDCs
The Investment Company Act was passed in 1940 as a much needed regulation following the 1929 stock market crash. At this time, investment companies were still very new, and BDCs nonexistent. The act instilled confidence in investors by requiring more transparency, but this provision also barred the public from investment opportunities.
By the 70s, the limitations of the 1940 act became a source of displeasure for many companies. Its restrictions limited the number of people that could invest, companies complained, drying up the amount of money going to small, growing businesses. In response, Congress passed the Small Business Incentive Act of 1980, which amended the 1940 Investment Act to add a new category of investment company called the BDC. The creation of the BDC was intended to increase the amount of money flowing to small companies by allowing anyone to purchase shares in the open market.
Following the act, only a handful of BDCs were actually formed before the turn of the decade, though the Private Equity Industry saw growth in the 80s that would help them down the line. BDCs began to form more rapidly beginning in the early aughts: 21 BDCs were created by 2008, rising to almost 50 by 2013. There are 84 today, 57 of which are publicly traded.
Modern Growth of BDCs
The rise of BDCs in the 21st century is indicative of their growing value in the world of investment and alternative lending. Some anticipate their further rise as an alternative to banks, especially when it comes to middle-market companies. As banks consolidate and grow larger, their focus has shifted to larger deals, making BDCs ideal for middle-market borrowers.
As I wrote in my article What CEOs Should Know About BDCs for Chief Executive Magazine, BDCs are thriving tremendously: they served an estimate of 65,000 businesses in 2014, with revenues ranging from $20 million to $200 million.
High growth over the last four years was in part driven by the availability of low debt funding costs a steady growing economy, rising equity markets, big banks’ market pullback, and certain hedge fund exits.
Some other factors that have contributed to the rise of BDCs are the many attractive qualities I outlined in my article. These include BDCs’ extensive business evaluation (which goes beyond just credit scores), high-risk investments that require healthy, long-term relationships with clients, and staffs of skilled professionals willing to create customized financial solutions.
A question is, will BDCs continue to grow? While many have seen share prices dip below net asset value (NAV) in the last year, indicative of some challenges and uncertainty in the industry. For example, there are concerns about the effect of potentially rising rates, the ramifications to the current credit cycle, and general concerns or credit quality.
As time goes by, the impact of these concerns will play out and there will be a separation between the better managed BDCs and those who have taken on increased risks. After this period, investors will recognize the fundamental soundness of well managed BDCs and the industry will resume its growth.