What Are Business Development Companies?
Business Development Companies (BDCs) were created in 1980 to provide loans and aid to small and mid-sized businesses hoping to finance their prospective enterprises. According to the Small Business Administration, small to mid-range business entities employ 50% of the private workforce space. BDCs raise business capital to provide these loans to small and mid-sized businesses from investors who own shares. Prior to the existence of BDCs, the ability for smaller companies to raise capital were minimal, often being rejected by banks. With the emergence of BDCs, small businesses, which are the backbone of the economy, are offered loans and incentives to promote the growth of their businesses — in turn stimulating a stronger market.
What Do BDCs Do?
BDCs are able to invest in numerous, types of securities that include debt and equity — known as a business’ capital structure. Generally, the BDCs’ strategy is to invest more in either debt or equity.
In the capital structure system, loans reap returns on investors’ principal and interest without the participation of the investor in the growth of the company (beyond providing managerial assistance as requested by the regulation). Separately, when investing in equity, the common stock of the small to mid-sized company may increase substantially in value depending on its growth.
What Makes BDCs Different From Traditional Closed-End Funds?
BDCs provide funds to an underrepresented asset class: the small and mid-sized U.S. business. They provide these loans without high investment minimums and other stricter requirements that previously available private limited partnerships required.
At their core, BDCs resemble traditional closed-end funds, administered by the Investment Company Act of 1940 — which have the potential to offer higher yields than conventional income strategies. There are several differences that make BDCs an attractive complement to their higher yield bond and leveraged loan fund colleagues.
Where BDCs depart from traditional closed-end funds, which leverage funds for larger companies, BDCs invest in the debt of small and mid-sized companies. Because there are fewer lenders in this investment market, investors can earn higher yields for their smaller businesses. The debt is less liquid but the protections and regulations that are standard in these loans offer a lower risk. Investors who wish to diversify their interest rate exposure enjoy lower risk and higher yields. Additionally, BDC portfolios carry fixed and floating-rate securities. The industry average of floating rate securities is roughly 60% of total assets, and BDCs invest in both. Although many loans have yield of 75-100bps, BDCs lend at rates that will increase when short-term interest rates climb, so they are poised to profit from a rising rate environment. So in terms of net of returns, the dividend yields for BDCs are most often greater than traditional closed-end funds.
How Are BDCs Different From Banks?
Years of more stringent regulations has raised the cost and financing of the alternative small and mid-sized asset class. Subsequently, fewer banks are lending to the aforementioned class. As banks become less willing, BDCs are filling the gap to offer capital to this marginalized class. With direct outreach and access to origination platform, BDCs create personalized sourcing and underwriting directly to borrowers — a shift from the traditional bank transaction. This direct delivery system provides a sense of security to the asset class previously lacking in the financial sector, while also proving to the borrower that they are real partners of theirs.
How To Choose A BDC Investment
Firstly, not all BDCs are affiliated with leading origination platforms. We here at Saratoga Investments Corp (NASDAQ: SAR)(“SAR”) are. Why that is relevant is that BDCs with origination access will usually take a more active role in the structure of transactions, capturing benefits that are unavailable to investors without the origination platform. Secondly, BDCs often leverage up to 1X debt-to-equity versus the traditional 0.33x of conventional closed-end funds. Thirdly, BDCs generally have greater diversification and do not use derivatives as leverage. Diverse sources better fund a multitude of investments while controlling interest rates and liquidity risk. Lastly, BDCs offer a more direct borrower-to-BDC assistance. What that means is that BDCs disclose more information, offer more transparency, and have more open-ended dialogues with their investors. Traditional closed-end funds and banks have a lower level of all of services.
The BDC Management TeamRelationship
Key to the investment decision is identifying the right BDC management organization. Responsible for managing investments, offering managerial assistance to portfolio companies, and making the investment portfolio lucrative, the team you pick can be the difference between a steady stream of dividend revenue and capital appreciation, or not. Though there is never a guarantee, you should research the risks of any investment, but the risk is mitigated when a BDC is managed by a knowledgeable team.
For more information on BDCs and investments management, visit Saratoga Investment Corp