Introduction to Business Development Companies
What is a BDC?
A BDC, or business development company, is a type of corporate structure created by Congress in 1980. It combined aspects of an operating company and an investment company in a new type of closed-end fund. The structure is designed to raise capital in the public equity markets and invest that capital in debt and equity of private or illiquid small and medium-sized domestic businesses in a pass-through entity vehicle.
Diversification and Leverage Guidelines
BDCs were developed to provide individual and retail investors access to an asset class that was typically only available to private investors and illiquid fund-type structures. As a result, several structural safeguards are put in place to reduce risk in the BDCs. Among those were reducing concentration risk and funding risk.
BDCs have several rules that limit the amount of concentration risk in the portfolio by forcing asset diversification, such as the limit that no single investment can be greater than 25% of assets at fair value. The portfolio must also be less than 50% positions that are individually greater than 5%. There's also a limitation on the amount of control equity positions a BDC can have.
When it comes to funding risk, BDCs are low-leveraged vehicles, particularly compared to most other financial services companies. Leverage is limited to one times debt-to-equity or a 200% asset-coverage ratio. What that means is, for every dollar of equity that a BDC raises it can borrow an additional dollar of debt and make two dollars’ worth of loans.
Because a business development company invests in the small and medium-sized private businesses, one of the stipulations is that the BDC has to offer managerial assistance to the companies that it invests in. That can come in many forms, but it typically comes in the form of having board observation rights, or outright sitting on the board for larger investments. If you think about a BDC, they often help companies form their capital structure, as well as underwrite and originate the loans those companies use to finance their growth.
Internally Versus Externally Managed BDC
There are two types of management structures for a BDC: an internally-managed BDC and an externally-managed BDC. For an internally-managed BDC, the employees that make the investment decisions and run the day-to-day operations work directly for the BDC. They receive a salary, bonus, and equity compensation. Under an externally-managed structure, the employees that make the investment decisions and run the day-to-day operations work for a third party, the investment advisor, who provides its services to the BDC under an external management agreement.
Externally Managed BDC Fees
For an externally-managed BDC, the fee structure generally consists of a management fee on assets under management, typically excluding cash, as well as a performance-based incentive fee. All in, the expenses for a BDC typically run around three to four percent of assets under management.
The BDC industry has grown tremendously over the last ten years. In 2004, there were a handful of BDCs. Total public equity in the sector was a cumulative $5 billion. Recently, there were around 45 publicly-traded BDCs that have raised a cumulative $28 billion in public equity, as well as a handful of private, non-traded BDCs.
Tax Treatment of BDCs
Many BDCs do elect to be treated as RICs, or regulated investment companies, whereas, as long as they distribute over 90% of their taxable ordinary income to shareholders as dividends, the income is only taxed once at the shareholder level and not at the corporation level. So BDCs are really investing in growing small and medium-sized private businesses and passing those cash flows directly to shareholders.
Attractive Income Potential
In the fixed-income world, the underlying assets that business development companies invest in are most similar to either high-yield bonds or leveraged loans. The underlying assets offer higher yields than those two asset classes because the companies are small and medium-sized businesses.
If you think about the way a BDC generates alpha, it's often by taking illiquidity risk, lending to a company that's too small to access the capital markets. Many BDCs also structure their own loans. They capture premium from creating a customized financing solution for the borrower, as well as developing a relationship with that borrower.
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The views and opinions expressed are those of the speaker and are current as of the video’s posting date. Video commentaries are general in nature and should not be construed as investment advice. Opinions are subject to change with market conditions. All performance information is historical and is not a guarantee of future results. For more information about Van Eck Funds, Market Vectors ETFs or fund performance, visit vaneck.com. Any discussion of specific securities mentioned in the video commentaries is neither an offer to sell nor a solicitation to buy these securities. Fund holdings will vary. All indices mentioned are measures of common market sectors and performance. It is not possible to invest directly in an index. Information on holdings, performance and indices can be found at vaneck.com.
Dean Choksi is Senior Vice President of Finance and Head of Investor Relations at Fifth Street Finance Corp. and is not involved in the portfolio management of Van Eck funds.
Please note that Van Eck Securities Corporation offers additional investment products that invest in the asset class(es) included in this video [Market Vectors BDC Income ETF]. Important disclosure for BDC Income ETF Investors: Business Development Companies (BDC) invest in private companies and thinly traded securities of public companies, including debt instruments of such companies. Generally, little public information exists for private and thinly traded companies and there is a risk that investors may not be able to make fully informed investment decisions. Less mature and smaller private companies involve greater risk than well-established and larger publicly-traded companies. Investing in debt involves risk that the issuer may default on its payments or declare bankruptcy and debt may not be rated by a credit rating agency. Many debt investments in which a BDC may invest will not be rated by a credit rating agency and will be below investment-grade quality. These investments have predominantly speculative characteristics with respect to an issuer’s capacity to make payments of interest and principal. BDCs may not generate income at all times. Additionally, limitations on asset mix and leverage may prohibit the way that BDCs raise capital. The Fund and its affiliates may not own in excess of 25% of a BDC’s outstanding voting securities which may limit the Fund’s ability to fully replicate its index. The Fund is currently concentrated in the financial services sector and may depend, to a greater extent, on the overall condition of the sector. The Fund may loan its securities, which may subject it to additional credit and counterparty risk.
The BDC Income ETF will indirectly bear its proportionate share of any management and other operating expenses and of any performance-based or incentive fees charged by the BDCs in which it invests, in addition to the expenses paid by the Fund which may negatively affect performance. A BDC’s incentive fee may be very high, vary from year to year and be payable even if the value of the BDC’s portfolio declines in a given time period. Incentive fees may create an incentive for a BDC’s manager to make investments that are risky or more speculative than would be the case in the absence of such compensation arrangements.
The “Net Asset Value” (NAV) of a Market Vectors Exchange Traded Fund (ETF) is determined at the close of each business day, and represents the dollar value of one share of the fund; it is calculated by taking the total assets of the fund, subtracting total liabilities, and dividing by the total number of shares outstanding. The NAV is not necessarily the same as the ETF’s intraday trading value. Market Vectors ETF investors should not expect to buy or sell shares at NAV.
ETF Fund shares are not individually redeemable and will be issued and redeemed at their NAV only through certain authorized broker-dealers in large, specified blocks of shares called "creation units" and otherwise can be bought and sold only through exchange trading. Creation units are issued and redeemed principally in kind. Shares may trade at a premium or discount to their NAV in the secondary market. You will incur brokerage expenses when trading Fund shares in the secondary market. Past performance is no guarantee of future results. Returns for actual Fund investments may differ from what is shown because of differences in timing, the amount invested, and fees and expenses.
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