Investing materials are loaded with acronyms for unconventional opportunities, and if you’ve ever grimaced and thought to yourself, “What’s the BDC meaning?” you aren’t alone.
A quick search to find out what BDC means can net you all sorts of answers: Business Development Council, Business Development Center, even Bottom Dead Council, whatever that is …
But if you’re an investor looking for unique ways to generate income and high yields, you’re looking up the acronym BDC for good reason. This type of BDC — a business development company — has a lot to offer, especially in today’s low-interest-rate environment.
If you’re hoping to learn what BDCs are, how they work, and how to get started investing in them, you’ve come to the right place.
BDC Meaning: What Is a Business Development Company?
BDC stands for business development company. A BDC invests in privately owned companies that are typically small or medium in size.
These companies need the support of a BDC, generally because they are experiencing difficulty, going through a period of growth, or aren’t able to secure financing in more traditional ways, like through banks or bond issuance.
BDCs to the rescue! These companies need the BDC to help them course-correct or scale for the future. The BDC invests in the struggling company to help that company develop, hence the name business development company.
With so many new startup companies popping up everywhere, BDCs sound like a perfectly timed new investment idea. But, BDCs were actually created in the 1980s in order to boost America’s struggling economy and create new jobs by supporting small businesses that were having a hard time raising money. As of April 2021, there were 47 publicly traded BDCs with a combined market capitalization of more than $49 billion.
How Does a BDC Work?
The ultimate goal of a BDC is to generate income and create capital gains by investing in these companies that need their help. When the struggling company is sold, the BDC will see a share of the profits.
BDCs vs. Private Equity
A BDC works much like a private equity or venture capital fund. But unlike private equity or venture capital opportunities, business development companies are attractive to everyday investors because just about anyone can invest in a BDC.
Why? Because they are public companies that are traded on the major stock exchanges. Whereas you must be an accredited investor with a certain level of net worth in order to gain entry into private equity and venture capital investment opportunities.
BDCs undergo significant regulation. This impacts tax status as well as diversification requirements.
As long as a BDC meets certain income, diversity, and distribution requirements, the company pays little or no corporate income tax. This favorable tax status doesn’t come for free, however. In exchange, the deal is that BDCs must pay out at least 90% of their taxable income in the form of ordinary dividends to their investors each year.
Good news for the investor, but this means that the BDCs retain only a small portion — 10% — of their earnings.
If real estate investment trusts (REITs) are coming to mind, you know your stuff! This tax status and dividend deal is very similar to the set up for REITs.
To comply with federal regulatory requirements, a BDC’s portfolio must be adequately diversified. No one investment can account for more than a quarter of the BDC’s holdings and at least 70% of the BDC’s investments must be with U.S. public or private companies with market capitalization under $250 million.
What Does All This Mean for BDC Investors?
So we know the BDC is helping small and medium-sized companies get off the ground or get back on track. We know that the government is watching them. And we know that the BDCs pay significant dividends.
As an investor, you need to know all of this, but what you should really be concerned about are the risks and rewards. So let’s dig into that. First, the good stuff…
Rewards of BDC Investing
In addition to paying higher than average dividends, business development companies offer several other rewards for investors, including:
Additional transparency. BDCs are regulated by the Investment Company Act of 1940 and the Securities and Exchange Commission. Because BDCs are heavily regulated public companies, they must provide investors with extensive information about their operations and their financial health. For you as an investor, this means you have greater insight into how your investment is being used by the BDC.
Opportunities to invest in up-and-coming private companies. Access to the private market and the potential upside opportunities is typically off limits for everyday investors. Investing in BDCs is a way in.
Enhanced liquidity. Typically investments with private companies lock up that money for quite a while. Investors can wait years for a liquidation event to occur. Should they really need that money, they can end up selling for a loss in the secondary market. With a BDC, investors have much better liquidity since you aren’t locking up your money for long periods.
Risks of BDC Investing
These advantages, of course, come with their share of risks. So, as with any type of investment, smart investors do their homework before jumping in.
Higher taxes. Yes, the BDC is not a taxable entity and therefore pays far less in corporate income tax, but as the investor, you still pay taxes and those taxes will actually be higher. Why? Because dividends from a BDC are considered ordinary income and are therefore taxed at ordinary income rates, which are higher than capital gains rates. Uncle Sam has to make up the difference somehow, right?
Less historical data. Even though the BDC concept has been around since the 80s, most of today’s BDCs are relatively young. For you as an investor, this means less historical data to rely on when making investment decisions.
Increased debt exposure. BDCs often leverage debt to build their portfolio companies. So an economic downturn, like the one we just saw in 2020, could easily cause the BDC to have to default on those loans.
More sensitivity to interest rates. Because BDCs rely heavily on debt, they will be significantly impacted when interest rates spike. Borrowing money becomes more expensive, which drives down profitability and decreases their ability to make favorable investments going forward.
Where to Invest in BDCs
Investors buy and sell BDCs in the same way you would buy or sell individual stocks, mutual funds, or exchange-traded funds (ETFs).
If you know exactly which BDC you’re looking for, you can find it using the ticker symbol and purchase it through a brokerage account or an individual retirement account. Or, if you’re just beginning to dabble in BDCs, it may be easier to look for an ETF or a mutual fund that offers the chance to invest in many BDCs at once.
Ready to Make an Investment in BDCs?
If you’re thinking that BDCs are right for you, it’s time to get started.
It is, however, important to understand that BDCs might not be right for every investor. If you’re on the more conservative side, BDCs might exceed the limits of your risk tolerance.
But if you’re an income-oriented investor who can accept that increased risk is typically accompanied by higher than average dividend yields and you’re willing to perform some due diligence, BDCs may just be a welcome addition to a strategically diversified retirement portfolio.
Now that you understand what BDCs are and how you can invest in them, you’re ready to dig a little deeper into investing in BDCs. The best way to do that is to continue learning, researching, and asking questions.
Note: This article originally appeared at Investors Alley.