Business Development Companies (BDCs) as Defined Under Section 2(a)(48)
BDCs are defined under Section 2(a)(48) of the Investment Company Act of 1940 (“1940 Act”). According to the 1940 Act: “Business development company means any closed-end company which—
- Is organized under the laws of, and has its principal place of business in, any State or States;
- Is operated for the purpose of making investments in securities described in paragraphs (1) through (3) of section 55(a), and makes available significant managerial assistance with respect to the issuers of such securities.”
The 1940 Act also requires that 70% of a BDCs total assets satisfy section 55. This means that the vast majority of a BDCs assets are securities of “eligible portfolio companies.” The United States Security and Exchange Commission (SEC) recently expanded the definition of eligible portfolio companies to include “Exchange-listed companies that have less than $250 million in market capitalization.” Prior to the recent amendment of Rule 2a-46, eligible portfolio companies were limited to domestic operating companies not listed on an Exchange.
BDCs as Regulated Investment Companies (RIC)
BDCs are generally treated as regulated investment companies (RICs). Pursuant to 26 U.S.C. §851, Regulated Investment Companies must have at least 90% of its gross income derived from:
- Dividends
- Interest
- Payments concerning securities loans, and
- Gains from the sale of stock or securities, or
- Other income derived with respect to its business.
In addition, BDCs may not invest more than 5% of their assets in a single security and not more than 10% of the outstanding voting securities of an issuer.
Furthermore, not more than 25% of the value of its total assets may be invested in:
- the securities of any one issuer;
- the securities of two or more issuers that the taxpayer controls and are engaged in the same or similar industry;
- or the securities of one or more qualified publicly traded partnerships
Positives of Investing in a BDC
Because BDCs must follow the requirements of regulated investment companies, they are required to distribute a minimum of 90% of their investment company taxable income to shareholders. BDCs were designed to help provide access to capital for small businesses.
Investing in a BDC helps to provide funding for small and mid-size companies that otherwise may not have access to the capital they need to survive. BDCs may allow a sophisticated investor to diversify their portfolio with investment in businesses that could have a high return on investment.
Negatives of Investing in a BDC
BDCs assets generally are made up of financially distressed companies or brand new, unproven, small to mid-size businesses. Therefore, they are risky investments. The companies that make-up BDCs are not market-tested, so there is uncertainty in how they will perform. An investor may not have access to all the information regarding the underlying assets that make up a BDC’s portfolio.
Furthermore, BDCs may overvalue the companies in their portfolio, a material fact of which investors are not informed. Without transparency regarding the underlying investments that make up a BDC, there is no way for an investor to know what kind of risk they are taking.
Business Development Companies are Risky
There are publicly traded BDCs and non-listed BDCS. The non-listed BDCs can carry higher yields but they can be much riskier investment than publicly traded BDCs.
Some examples of private BDCs are:
- Business Development Corporation of America
- Carey Credit Income Fund
- FS Energy and Power
- Sierra Income Corp.
One significant risk of non-traded BDCs is their lack of liquidity. Investors in non-traded BDCs can be stuck in their BDC investments for years, or sometimes forever. Further, the true value of such private BDCs usually is unavailable. Indeed, the stated value is not a market value and usually does not reflect what the BDC shares could be sold. BDCs are risky investments and can result in an investor losing all of their principal investment.
Brokerage Firms’ Recommendations and Sales of BDCs to Unsophisticated Investors and Retirees
Most private BDCs pay far higher commissions to the brokers and brokerage firms selling such BDCs than traditional investments like common stocks and bonds do. As such, to “earn” such high commissions, many financial professionals recommend and sell BDCs to risk-averse customers like retirees and other investors who rely on the income from their investment to live.
Unfortunately for many brokerage firm customers, many stockbrokers inform their clients that BDCs are “safe” or conservative investments suitable for risk-averse investors. When making recommendations to purchase securities, financial advisors have the duty to fully explain all important risks of such investments. Many investment advisors, however, do not disclose the true risks inherent in BDCs, including the high risk level associated with investing in BDCs, resulting in investors thinking that their investments in certain BDCs will not suffer significant losses.
