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The Fundamentals of Non-Traded Business Development Companies
Business Development Companies (BDCs), as established investment entities, specialize in bolstering small and medium businesses, with a particular focus on new and struggling entities. By offering crucial debt financing, BDCs provide a solid financial backbone for these businesses. Adhering to the Investment Company Act of 1940, BDCs are registered and are either public or private. Their mandate stipulates that a minimum of 70% of their assets must be invested in domestic private companies. Traded BDCs must also be registered with the Securities and Exchange Commission (SEC) to trade on an exchange. As of May 4, 2021, there were just above 30 traded BDCs available in the market.
Similar to stocks, investors can trade shares of BDCs on an exchange. On the flip side, private BDCs, known as non-traded business development companies, are immune to the share price volatility of the public market. However, non-traded BDCs come with their own set of substantial risks, including:
- Stringent wealth requirements
- High initial investments
- Elevated sales commissions and fee structures
- Illiquidity
- Extended investment timeframes
- Restrictions and suspensions on redemptions
Despite these risks and the high costs, shareholders can still reap substantial rewards through generous distributions in a prosperous year. Yet, when the net asset value (NAV) of a company dips, the high cost of such investments can be glaring. These factors, among others, have led to a decline in the popularity of non-traded BDCs since their peak in 2014. So, what does the current landscape look like for non-traded BDCs?
The Upsides and Downsides of BDCs
BDCs are typically known for their high potential yield, largely due to their tax-friendly structure. This can often result in higher dividend yields compared to other common stocks. BDCs provide a measure of accessibility, often being listed on national exchanges, thereby offering considerable liquidity. They invest in private instruments that are typically out of reach for retail investors. Thus, BDCs enable investors to gain exposure to private equity-like investments without any lock-ins or minimum investments.
However, they come with their share of risks. The portfolio and liquidity risk are significant since BDCs hold illiquid investments in non-publicly traded companies, which are often not investment-grade and lack transparency. Other risks include key personnel risk, credit and interest rate risk, diversification risk, and high management fees.
The Unusual Structure and Hefty Fees of BDCs
BDCs have been in existence since 1980, and like real estate investment trusts (REITs), BDCs registered as investment companies (RICs) can bypass corporate taxes provided they distribute at least 90% of their taxable income to shareholders annually. The structure of BDCs is unique due to the double-digit commissions frequently associated with this sector. Many investors pay a 10% commission to their brokers while other BDCs follow a two and twenty fee structure, similar to hedge funds. Here, the BDC charges 2% annually on the total value of the investor's assets plus a 20% fee on any profits. This structure necessitates that the returns should outperform other investment opportunities to be considered a smart choice.
Investors get a golden opportunity to invest in emerging, promising companies. BDCs traditionally promise higher-than-average interest income, earning them high regard among investors. The underlying debt of these BDCs typically yielded between 7% to 10% from 2015 to 2017, according to investment analytics firm FactRight.
Unlike venture capital funds, even small, non-accredited investors can buy shares in BDCs. However, non-traded BDCs are also known for their riskiness, often more so than traditional junk bond funds. It's not just the significant expenses but also their illiquidity due to the lack of listing that can make them risky.
The Troubled Times for BDCs
Previously attractive investments, market conditions caused a decrease in performance and sales of BDCs, partly due to an increase in loan defaults, changing regulatory rules, an increase in transparency about company fees, and heavy investment in the energy market which was negatively impacted by the global decline in oil prices.
In 2016, non-traded BDC fundraising totaled $1.9 billion, which fell by 58% the next year to $840 million equity raised. In 2019, BDCs raised $362.3 million, a sharp decline from the $112 million raised in the first quarter of 2018.
The sales slowed down even more due to the COVID-19 pandemic, which created panic in the global economy. Many investors were hesitant about investing in such risky endeavors. The non-traded BDC sector failed to mirror the returns of their underlying indexes, with the Stanger Non-Listed BDC Total Return Index posting a return of -14.3% in 2019, compared to the S&P BDC Total Return Index, which returned -8.8%.
The Investor Exodus and the Future
Many firms only allowed redemptions once per quarter, but some had to freeze requests completely. As a result, investors pulled out as much as $25.7 million in the second quarter of 2015, $47.3 million in the next quarter, and another $64 million in the final quarter of 2015.
Top 5 BDCs companies to invest
Ares Capital: The Dominant Leader
Market Capitalization: $10.3 billion Dividend Yield: 9.9%
Ranking as the globe's leading BDC based on market capitalization, Ares Capital (ARCC, $19.45) boasts a worth slightly beyond the $10 billion mark. It stands out not only for its size but also for its cautious asset allocation. By the end of the previous year, the company invested 43% of its portfolio in first-lien loans, complemented by an additional 18% in second-lien loans. Equity constitutes only 28% of its investments.
Main Street Capital: The Unquestionable Blue-Chip
Market Capitalization: $3.4 billion Dividend Yield: 6.4%
If you liken BDC stocks to the proverbial Main Street, then it's only fitting to mention Main Street Capital (MAIN, $42.27) first. This BDC enjoys the reputation of being among the top-tier operators in the sector, not to mention its recognition as a true blue-chip entity – all while consistently disbursing monthly dividends to its investors.
Owl Rock Capital: The Thriving Newcomer
Market Capitalization: $5.3 billion Dividend Yield: 9.8%
Coming onto the scene in 2019, Owl Rock Capital (ORCC, $13.53) is the newest entrant in the BDC sector. Notwithstanding its relatively recent inception, the company has managed to withstand the whirlwind initial years, delivering a consistent flow of dividends to shareholders, culminating in a present yield of over 9%.
Hercules Capital: The Venture-Centric Dynamo
Market Capitalization: $2.1 billion Dividend Yield: 10.3%
Daring to deviate from the conventional path, Hercules Capital (HTGC, $15.26) offers a more adventurous approach to BDC investments. As previously mentioned, BDCs are often considered as publicly-traded private equity firms. Yet, Hercules chooses to diverge, functioning more like a venture capital firm.
TriplePoint Venture Growth BDC: The High-Yield Speculative Bet
Market Capitalization: $441.0 million Dividend Yield: 12.7%
Finally, we have TriplePoint Venture Growth BDC Corp (TPGV, $12.50), a BDC worth exploring despite its smaller scale. As the smallest BDC on this list, with a market cap merely touching $441 million, TriplePoint certainly falls into the speculative category. However, its attractive dividend yield of 12.7% and its focus on growth could make this BDC an intriguing option for consideration.
While the selection of BDC stocks can often seem overwhelming, the key is to select companies that align with your risk tolerance and investment goals. Each BDC mentioned here offers something unique, from the conservative portfolio of Ares Capital to the venture-like operations of Hercules Capital. While their dividend yields are appealing, remember that investing always comes with risks, and thorough due diligence is essential. As always, a diversified portfolio can help mitigate risks and improve the chances of reaching your financial objectives.
The Final Verdict
The high fees, low liquidity, and low transparency associated with non-traded BDCs might make it challenging to justify their inclusion in your investment portfolio. However, with the industry consolidating and many BDCs shifting to a more flexible, interval fund structure while lowering their fees, there might be a turning point on the horizon for these investment vehicles.
