Business Development Company (BDC)

A business development company is a closed-end fund that elects to be regulated under a special part of the Investment Company Act of 1940 written for funds that finance smaller businesses. The statute defines it as a closed-end company, organized and based in the United States, that "is operated for the purpose of making investments in" a defined set of eligible securities and "makes available significant managerial assistance" to the companies it treats as qualifying, and that has elected to be subject to the BDC provisions of the Act. In the SEC's plainer description, BDCs "are a way for retail investors to invest money in small and medium-sized private companies and, to a lesser extent, other investments, including public companies." Some BDCs focus on private credit, lending directly to businesses or buying syndicated loans.

The 70 percent test. A BDC may not acquire any asset outside the permitted categories unless, at the time, permitted assets make up "at least 70 per centum of the value of its total assets." The categories center on securities of the companies the statute makes eligible, which in the SEC's description means small and medium-sized private, or some small public, companies, typically early in their development or financially distressed and unable to borrow from a bank. That concentration is what distinguishes a BDC from an ordinary closed-end fund holding public stocks or bonds.

How BDCs are regulated. The SEC notes that BDCs "are not registered with the SEC as investment companies," yet are subject to many of the Investment Company Act's protections, including governance requirements, compliance and recordkeeping rules, and prohibitions on certain conflicts of interest. A publicly traded or retail-offered BDC files a Form N-2 registration statement with a prospectus, and every BDC files 10-K, 10-Q and 8-K reports, all on EDGAR. A privately offered BDC files a less detailed Form 10 and provides no prospectus, usually only a private placement memorandum that, as the SEC notes, is typically not reviewed by any regulator.

Leverage. BDCs "have more leeway than other closed-end funds, mutual funds, and ETFs to invest using debt and other leverage," in the SEC's words. The statute sets the required asset coverage for a BDC's borrowing at 200 percent, meaning assets (net of other liabilities) at least twice the debt. Since a 2018 amendment, a BDC can drop that to 150 percent, permitting roughly twice as much debt per dollar of equity, if its board approves by the statute's "required majority" (effective one year later) or more than 50 percent of the votes cast at a shareholder meeting approve (effective the next day). It must disclose the change, and a BDC whose shares are not listed on an exchange must also offer to buy back the shares held on the approval date, 25 percent in each of the following four quarters.

Three kinds of BDC. The SEC divides them by how shares are bought and sold. A publicly traded BDC trades on an exchange, so anyone can buy or sell at the market price, which can differ from the value of the holdings, as with any closed-end fund. A retail-offered BDC, commonly called non-traded, is sold continuously to investors who meet state-set income or net worth minimums and usually offers to repurchase shares quarterly or monthly. A privately offered BDC is generally sold to accredited investors, and without a repurchase program its holders may have to wait for a listing, a sale of the portfolio or a wind-down, an event the SEC notes may come several years, for example five to seven, after the initial investment. The SEC tells investors in non-traded BDCs to ask whether an up-front fee will reduce the initial investment and what ongoing management and performance fees apply.

A BDC raises money from investors, borrows more against its portfolio up to the statutory limit, and lends or invests the total in private companies. It earns interest and fees, pays its own borrowing costs and management fees, and pays distributions to shareholders.

Take an example of what the leverage limit allows. A BDC has $100 million of shareholders' equity. At 200 percent asset coverage it can borrow up to $100 million, giving $200 million of assets against $100 million of debt (ignoring other liabilities). At 150 percent it can borrow up to $200 million, giving $300 million of assets against $200 million of debt. Now suppose its loans lose 10 percent of their value. Under the first structure that is a $20 million loss, 20 percent of the shareholders' equity. Under the second it is a $30 million loss, 30 percent of the equity. The higher limit raises the income a BDC can earn on its equity in good years and deepens the hit in bad ones, because the debt has to be repaid in full either way.

Pros

• Gives individual investors access to private company lending and investment, with SEC registration and periodic reports.
• Publicly traded BDCs can be bought and sold daily on an exchange.
• The publicly traded form offers exposure to the kind of private company investing the SEC compares to venture capital and private equity, without a private fund's investor qualifications.

Cons

• The borrowers are often early-stage or distressed companies, so defaults are a real risk.
• Leverage, up to twice equity under the 150 percent limit, magnifies losses as well as gains.
• Non-traded and private BDCs are illiquid, can be sold back only on the BDC's schedule, and may carry up-front fees.
• Fees can be higher than for other funds, including performance fees on top of management fees.
• A publicly traded BDC's market price can fall below the value of its holdings.