BDCs, the Good, the Bad, and the Ugly

Overview of Business Development Companies (BDCs)

The White Law Group represents investors in FINRA arbitration claims against brokerage firms. In that capacity, the firm has handled a number of cases involving business development companies (or BDCs). The following are some of the firm’s observations on the good, the bad, and the UGLY involving these high-risk, illiquid investments.

What is a Business Development Company (BDC)?

A Business Development Company (“BDC”) is a form of investment company that invests in small and mid-sized businesses. Investors can buy shares in a BDC, and the money from their investment is used to fund the businesses. In turn, investors can profit from dividends paid on their investments, or, in some cases, the sale of their shares.

BDCs were created in 1980 after Congress approved a series of amendments to the Investment Act of 1940. Section 2(a)(48) of the 1940 Act defines a BDC as (A) closed-end company that is organized under the laws of, and has its principal place of business in, any State or States; (B) is operated for the purpose of making investments in securities specified within Section 55(a) of the 1940 Act and, makes available “significant managerial assistance” with regards to the issues of such securities, and (2) has elected business development company status.

In order to comply with BDC regulations, a BDC must also maintain at least 70% of its investments in eligible assets before investing in non-eligible assets. The creation of BDCs was meant to attract investments in smaller companies that couldn’t attract traditional forms of capital. BDCs have become increasingly popular in recent years, in part due to their ability to create strong returns on investments. However, BDCs are not without their risks and pitfalls.

According to section 55(a) of the 1940 Act, a BDC must have at least 70% of its total assets in the following investments:

Privately issued securities purchased from issuers that are eligible portfolio companies
Securities of eligible portfolio companies that are controlled by a BDC and of which an affiliated person of the BDC is a director
Private securities of companies subject to bankruptcy, insolvency, or a similar proceeding where they are unable to meet their financial obligations.
Cash, cash items, government securities or high-quality debt securities
Office furniture and equipment, interests in real estate and leasehold improvements and facilities maintained to conduct the business of the BDC.

Qualities of a BDC

BDCs operate much in the same way as non-traded REITs (Real Estate Investment Trusts). BDCs pool investor money and use those funds as capital to invest in various businesses. The goal of a BDC is to invest in small and medium sized businesses and help sustain and develop growth in those underlying businesses. When those businesses are profitable, the BDC can be a strong investment. Additionally, certain BDCs offer a desirable tax structure for investors.

A BDCs can be formed as a regulated investment company (RIC). As a result, the BDC must distribute at least 90% of their investment company taxable income to shareholders each year.

To continue to be treated as a RIC for tax purposes, the BDC must also (1) continue to qualify as a BDC within the Investment Company Act of 1940; (2) derive at least 90% of their gross income from dividends, interest, payments on securities loans, gains from the sale of stock or other securities, or other income derived from their business; and (3) satisfy quarterly RIC diversification requirements by not investing more than 5% of their assets in any single security and no more than 10% of a given security’s total voting assets. Additionally, they must not invest more than 25% into businesses they control, or businesses within the same industry.

Advantages of Investing in BDCs

Business Development Companies may seem more attractive than other types of investment funds. First, BDCs provide investors with the same degree of liquidity as other publicly traded investments. Unlike open-ended investments, or mutual funds, investors can do more than only buy and sell shares directly to and from the fund itself.

Second, managers of BDCs have access to capital that isn’t subject to shareholder redemption or the requirement that capital be distributed to investors as investments are realized or otherwise generate income. Third, managers of BDCs may begin earning management fees immediately after the BDCs have gone public. Fourth, BDCs have flexibility that is not found in other types of registered investment funds.

BDCs use this flexibility to leverage and engage in affiliate transactions with portfolio companies. Along with these benefits, a BDC is similar to venture capital because they are required to offer significant managerial assistance to their portfolio companies, similar to a venture capitalist.

Like a venture capitalist, a BDC assumes more risk and consequently gets to invest at a much lower valuation that would be available in the public markets. This means that BDCs are open to the average net worth investor, not only a high net-worth investor.

What are the risks of investing in a Business Development Company?

These investments are not without risk, however. Within the BDC’s prospectuses there are risk factors that investors should be wary of. One risk found when investing in a BDC is how relatively new these businesses are. Because these companies are newly formed, there are many uncertainties that come along with any new business, and these BDCs run the risk that the investment objectives will not be achieved, and as a result, the value of the stock could decline substantially.

Another risk that investors may encounter when dealing with these new investments is because the new companies have relatively few investments, the public offering may be deemed to be a “blind pool” offering. This means that there may be no stated investment goal for the funds raised by the investors.

Additionally, investors may not be able to evaluate any historical data or assess investments prior to the purchasing of any shares within a BDC. Companies that have been able to establish themselves within other investment areas still hold no guarantee that there will be any success when operating as a BDC. By way of example, a new BDC, Newtek, mentioned this risk in their investor prospectus.

“Although Newtek has operated since 1998, we have no operating history as a BDC. As a result, we can offer no assurance that we will achieve our investment objective and that the value of any investment in our Company will not decline substantially. As a BDC, we will be subject to the regulatory requirements of the SEC, in addition to the specific regulatory requirements applicable to BDCs under the 1940 Act and RICs under the Code. Our management has not had any prior experience operating under tis BDC regulatory framework, and we may incur substantial additional costs, and expend significant time or other resources, to do so. In addition, we may be unable to generate sufficient revenue from our operations to make or sustain distributions to our stockholders.”

These are not the only risks a BDC is subject to. Another BDC, Owl Rock Capital Corp II invests in securities that are rated below investment grade by rating agencies or that would be rated below investment grade if they were rated. Below investment grade securities, which are often referred to as “junk,” have predominantly speculative characteristics with respect to the issuer’s capacity to pay interest and repay principal. They may also be illiquid and difficult to value.

Junk Bond Exposure may have an adverse effect on Investors’ shares

BDCs also invest a large percentage in junk bonds, and some BDC’s such as the Corporate Capital Trust II may fluctuate heavily with the use of junk bonds. From the prospectus it appears that Corporate Capital Trust has a lot of junk bond exposure:

Standard & Poor’s rating Fair Value Percentage of Portfolio

BB- $503,326 13.0%

B+ $280,540 7.2%

B $516,757 13.4%

B- $1,326,361 34.2%

CCC+ $1,023,344 26.4%

CCC $200,000 5.2%

CCC- $24,274 0.6%

Total $3,874,602 100%

The use of these lowly graded junk bonds may have an adverse effect on an investor’s share, as the market volatility is highly affected by the concentration in mostly B- to CCC+ junk bonds, compared to investment grade bonds.

Interest Rates Play a Part

Additionally, interest rates can play a large role in the profitability of BDC investments. BDCs are most effective when interest rates are higher. This is because smaller companies seek out lenders who can offer them lower or more flexible rates when interest rates increase. Unfortunately for BDC investors, interest rates in the US remain at historic lows, and a growing bear market threatens the likelihood of any future rate increases.

As a result, fewer companies seek out BDC lenders, and BDCs lose negotiating leverage, resulting in lower payouts for investors. When investments go wrong with BDCs, they can go very wrong.

Additional Risks of Investing in a BDC

Additional risks associated with investing in a Business Development Company depend greatly on the structure and underlying investments of the BDC in question. The main distinction between the riskier and safer classes of BDCs is their liquidity. Many BDCs are set up much like closed-end investment funds and are public companies that are listed on the NYSE, Nasdaq, and other exchanges.

These publicly traded BDCs allow for a level of transparency and liquidity that makes them less risky investments than their privately-held counterparts. However, publicly traded BDCs are, like any investment product, not without risk. The value of a BDC depends entirely on the value and health of the underlying business investments.

For example, many BDCs invest in oil and gas ventures that are unable to secure bank loans. In the current market, these smaller oil and gas companies are at great risk of bankruptcy. The failure of just one of a BDCs’ underlying assets can mean significant losses for investors. Not only are risks within the market present, but high management fees are attached to the BDCs when purchased. A publicly traded BDC, Full Circle Capital (with a proposed merger into Great Elm Capital Corp.), exemplifies how many fees are added onto a BDC.

Basic Fees Associated with one BDC — Full Circle Capital

Management Fee	1.5% of average gross assets, excluding cash
Income Incentive Fee	20% subject to a 7% hurdle, a full catch-up provision up to 8.75%, and 20% of returns thereafter
Capital Gains Incentive Fee	20% of cumulative realized capital gains, net of cumulative realized losses and unrealized capital depreciation, less prior Capital Gains Incentive Fee payments.
Total Return Test	Income Incentive Fee will be deferred unless GECC achieves a 7% total return on net assets on a rolling three-year basis.

Along with these fees, financial advisors are paid by selling these products, which usually amounts to a 7-10% commission fee. When you add up all these fees it is difficult for the investments to be successful.

Non-traded BDCs are Risky

In addition to publicly traded BDCs, there is also another class of BDCs that are not listed on exchanges. These BDCs often carry much higher yields and can be a tempting investment option, however they are generally a much riskier investment than indexed BDCs.

Non-traded BDCs include Franklin BSP Lending Corp. (formerly known as Business Development Corporation of America BDCA) and FS Energy and Power. The first major component in the non-traded BDC’s risk profile is its lack of liquidity. Without an open market to trade in, owners of non-traded BDCs can be stuck holding their investments for years, sometimes without ever getting the opportunity to sell.

Additionally, the actual value of a BDC is not always clear or available. The SEC requires non-traded BDCs to be valued just once a quarter. Furthermore, this valuation is not market value, and thus not a reflection of what the BDC shares could be sold or redeemed for. Rather, the quarterly calculation is a “good-faith” valuation conducted by the BDCs board of directors and is based on the assets and overall financial well-being of the underlying companies.

Are non-traded BDCs suitable investments?

For these reasons, non-traded BDCs have not been deemed suitable for all investors. Suitability standards generally require an investor to have either a net worth of at least $250,000, or a net worth and an annual gross income of at least US $70,000. These standards are a minimum threshold, proper discussion of liquidity, risk, and diversification needs should be discussed with a financial adviser before investing. In order to qualify as a non-listed BDC there are requirements that need to be met.

What are the requirements?

Must be sold to accredited investors only
Must be reviewed by FINRA
Must be approved to sell in each state where solicitations will occur, requiring compliance with the National Association of State Securities Administrators.
Continuous offering over a period of time
There must be a liquidity event usually within five to seven years of the initial offering.

BDC Sales & Performance took a Dive in 2020

Sales of nontraded BDCs hit new lows in 2020 and also had poor performance due to COVID-19’s negative effect on returns.

In 2020, broker-dealers reportedly sold just $362.3 million in nontraded BDCs last year, the least since 2010, which was the year after the first product was launched, according to Robert A. Stanger & Co. Inc. That amount is one-third less than 2019 and a mere fraction of its peak in 2014 when brokers sold almost $5.5 billion, according to the Stanger report.

Broker-dealers have sold more than $22.6 billion of nontraded BDCs since 2009, with FS Investments accounting for about half that total. The brokers or advisors usually charge a 7% commission and the firm 1%, which translates into a total of $1.8 billion in commissions over that time, according to Investment News in February 2021, citing the Stanger report.

Many of these non-traded BDCs were promised to provide steady growth, and invulnerability from volatile markets, which has not happened. According to Wall Street Journal, FINRA’s Vice President for Corporate Financing has said these products are an “ongoing concern” for the regulator and that “firms must ensure they are suitable for an investor’s risk profile and investment strategy.”

According to The Securities and Exchange Commission, the regulator announced in April 2020, temporary, conditional exemptive relief for business development companies (BDCs) to enable them to make additional investments in small- and medium-sized businesses, including those with operations affected by the coronavirus (COVID-19) pandemic.

The latest relief would reportedly provide additional flexibility for BDCs to issue and sell senior securities in order to provide capital to these companies, and to participate in investments alongside certain private funds that are affiliated with the BDC.

What about the unregistered BDCs?

Aside from traded and non-traded Business Development Companies, there is a third category of BDCs that can present a unique set of risks to investors. While most BDCs are registered with the SEC and subject to regulation and reporting requirements, one subset of BDCs is not. Certain BDCs are offered through a Regulation E (Reg E) exemption of the Securities Act of 1933.

This exemption precludes BDCs from having to conduct regular valuations or report their financial status if they meet a loose set of requirements. These requirements include an absence of past regulatory issues and a limit on the amount of money that can be solicited for investment. The exemption allows a company to raise up to $5 million in a 12-month period without registering with the SEC.

Unregistered BDCs are also more likely to be carrying non-secured debt in companies that have a higher risk of bankruptcy. Most BDCs seek to have their loans protected by receiving a property interest or equity in the companies they invest in. By doing this, the BDCs increase their chances of salvaging some of the investment’s value in the case of a bankruptcy.

Unfortunately for investors in unregistered BDCs, not only are they likely investing in weaker and less stable companies, they are most likely not adequately protected in the case of bankruptcy. Investors in Business Development Companies should make certain that they are investing in BDCs that carry as few of these unnecessary risks as possible. Losses in unregistered BDCs can be catastrophic and extremely difficult to mitigate. Remember, the higher the purported return on a BDC, the riskier the underlying investments are.

Questions to ask before investing in BDCs

Regardless of what kind of BDC you are being offered, there are several questions that you should ask. The first concerns the fees and commissions associated with the investment. Much like REITs, BDCs boast high returns, but the devil is often in the details when it comes to how much money you’re actually making.

BDCs often charge both a management fee and a performance fee that is deducted from dividend payments. The management fee is normally around 2%, however, the performance fee can often meet or exceed 20%. These fees are not common with most closed-end investment products, however, a special exception to the Investment Act’s prohibition against such fees is applied to the operators of BDCs. Additionally, these products are often a very profitable sale for brokers and investment advisors.

It is not uncommon for a BDC to be sold with a commission of 10% or more. All of these additional costs should be taken into account when analyzing the profitability and suitability of such an investment.

In addition to a discussion on fees and costs, investors should also know that they are entitled to certain information about most BDCs prior to making an investment. The offering materials for a BDC and/or the adviser selling the product should share the following information with potential investors:

A description of the offering’s objectives and its investment methodology
The types of companies and securities in which it plans to invest
The amount of capital the BDC seeks to raise, and how it plans to spend the money
The liquidity of the BDC and the rules that govern redemption and sale
If distributions are guaranteed in frequency or amount and the source of these payments
The operating history of the BDC and any potential conflicts of interest.

Overview of BDC Sponsors

Some of the sponsors of these riskier BDCs include: AR Global, Business Development Corporation of America (BDCA), CION Investment Management, CNL Securities, FS Investments (formerly known as Franklin Square) (FS Energy and Power, FS Global Credit Opportunities, FS/KKR Corp. Capital II), Hines Securities (MCS Income Fund, formerly known as HMS Income Fund), NorthStar Securities, and the Sierra Income Corp.

(1) Franklin BSP Lending Corp.

Franklin BSP Lending Corp. (formerly known as BDCA) has its main office in New York City. Founded in 2010, this non-traded BDC formerly known as Business Development Corporation of America was sponsored by AR Global Investments. AR Global, founded in 2007 as a small asset manager, actively sponsors both traded and non-traded alternative investments, most notably REITs. AR Global is also involved in open and closed-end mutual funds.

Franklin BSP Lending Corp. invests mainly in first and second lien senior secured loans and mezzanine debt issued by middle market companies.

(2) CION Investment Corporation

CION Investment Corporation is located in New York City. Founded in 2011, this BDC is sponsored by ICON, which provides alternative investment products to individuals and institutional investors. ICON, the sponsor company, has been an alternative investment manager for around 30 years. They manage REITs, equipment finance funds, and provide advisory services for middle-market companies.

CION seeks to invest in companies with an EBITDA of $50 million or less. The fund primarily invests in senior secured debt, as well as private and thinly-traded U.S. middle market companies. This fund has 16.1% of its holdings in business services, while 14.5% of its holdings are within the high-tech industries. CION has around $907 million in total assets, while the total equity raised by the Fund has been around $937 million.

The company was offered as a non-traded BDC but listed its shares on the New York Stock Exchange on October 5, 2021 under the ticker CION after a 2-to-1 reverse stock split on Sept. 21. On a split-adjusted basis, some investors who purchased CION as a non-traded BDC may be facing close to a 40% loss on the principal on their original investment, not including any reinvested distributions.

Shares of CION were originally offered at a reverse split adjusted price of $20.00 per share in an offering declared effective in 2012. The NAV per share adjusted for the reverse split was $16.34.

According to Market Watch, shares of CION closed on August 1, 2022 at $9.23.

(3) Franklin Square/FS Investments/FS KKR Capital Corp. II

FS KKR Capital Corp. II (FSKR) was launched at the end of 2019 as the product of a merger of four non-traded BDCs –FS Investment Corporation II (FSIC II), FS Investment Corporation III (FSIC III), FS Investment Corporation IV (FSIC IV) and Corporate Capital Trust II (CCT II). The new entity began trading on the New York Stock Exchange in June 2020, after a 2019 merger between four FS Investments entities. The company said it was looking to take advantage of dislocations in the market caused by the coronavirus global pandemic.

Unfortunately for investors, due to a 4 to 1 reverse stock split, each of the four common shares issued and outstanding were combined into one share, reducing the number of shares outstanding from approximately 691.2 million to approximately 172.9 million. FSKR’s net asset value per share as of March 31, 2020 was $24.68, instead of $6.17 per share.

According to a press release on Feb. 1, 2021, FS KKR Capital Corp. (NYSE: FSK) and FS KKR Capital Corp. II (NYSE: FSKR), announced preliminary estimates of financial results for the fourth quarter ended December 31, 2020. The Companies also are reportedly providing preliminary estimates of results after a proposed merger of FSK and FSKR, was announced on November 24, 2020.

FSEP (FS Energy & Power Fund) is a publicly registered, non-traded business development company sponsored by FS Investments. According to the company’s web page, market events in 2020 have impacted the financial markets and significantly disrupted U.S. and global economies, including energy markets.

The fund focuses primarily on investing in the debt and income-oriented equity securities of privately held U.S. companies in the energy and power industry. FSEP’s investment objectives are to “generate current income and long-term capital appreciation,” according to its website.

(4) Sierra Income Corp./Barings BDC

Sierra Income Corporation has its headquarters in New York City. Founded in 2012, this non-traded BDC is sponsored by Medley Management, and invests in mid-market businesses. Medley Management was formed 14 years ago, and focuses on credit-related investment strategies, primarily originating senior secured loans to private middle market companies in the US that have revenues between $50 million to $1 billion.

Sierra Income Corporation and Barings BDC Inc. (NYSE: BBDC) completed a planned merger in 2021. The completion of the merger marks the end of a long liquidity process for Sierra Income Corporation.

Sierra shareholders reportedly received cash ($0.9784) and stock (0.44973 shares of BBDC common stock) totaling $5.85 per Sierra’s shares. Shares were originally sold for $10 per share. Sierra Income Corp. Completes Merger with Barings BDC Inc. (BBDC)

(5) Hines Securities

Hines Securities, founded in 2003, has its main office in Houston, Texas. The Firm oversees the sale of sponsored investment products to individual investors through broker-dealer firms and their financial advisors. Along with the BDC, Hines Securities has three non-traded REITs that they manage. Their main BDC offering is MSC Income Fund (HMS Income Fund). See Investor Alert: MSC Income Fund, Inc. (fkn HMS Income Fund, Inc.).

MSC Income Fund is a non-traded BDC, launched in 2012. The Fund has targeted investments with senior secured loans, second lien loans and mezzanine debt, and selected equity investments of private companies with annual revenues between $10 million and $3 billion. As of March 31, 2016, the Fund has debt investments in 117 companies and equity investments in 23 companies representing 42 business sectors in the middle-market and lower-middle market.

Free Consultation with a Securities Attorney

Business Development Companies have garnered a lot of attention in recent years given their associated high distribution yields compared to more traditional fixed income investments. However, many people have invested in this product without conducting or being advised of the potential risks, as higher yields are associated with higher risks. BDCs can give individuals the chance to purchase shares in a managed portfolio made to private US companies. Added benefits include institutional portfolio management and potential protection from rising interest rates.

Like all investments, BDCs do not come without risks. Limited liquidity, distributions that may not be guaranteed in frequency or amount, and limited operating history are just a few risks that investors take on when investing in a BDC. Business Development Companies can be a good investment for the right investor, along with a diversified portfolio and sufficient due diligence. BDCs should only be recommended to those investors who are able to both weather substantial losses and those who are not in need of immediate liquidity. Investors should be particularly cautious of riskier non-public and non-traded BDCs.

If you invested in a BDC and would like a free consultation with a securities attorney, please call The White Law Group at 888-637-5510.

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Seattle, Washington. For more information on the firm and its representation of investors, visit https://whitesecuritieslaw.com.

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