The White Law Group represents investors in FINRA arbitration claims against brokerage firms. The firm has handled several cases involving business development companies in that capacity. 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 BDC?

A Business Development Company (BDC) is a type of investment company that invests in small and mid-sized businesses. Investors buy shares in BDCs, and their money funds the businesses. In turn, investors can profit from dividends paid on their investments or, in some cases, from selling their shares.

Business development companies were created in 1980 after Congress approved amendments to the Investment Act 1940. Section 2(a)(48) of the 1940 Act defines BDCs 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 to make 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.

To comply with regulations, BDCs must maintain at least 70% of their investments in eligible assets before investing in non-eligible assets. These companies were created to attract investments in smaller companies that couldn’t attract traditional forms of capital. They have become increasingly popular in recent years, partly due to their ability to generate strong investment returns. However, BDCs are not without their risks and pitfalls.

According to section 55(a) of the 1940 Act, a company 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 business development company and of which an affiliated person of the BDC is a director
• Private securities of companies are subject to bankruptcy, insolvency, or a similar proceeding where they cannot 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 company’s business.

Qualities of Business Development Companies

BDCs operate much like non-traded REITs (Real Estate Investment Trusts). Companies pool investor money and use that capital to invest in various businesses. The goal of a business development company is to invest in small and medium-sized businesses and help sustain and develop growth in those underlying businesses. When those businesses are profitable, BDCs can be a substantial investment. Additionally, some of these companies offer a desirable tax structure for investors.

Business development companies can be formed as a regulated investment company (RIC). As a result, the company must distribute at least 90% of its investment company taxable income to shareholders each year.

To continue to be treated as a RIC for tax purposes, BDCs must also (1) continue to qualify as a company 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, BDCs must not invest more than 25% into businesses they control or businesses within the same industry.

Advantages of Investing BDC Stock

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

Second, managers of these companies 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 business development companies may begin earning management fees immediately after the BDCs go public. Fourth, business development companies have flexibility that is not found in other registered investment funds.

Companies use this flexibility to leverage and engage in affiliate transactions with portfolio companies. In addition to these benefits, a business development company is similar to a venture capitalist in that it must offer significant managerial assistance to its portfolio companies.

Like venture capitalists, BDCs assume more risk and consequently invest at a much lower valuation than would be available in the public markets. This means these companies are open to the average net worth investor, not only the high net worth investor.

What are the risks of investing in Business Development Companies? 

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

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

Additionally, investors may be unable to evaluate historical data or assess investments before purchasing shares in BDCs. Companies that have established themselves in other investment areas do not guarantee success as business development companies. For example, a new investment company, Newtek, mentioned this risk in its 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 this 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 BDCs are subject to. Another business development company, Owl Rock Capital Corp II, invests in securities rated below investment grade by rating agencies or that would be rated below investment grade if they were rated. The investment grade securities below, often referred to as “junk,” have predominantly speculative characteristics concerning the issuer’s capacity to pay interest and repay principal. They may also be illiquid and difficult to value.

Junk Bond Exposure may hurt Investors’ shares.

BDCs also invest a large percentage in junk bonds, and some BDCs, 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%

BDCs’ use of these low-graded junk bonds may adversely affect an investor’s share, as the concentration in mostly B. CCC+ junk bonds, compared to investment-grade bonds, highly affects market volatility.

Interest Rates Play a Part 

Additionally, interest rates can significantly affect investment profitability. Business development companies are most effective when interest rates are high. This is because smaller companies seek out lenders who can offer them lower or more flexible rates when interest rates increase. Unfortunately for investors in BDCs, interest rates in the US remain at historic lows, and a growing bear market threatens the likelihood of future rate increases.

As a result, fewer companies seek out business development company lenders, and these companies lose negotiating leverage, resulting in lower payouts for investors. When investments in business development companies go wrong, they can go very wrong.

Additional Risks of Investing in BDCs

Additional risks associated with investing in a Business Development Company depend significantly on its structure and underlying investments. The main distinction between these riskier and safer classes is their liquidity. Many companies are structured like closed-end investment funds and are publicly listed on the NYSE, Nasdaq, and other exchanges.

These publicly traded BDCs allow for transparency and liquidity, making them less risky investments than their privately held counterparts. However, like any investment product, publicly traded business development companies are not without risk. A company’s value depends entirely on the value and health of its underlying business investments.

For example, many business development companies invest in oil and gas ventures that cannot secure bank loans. These smaller oil and gas companies are at significant risk of bankruptcy in the current market. The failure of just one of a BDC’s underlying assets can mean substantial losses for investors. Not only are risks within the market present, but high management fees are attached to the companies when purchased. A publicly traded business development company, 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 of 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 the fees associated with BDCs, 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 Business Development Companies are Risky 

In addition to publicly traded business development companies, there is another class of companies not listed on exchanges. These BDCs often carry much higher yields and can be tempting. However, they are generally much riskier investments than indexed companies.

Non-traded business development companies include Franklin BSP Lending Corp. (formerly known as Business Development Corporation of America BDCA) and FS Energy and Power. The first principal component in a 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, a company’s actual value is not always clear or available. The SEC requires non-traded business development companies to be valued once a quarter. Furthermore, this valuation is not market value and thus does not reflect what the company’s shares could be sold or redeemed for. Instead, the quarterly calculation is a “good-faith” valuation conducted by the BDCs’ board of directors based on the underlying companies’ assets and overall financial well-being.

Are non-traded Business Development Companies suitable investments? 

For these reasons, non-traded companies 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 before investing in a business development company. These standards are a minimum threshold. Before investing, a financial adviser should properly discuss liquidity, risk, and diversification needs. Some requirements must be met to qualify as a non-listed BDC.

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 some time
• There must be a liquidity event within five to seven years of the initial offering.

BDC Sales & Performance took a Dive in 2020 

Sales of nontraded business development companies hit new lows in 2020 and performed poorly due to COVID-19’s negative effect on returns.

In 2020, broker-dealers reportedly sold just $362.3 million in nontraded companies 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 in 2019 and a mere fraction of its peak in 2014 when brokers sold almost $5.5 billion in BDCs, according to the Stanger report.

Since 2009, broker-dealers have sold more than $22.6 billion of non-traded business development company stock, 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 $1.8 billion in commissions over that time, according to Investment News, which cited the Stanger report in February 2021.

Many of these non-traded BDCs were promised to provide steady growth and invulnerability from volatile markets, but this has not happened. According to the 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 exemption 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 provide additional flexibility for any business development company seeking to issue and sell senior securities to provide capital to these companies and to participate in investments alongside certain private funds affiliated with the company.

What about the unregistered BDCs? 

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

This exemption precludes BDCs from conducting regular valuations or reporting their financial status if they meet a loose set of requirements. These requirements include an absence of past regulatory issues and a limit on how much money can be solicited for investment. The exemption allows a company to raise $5 million in 12 months without registering with the SEC.

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

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

Questions to ask before investing in a Business Development Company 

Regardless of what kind of company 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, business development companies boast high returns, but the devil is often in the details regarding how much money you’re making.

BDCs often charge management and performance fees deducted from dividend payments. The management fee is generally around 2%; however, the performance fee usually exceeds 20%. These fees are unfamiliar with most closed-end investment products; however, a notable exception to the Investment Act’s prohibition against such fees applies to BDC operators. Additionally, these products are often very profitable sales for brokers and investment advisors.

Selling a business development company with a commission of 10% or more is not uncommon. These additional costs should be considered when analyzing the profitability and suitability of such an investment.

In addition to a discussion on fees and costs, investors should know that they are entitled to certain information about most BDCs before making an investment. The offering materials for a company 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 business development company 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 business development company and any potential conflicts of interest.
• Overview of the company’s Sponsors

Some of the sponsors of these riskier business development companies 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.

Free Consultation with a Securities Attorney 

Business Development Companies have garnered much attention in recent years given their associated high distribution yields compared to 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. These companies can allow individuals to purchase shares in a managed portfolio by private US companies. Added benefits include institutional portfolio management and potential protection from rising interest rates.

Like all investments, business development companies 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 investors take when investing. Business Development Companies can be a good investment for the right investor, with a diversified portfolio and sufficient due diligence. BDCs should only be recommended to investors who can weather substantial losses and those who do not need immediate liquidity. Investors should be particularly cautious of riskier non-public and non-traded BDCs.

If you invested in a BDC and want 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.

Frequently Asked Questions

What is a BDC in private credit? 

In the past, small businesses in need of capital often sought bank loans. However, bank lending to businesses is becoming less common as regional banks nationwide close. Business development companies (BDCs) have stepped in to fill the void left by these regional banks. BDCs are generally less regulated than traditional banks and can thus offer more customized loan terms. This is especially important for small, newly formed businesses that may not meet banks’ requirements.

What is the difference between a non-traded BDC and an interval fund? 

There are several key differences between non-traded BDCs and interval funds. BDCs invest in small and medium-sized, privately traded businesses, whereas interval funds invest in various asset classes, including private equity and debt. With interval funds, income and capital gains distributions occur regularly, while BDCs distribute at least 90 percent of taxable income.

What is the best BDC for me to buy? 

The best BDC for you depends on your investment goals. Before making an investment decision, review the dividends it distributes, any fees associated with the investment, and how well the business development company’s investments performed in the previous year.

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