That New Vehicle Smell: Solid returns have spurred the growth of business development companies among yield-hungry investors


The long, seemingly unending period of low interest rates and low returns on fixed-income investments has pushed investors to look for ways to boost their portfolios’ performance. One of the nontraditional investments getting a lot of attention because of its high yields relative to more traditional fixed-income investments are business development companies (BDC), a form of publicly registered investment company in the United States that provides financing to small and mid-sized businesses.

According to data from Closed-end Fund Advisors (CEFA), the average income yield on the BDC universe (both debt- and equity-focused firms), as of June 30, 2015, is about 9.5 percent. The long-term average is more than 6 percent. Any way you look at it, this is a very attractive return for yield-starved investors.

These types of returns have spurred rapid growth in the past 10 years. There has only been one BDC IPO year-to-date, but there were four to six per year from 2009–2014. Only five BDCs existed in 2004.
Many investors, however, have moved into this product without fully appreciating the potential pitfalls. Not all BDCs are created equal. And no matter how you slice it, higher yields are associated with higher risks — no matter how much we might want to wish away that relationship.

BDCs are essentially publicly traded closed-end funds that make investments in private or small public businesses that need funding to help them grow. BDCs were originally set up by the SEC to give retail investors the ability to participate as equity owners in growing firms just as institutional investors do. Most BDCs, however, have moved from acquiring equity positions to providing debt, primarily mezzanine. Of the roughly 55 BDCs in the market, more than 40 are debt focused.

“Different companies specialize in different kinds of debt,” says Steven Davidoff Solomon, a professor of law at the University of California, Berkeley, “but the mainstay has been mezzanine debt and collateralized loan obligations — pools of leveraged loans. This debt is often issued in connection with private equity buyouts and is of the riskier ilk. This makes business development companies a friendly cousin to a true private equity fund.”

One major distinguishing characteristic of BDCs is that they are open to any investor, whereas private equity funds typically are available only to institutional or wealthy investors. This is a double-edged sword in that it allows any investor to participate in the growth of emerging companies, but it also opens retail investors to risks they may not fully understand.

“BDCs can be viewed as a hybrid between a traditional investment company and an operating company,” explains Kevin Mahn, CIO of SmartTrust Unit Investment Trusts. “They represent a transparent portfolio of loans, similar in some sense to private equity or venture capital that can be traded publicly generally without restriction or back-end fees.”

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