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One of the favorite investments for income-seeking investors that our colleague Tim Plaehn recommends is business development companies, or BDCs.
Business development companies provide equity and debt financing sources for small-to-medium-sized corporations. They act as commercial lenders to companies that cannot get financing through the banking system. Currently, BDCs hold a quarter of assets under management in the private credit market.
Here’s why now is a great time to be buying them…
What Is a BDC?
At the most basic level, a BDC is a tax-efficiency play. Under a 1980s law, BDCs were set up to channel funds towards those small and middle-market companies that lack access to capital markets bigger players enjoy. BDCs must invest 70% of their assets in private U.S. companies or smaller public ones.
In addition, BDCs are structured as pass-through entities, which means they do not pay corporate income tax if at least 90% of net investment income is paid out as dividends. These companies are limited to debt that is no more than two times equity. (Until 2018, the limit was a debt of one times equity.) Most BDCs have continued to manage close to a one-to-one debt-to-equity ratio.
BDCs are structured as closed-end funds: after they raise capital in a share issuance, investors can buy the shares from other investors, but these purchases do not contribute new capital to the fund. New capital comes from the issuance of more shares.
BDCs: Then and Now
BDCs have evolved over the years. A structure set up to get capital to up-and-coming businesses is now mostly a way to finance middle-market leveraged buyouts. According to Moody’s, 80% of BDC transactions involve a private equity-sponsored business.
The size of the BDC market has soared in the past couple years, in no small part because of the exceptional debut of the Blackstone Private Credit Fund (BCRED) in 2021. In two short years, BCRED has gone from managing $0 to $48 billion, making it the biggest BDC. However, there is no public trading market for shares of BCRED and an investor’s ability to dispose of shares is limited to repurchase by Blackstone, subject to the limitations (5% per quarter) described in BCRED’s prospectus. These limitations mean only wealthy individual investors can buy it.
This one BDC aside, how have they performed historically?
I would say BDCs have fulfilled the promise of…
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