Is a Business Development Company Worth the Risk?

Income-hungry investors searching for high yields outside of Treasury bonds and other traditional fixed income investments may consider adding a business development company (BDC) to their stock strategy—but with higher yields also comes greater risk. Here's what to know about publicly traded BDC investments before you consider adding them to your portfolio.

A BDC combines the characteristics of publicly traded companies and closed-end (private) investment vehicles. By providing financing to fledgling or struggling companies that may be unable to obtain bank loans or raise capital elsewhere, BDCs can expose investors to investments similar to those associated with private equity or venture capital firms.

Because BDCs—which trade like stocks but are managed like funds—invest in higher-risk businesses, they can charge higher interest rates on their loans and, in turn, offer attractive yields for investors.

One benefit of BDCs is their tax structure, which may bolster dividend yields. BDCs can elect to be taxed as regulated investment companies, which means they're exempt from corporate income tax so long as they distribute at least 90% of their profits, typically as dividends, to shareholders. The result is high-single-digit to low-double-digit yields that far outpace many traditional fixed income products and even some dividend stocks. Keep in mind that any dividends you receive from BDC investments will be reported as taxable income.

Another benefit of BDCs is their availability to investors who want to invest in private equity. Whereas private equity firms generally serve larger companies, BDCs tend to focus debt financing to small- and mid-size companies, allowing them to play a more active management role and make operational improvements that could add significant value. Though nonpublicly traded BDCs—like traditional private equity firms—may be accessible only to investors who meet certain income or high-net-worth requirements and carry unique risks including limited liquidity, you can buy and sell shares of publicly traded BDCs on the stock exchange.

As with other high-yield investments, however, BDCs should be approached with caution. First and foremost, most BDCs are publicly traded companies—not bonds—and come with the same market risks as other equities, including increased volatility. Beyond that, BDCs:

• Are sensitive to interest rates. BDCs use borrowed money to provide financing to other companies at higher rates. As interest rates rise, a BDC's profit margins could suffer.
• Are subject to credit risk. The types of companies BDCs invest in may be more likely to default on their loans or even go out of business, which could undermine overall returns.
• Charge high fees. In addition to their relatively steep management and service fees, BDCs may charge incentive fees on profits earned as well as loan-servicing fees.
• Lack transparency. Although publicly traded BDCs offer daily liquidity, they generally hold illiquid, and often not investment-grade, investments in private companies, which aren't required to make public disclosures, making it difficult to assess a BDC's true risk-reward profile.
• Lack of diversification. BDCs often concentrate assets in small- to mid-size developing and distressed companies. Such companies may share risks in loan repayment and economic resilience. Each BDC invests across various companies but cannot hold more than 25% of its assets in one company.
• Are managed by a small team. A few key personnel drive BDC investments decisions, and the board of directors can vote to replace the external manager. Any changes or loss of expertise can adversely impact the company.

Investors who feel comfortable taking on these risks might still consider investing in a BDC exchange-traded fund or mutual fund rather than an individual publicly traded BDC. Funds provide exposure to multiple BDCs in a single investment, which reduces the impact any one BDC will have on your portfolio. That said, remember that BDCs are relatively risky and should be viewed as part of your stock allocation, not your fixed income portfolio. Your financial advisor can help you research and do due diligence as well as make sure a BDC strategy aligns with your investment objectives.