Yassin Ibrahim
Investing.com – Business development companies, or BDCs, are taking the investment world by storm as income-seeking investors flock to this asset class that has earned a reputation for generating attractive dividend-like returns by filling a middle-market funding gap. left behind by traditional banks.
The BDC sector has seen significant growth, according to a recent report from Jefferies, with total assets under management increasing from $12 billion in 2000 to more than $260 billion by 2023.
What are business development companies?
A BDC is an investment firm that typically invests in the middle market industry with a focus on smaller private companies, or those generating $5 million to $100 million in earnings before interest, taxes, depreciation, and amortization (EBITDA). Business development companies primarily provide debt financing in the form of high-quality secured loans, but their investment strategies can be more diverse.
Business development companies receive coupon payments on debt, or advance loans and various fees from borrowers, which are then distributed to investors. While debt financing is their primary focus, business development companies can also invest in equity capital. When shares of these equity investments rise in value, business development companies may sell them to obtain additional returns. Business development companies are required to distribute about 90% of their investment income to investors, usually in the form of dividends.
The origin story of BDCs goes back to the 1980s, the period following the financial crisis of the late 1970s that led to increased regulation and compliance, forcing banks to tighten lending standards and leaving middle-market companies struggling to access debt capital.
Congress was forced to act, creating the Small Business Incentives Act of 1980 to “encourage private equity firms to provide debt capital to these middle market companies,” Dan Truglio, CFO of Horizon Technology Finance (NASDAQ:), told Investing. Yassin Ibrahim from .com in a recent interview.
In addition to declining bank lending, small businesses stay private longer and tend to rely on debt capital to finance their growth.
Private vs. General: Liquidity issues
Not all BDCs are created equal; Some are more liquid than others.
Publicly traded BDCs, which trade on public exchanges like the Nasdaq, sit at the top of the liquidity scale. In contrast, PEDCs mirror typical private equity fund structures with returns distributed at the end of the investment cycle and tend to be less liquid. Permanent BDCs fall somewhere between public and private BDCs, offering investors the opportunity to redeem investments during specified periods known as redemption windows.
Purchasing shares of publicly traded BDCs allows investors to gain exposure to the underlying assets and receive the income generated by those assets.
“When you buy our shares, you get a very small portion of each one of those loans spread across the portfolio, and then you receive monthly or quarterly distributions of our income in the form of dividends,” Trinity Capital President and CEO Kyle Brown told Investing.com.
High returns from delivery Middle market financing gap
Distributions, or dividend yields generated, typically range from the high single digits to mid-teens income, so it’s no surprise that investors are turning to business development companies (BDCs) to fix their income.
Returns generated on BDCs’ underlying assets, especially senior secured loans, “range for some BDCs in the high single digits to total returns in the mid-teens,” Brown said.
But how do business development companies generate such attractive returns?
impact: Most BDCs leverage their equity or pooled capital pool. This amplifies the return they can offer investors by borrowing at a lower interest rate and then lending it at a higher rate to their portfolio companies.
Business development companies (BDCs) are legally permitted to borrow up to two times their equity base; For every $1 worth of stock, they can borrow up to $2. However, Brown added that for most BDCs, incl Trinity Capital Company (NASDAQ:), leverage is about one to one.
“That high yield is why yields are a little bit higher,” Brown added.
expenses: While leverage provides an important boost to returns, fees charged to borrowers also contribute significantly.
The fees charged to the borrower can vary by BDC and may include a commitment fee charged at the beginning of the loan, a prepayment fee if the borrower repays the loan early, or a backend fee charged at the end of the loan or upon some event.
“We (Horizon Technology Finance) have a specific unique product where we get a current payment voucher,” Truglio said. “We get a commitment fee up front and we get a fee at the end. In general, we’re usually in the range of 11% to 14% of income if the company makes each payment from day one to month 60.”
Internally managed business development companies have the resources to manage investments directly rather than outsourcing. This allows them to generate additional income through third party capital management.
“Our BDC and some other internally managed BDCs including Hercules and Main Street have additional funds under management that our investors benefit from because we can charge management fees and incentive fees on other pools of capital,” Brown said.
While huge dividends are attractive, seasoned investors know that risks always need to be considered before looking at any asset class.
Understanding Risk: What Every BDC Investor Should Know
When investing in debt instruments, credit risk must be managed. Since business development firms may invest across different companies from venture-backed startups to late-stage companies, investors should be aware that risk levels may vary widely.
Horizon Technology Finance invests in development stage companies in the life sciences and technology sectors, which often have negative EBITDA due to high cash burn rates. While these investments carry higher risks compared to companies with positive EBITDA, the returns associated with venture debt investments are often higher to compensate for this increased risk.
It also helps to adopt a proactive management approach to identify any potential problems, Truglio said.
“We look at each of our companies on a monthly basis, conduct quarterly portfolio reviews, and take a deep dive into each of the companies, their cash position, performance, sponsors, management team… and stay ahead of it,” he added.
For publicly traded business development companies (BDCs), which are subject to SEC reporting requirements, the “biggest risk” is valuations, Brown said. He added that since publicly traded BDCs are required to value their assets on a quarterly basis, short-term economic changes can affect valuations, impacting BDC stocks even “if the ability to collect the loan is not diminished.” .
But for investors whose primary goal is to generate income, fluctuations in valuations are less worrisome than for those looking to “time the market.”
“If you’re an investor looking for return and income, this probably won’t impact you as much because you’ll continue to invest; but you’ll continue to invest,” Brown added. You will continue to collect your profits while watching the valuations fluctuate.
“But if you’re trying to get in and out of a stock, timing the market could be an issue because valuations could fall,” he warned.
Do business development companies face the risk of falling interest rates or recession?
As the Fed begins its rate-cutting cycle, many investors are concerned that income derived from loans – which typically float above a benchmark interest rate such as SOFR – could come under pressure.
This raises concerns about the high profits offered by business development companies.
While the return on these debt investments managed by BDCs may decline as interest rates fall, borrowing costs also decline, helping to mitigate the impact on margins.
“Most BDC core earnings are not at significant risk from Fed rate cuts,” Jefferies said in a recent note. Jefferies stressed that there are several mitigating factors, including accelerated origination and refinancing fees, and improved credit performance, which should help BDCs maintain earnings coverage.
In anticipation of further interest rate cuts, the Leveraged Loan Index default rate has seen a modest decline this year, S&P Global said, and could remain near 1.50% through June 2025, from 1.55% as of June 2024.
While a decline in interest should not “significantly impact BDCs,” Brown emphasized that “it is important for investors to look at individual BDCs” and understand their underlying assets along with performance over different economic and interest cycles – including… That is the zero interest rate period.
The art of creating deals
As the number of funds within business centers increases, their ability to provide high-quality investment opportunities can give them an advantage over competitors. “It’s critical, for sure,” Truglio said of deal sourcing, stressing the importance of business development firms “putting quality assets on the balance sheet.”
“Closing deals effectively not only allows us access, but also enhances our competitive advantage,” he added. A long-term management team is a critical combination of a successful business development center because it gives “access to market” for creation opportunities.
To BDC or not to BDC?
Whatever the economic or interest rate cycle, due diligence remains essential for investors considering which BDC to invest in.
For investors looking at business development companies, “what you really want to focus on is the management team,” Truglio said, asking “how long have they been in the industry, and do they understand the market?”
When evaluating a BDC’s dividend yield, Truglio believes it is important for retail investors to understand how BDC has been able to generate income to cover those dividends over time, what is the strength of their portfolio to continue to cover those dividends and how has they grown over the years?
The access that business development companies provide to private credit opportunities and the opportunity to build income suggests that this asset class is unlikely to run dry any time soon.
“I think the outlook going forward is that capital will continue to flow,” Truglio said, touting continued optimism about the future of BDCs. “We will see more activity and companies that have been able to reduce their costs and maintain high enterprise value. “.