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.
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.”
The primary advantage of BDCs is, of course, the yield. They currently have a one-year average yield of 10.7 percent, with the three-year NAV total returns coming in at more than 29 percent.
The major appeal of BDCs is that they often pay — at least in the past few years — hefty dividends from the high interest rates charged on the loans they make to small businesses. Of course, these high rates of interest reflect the high risk involved with some of these loans.
Those investors looking to add BDCs to their portfolio need to do their homework if they want to mitigate the risks.
“We like a portfolio of BDCs that blend to about 60 percent first-lien loans and about 80 percent variable loans,” says John Cole Scott, CIO, Closed-End Fund Advisors. “This protects investors from two possible outcomes. Variable loans protect from rates rising faster than we expect, and first-lien exposure helps to protect from unexpected economic or market headwinds, such as Greece, oil, flash crash, bear market, negative GDP growth, etc. We also pay attention to nonaccrual loans and like to keep the average under 3 percent.”
Scott also recommends that investors diversify.
“We recommend investors own six to 10 BDCs, as then they reduce the risk per BDC and typically gain exposure to 500 to 1,000 underlying companies while still being able to pick the top 20 percent to 25 percent of the BDC sector.”
BDCs appear to be here to stay, but as with all nontraditional investments, investors and their advisers need to be extra careful. The high yields are real, but the risks are just as real. The sector will be tested as interest rates begin to rise. If it can handle the coming increase in the cost of capital, it likely will become a standard addition to the portfolios of sophisticated private investors. The next couple of years will be a very interesting time for this emerging investment product.
(To read a full-length feature article on this subject, see the September issue of Real Assets Adviser.)
Sheila Hopkins (firstname.lastname@example.org) is a freelance writer living in Clemson, S.C.