business development companies

Last week, a reader commented on business development companies(BDCs).  I said I’m not a fan.

I’d like to elaborate.

BDCs are SEC-regulated closed-end investment companies that typically invest in small- and medium-sized firms.   In one sense, they can be regarded as a poor-man’s private equity.  In another, they can be viewed as the successor to the “blind pools,” a type of IPO that was in vogue when I entered the market in the late 1970s.  The issuer usually had no specific use stated for the funds raised;  the pools often ended in tears for sharehlders.

BDCs are often not SEC-registered.  That is, they aren’t subject to the detailed disclosure that publicly traded firms are.

They do have a tax advantage over ordinary industrial or service firms.  As investment companies, provided that they satisfy restrictions on the scope of their operations, including that they distribute virtually all their net income, they–like other investment companies, such as mutual funds, ETFs and REITS–are exempt from corporate tax on their earnings.

This is a powerful plus.  Because of it, BDCs tend to focus on owning mature, cash-generating businesses and they tend to have high dividend yields as their main attraction.

What’s not to like about this?

My issue is that the analysis of BCDs is a lot more complex than finding out what you need to know before buying the stock of an individual company or a mutual fund or ETF.  You’re not only becoming a part owner of a company, you’re investing side by side with the BDC operator, who has an extremely large degree of control and influence over the companies you own together.  Because of this, you have to not only understand the companies, but you also have to know and trust the people running the BDC.

In my experience, this second task takes a long time and considerable work.  Even when you’re satisfied, holding a BDC also involves accepting a higher level of risk than simply owning a garden-variety publicly traded stock or fund.  I question whether the returns are high enough to justify making this extra effort and exposing my portfolio to the extra level of risk.

 

 

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