A business development company (BDC) is a type of closed-end fund that pools investor money to lend to, and sometimes buy stakes in, small and mid-sized U.S. companies, many of them private. BDCs often pay high distributions because most must pass on 90% of taxable income. They also carry leverage, higher fees, valuation uncertainty and, for non-traded BDCs, limited liquidity.
You are looking for income, and a fund with a high distribution rate keeps showing up in screens or in a pitch from a broker. It invests in "middle-market loans" and calls itself a BDC. Before deciding whether it belongs anywhere near your portfolio, you want to understand what you would actually own, what you would pay, and how you would get your money back out.
What is a BDC?
A BDC is a closed-end investment fund that gives everyday investors exposure to smaller private businesses. According to the SEC's investor bulletin on publicly traded BDCs, BDCs invest in small and medium-sized private companies and, to a lesser extent, public companies. Many focus on private credit: lending directly to businesses or buying pieces of syndicated loans.
Technically, BDCs are not registered investment companies, but the SEC notes they are subject to many protections of the Investment Company Act, including governance, compliance and conflict-of-interest rules.
How does a BDC make money?
A BDC earns interest on loans and, sometimes, gains on equity stakes. It then pays most of that out to shareholders.
At least 70% in qualifying assets
The SEC bulletin states that at least 70% of a BDC's total assets must be in certain types of investments, including privately issued securities, distressed debt and government securities.
Leverage up to 2 to 1
BDCs can borrow more than most funds. Under certain conditions, a BDC may borrow up to $2 for every $1 of investor equity, according to the SEC. Leverage raises income when loans perform and magnifies losses when they do not.
The 90% payout
Most BDCs elect a tax status that requires them to distribute 90% of taxable income each year. That is why their yields look high. It also means little income is retained to absorb future losses.
What are the three types of BDCs?
The biggest practical difference between BDCs is how you buy and sell them. The SEC's bulletin on non-publicly traded BDCs compares the three:
| Publicly traded BDC | Non-traded (retail-offered) BDC | Private BDC | |
|---|---|---|---|
| Who can invest | Anyone | Investors meeting state suitability minimums | Generally accredited investors |
| How you buy | On an exchange at market price | From the BDC in a continuous offering | Through a private placement |
| How you sell | On an exchange at any time | Usually only in periodic repurchase offers, often quarterly or monthly | Often not until a liquidity event, possibly 5 to 7 years out |
| Offering document | Prospectus | Prospectus | Private placement memorandum |
All three file 10-Ks, 10-Qs and 8-Ks with the SEC, so you can read their portfolios and results on EDGAR.
What does a BDC cost?
BDC fees are typically higher than those of mutual funds or ETFs. The SEC bulletin says externally managed BDCs generally charge an advisory fee of 1.5% to 2% of gross assets each year, plus incentive fees of up to 20% of profits.
The detail that surprises people is "gross assets." Because the fee is charged on assets including borrowed money, leverage raises the fee as a share of your equity.
A worked example
Suppose a BDC has $100 million of investor equity and borrows $100 million, so it holds $200 million of loans. A 1.5% fee on $200 million of gross assets is $3 million a year. Measured against the $100 million that shareholders put in, that is 3% before any incentive fee or operating expenses. Buying in an initial offering can add a sales charge on top.
What are the risks of investing in a BDC?
As with any investment, you can lose money in a BDC. The SEC bulletins highlight these risks:
Credit risk
BDC borrowers are smaller, often early-stage or financially distressed companies that may be more likely to default than large public companies.
Valuation risk
Private loans and stakes do not trade, so the BDC's managers estimate their value. The SEC warns the value assigned may differ materially from what the BDC ultimately receives.
Leverage and rate risk
Borrowing magnifies losses, and higher interest rates can raise the BDC's own borrowing costs.
Market price risk
Publicly traded BDC shares can trade at a premium or a discount to net asset value. The SEC notes that prices typically drop after an initial offering.
Liquidity risk
Non-traded and private BDCs may limit or suspend repurchases, leaving you unable to sell when you want. Our guide to liquidity risk explains why this matters most when you need the money.
Return of capital
Distributions can include a return of your own principal, which shrinks the fund's asset base. The BDC must send a written notice when that happens.
Questions to ask before buying a BDC
The SEC suggests asking these before you invest:
- What kinds of companies does the BDC invest in, and how highly rated are its loans?
- How much debt has it taken on?
- Has it paid distributions consistently, and how much was return of capital?
- What are the total ongoing fees, including incentive fees?
- For non-traded or private BDCs, how and when can you sell, and can repurchases be suspended?
Read the fee table in the prospectus or PPM, plus the latest 10-K, before you commit.
How is a BDC different from investing directly in private credit?
A BDC is one wrapper for private lending. Other wrappers include interval funds, private credit funds and direct investments in specific receivables, such as merchant cash advances. Each differs in liquidity, fees, diversification and who can invest, so compare the structure as carefully as the yield.
Frequently asked questions
Are BDC distributions guaranteed?
No. Distributions depend on the income from the BDC's loans and investments and can be cut. Part of a distribution can also be a return of your own capital.
Can anyone invest in a BDC?
Anyone can buy a publicly traded BDC on an exchange. Non-traded BDCs require investors to meet state suitability standards, and private BDCs are generally limited to accredited investors.
Why do BDCs pay such high yields?
They lend to riskier, smaller companies at higher interest rates, use leverage, and must distribute most of their taxable income. Higher yield reflects higher risk.
Is a BDC the same as a REIT?
No. Both pass through most of their income to shareholders, but a REIT owns or finances real estate while a BDC lends to and invests in operating businesses.
Related: What is private credit? · What is a private placement? · What is liquidity risk?