Investor Alert: BDCs

Law IACBy Robert Noens, Spring 2017 Student Intern

Attention investors! There is a brand-spanking new financial vehicle out there; and let me tell you, they are selling like hot cakes. And, you – yes, you! – stand to make a whole lot of money on these bad boys. So, what do you say? Are you interested?

The investment vehicle I am talking about is called a Business Development Company or, more commonly, a “BDC.” These BDCs are complicated creatures, however, and not just anyone can handle them. In fact, I previously shied away from even explaining the mere concept of a BDC in a previous post because of their sheer complexity. That said, I am back for a second shot. Except this time, I am undertaking the challenge to warn investors about BDCs. You see, BDCs are not as great as my infomercial of a sales pitch above may have made them seem. BDCs can be very high-risk investments, and investors should be educated on just how potentially risky BDCs can be.

 First Question: What is a BDC?

The basic premise for the vast majority of BDCs, which I pulled from FINRA and the Small Business Investor Alliance, is this: A company, specifically a Business Development Company, that pulls together investors’ capital and then loans that capital out to (generally speaking) smaller businesses in need of investment. In return for the much-needed capital, these companies will promise to pay back their loans at higher-than-average interest rates. That, however, is where the similarities end. Based on which BDC you are dealing with, the characteristics of one’s BDC can vary drastically.

Second Question(s): What are the different characteristics of BDCs, and what makes them so risky?

The first thing one needs to keep in mind is that any BDC can possess any combination of the following factors. The more factors your BDC has, the riskier the BDC becomes. So, let’s examine some common characteristics of BDCs (warning: this is not an exhaustive list):

Closed-ended. Some BDCs are what is known as closed-ended. As a post by Christopher Pugh, a Fall 2014 student intern, explains, any investment that is closed-ended means that the fund or investment has a minimum distribution rate that it promised to meet (i.e. a 14% return on investment), and, in order to meet this distribution rate, the fund can pull from a certain portion of its asset base (i.e. the investors’ principals). While BDCs have rules in place to put investors on notice of their practices and limits to how far down managers may reach into investors’ principals, supplementing returns from your principal is not usually indicative of a sound long-term investment strategy.

Illiquid. Illiquidity is one of, if not the most, common high-risk characteristics of BDCs. According to the Cambridge Dictionary, liquidity is “the fact of being able to be changed into cash easily.” Consequently, illiquidity is when one cannot change their investment into cash easily. The reason for this conundrum is almost inherently entangled in the DNA of BDC. BDCs invest capital into small companies that are expected to pay the money back over time. Thus, once one’s money has been distributed, one cannot simply “yank” their investment out if need be. The money is tied up in multiple developing business, and whoever is managing the BDC is unlikely to be able to pay you your principal back on short notice and meet distribution requirements. They manager must either wait until either some of the businesses in the fund have paid back enough of the invested capital, or they will have to pull from some of the BDC’s liquid assets (i.e. take advantage of the closed-ended aspect of the BDC).

Highly Leveraged. As with the other categories, many BDCs maintain a high level of leverage over their loans/funds. Leverage, as described by Professor Ian Giddy of NYU, is when one finances or funds a business that has a higher than average debt-to-asset ratio for their industry. The higher the debt-to-asset ratio, the more leverage one is said to have. This leverage is what allows BDCs to collect such high interest rates, and the companies that BDCs lend to tend to need large amounts of capital relative their assets. Granted, this need is usually short-lived and for a very specific need (i.e. takeovers or expansions); however, there is an inherent risk in lending to an entity that does not have the assets to repay you if something goes wrong. BDCs know that some companies they lend to will not be able to pay back their loans with interest. To offset this, BDCs will spread their loans around to different companies, hoping that the high-interest payments from other companies will offset the losses from those that default. Again, sound familiar? It should, because trying to offset losses from defaults on highly-leveraged loans by grouping them together with other highly-leveraged loans is astoundingly similar to how many mortgaged-back securities worked prior 2008. Moreover, the similarities do not stop there; many times, to sell new mortgages, the mortgage companies would commonly offer floating interest rates (i.e. rates that adjust over the course of the loan). These floating interest rates tend to start low; however, once one is locked in, they can fluctuate immensely and can cause serious hardship for repayment, and many BDCs do the same thing. It is not uncommon for BDCs to offer businesses floating-rates to the companies they invest in, which only adds one extra layer of potential risk to cornucopia of chaos within BDC investments.

Final Question: Should I avoid BDCs all together?

The answer is it depends. Every BDC is different, and whether one should invest depends on their risk tolerance and the BDC. Ultimately, be realistic, research investments, and seek professional advice before engaging in any investment. The important thing is to be informed.