Business development company

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A business development company (BDC) is a company designed to help grow small and midsize companies (mostly privately owned companies). These companies are similar to venture capital funds, but are public stocks listed on the New York and NASDAQ stock exchanges. BDCs were created by Congress in the Small Business Incentive Act of 1980.[1] To qualify as a regulated BDC, companies must be registered in compliance with Section 54 of the Investment Company Act of 1940. They are similar in structure to closed-end funds.[2]

Overview

A BDC usually invests in privately held companies in three ways:

  1. By offering debt financing to the company.
  2. By offering equity financing to the company by taking an equity stake in the company.
  3. By taking an active consultancy role in the management of a company.

BDCs roughly fall into three types:

  • Growth focused: These BDCs resemble venture capital funds. They invest mostly equity capital in early development stage companies which usually have limited operating histories.
  • Value focused : These BDCs invest in companies with more established operating histories than do growth focused BDCs.
  • Income focused: An income focused BDC primarily makes loans to later stage companies. The loans often are accompanied with warrants.[3]

BDCs are similar to real estate investment trusts (REITs) in that they must distribute 90% of investment income. Distributed income and capital gains are not taxed at the corporate level but are assessed to the individual shareholder when distributed. BDC's usually have high dividend yields. These dividends (primarily representing interest on loans) are considered ordinary income and are not qualified dividend, which under current tax law are taxed at lower rates. However, any dividends that a BDC receives from a stock investment and distributes to shareholders can be a qualified dividend.

A BDC is limited to 1:1 leverage. This means that a BDC with $100 of equity can borrow a maximum $100 dollars and invest $200 in businesses[4]

Regulation

To be treated as a "regulated investment company" (RIC) under Subchapter M of the Internal Revenue Code a BDC must:

  • Qualify as a regulated investment company.
  • Distribute to stockholders in a timely manner at least 90% of their "investment company taxable income," as defined in the Internal Revenue Code -- this rule similar to that of REITs means BDCs are typically high yielding stocks.

A BDC will receive an exempt status on the 4% nondeductible federal excise tax if they distribute to their shareholders:

  • 98% of their ordinary income for each calendar year, and
  • 98% of their capital gain net income for the one-year period ending December 31 in that calendar year, and
  • Any income not distributed in prior years.

In order to qualify as a regulated investment company for federal income tax purposes, the BDC must, among other things:

  • Continue to qualify as a business development company under the 1940 Act.
  • Derive in each taxable year at least 90% of their gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities, or other income derived with respect to their business of investing in such stock or securities (the "90% Income Test").
  • Diversify their holdings so that at the end of each quarter of the taxable year:

- At least 50% of the value of their assets consists of cash, cash items, U.S. government securities, securities of other regulated investment companies, and other securities if such other securities of any one issuer do not represent more than 5% of their assets or more than 10% of the outstanding voting securities of the issuer.

- No more than 25% of the value of their assets is invested in the securities (other than U.S. government securities or securities of other regulated investment companies) of any one issuer or of two or more issuers that are controlled (as determined under applicable Internal Revenue Code rules) by the BDC and are engaged in the same or similar or related trades or businesses (the "Diversification Tests).

-- Introduction to BDCs


Mutual funds and BDCs

A BDC can be either internally managed by its staff or externally managed by hiring an investment advisor. An internally managed BDC does not pay advisory fees. It pays the operating costs of the business.

An externally managed BDC has an investment advisor and pays advisory fees. Approximately half of all DBCs are now externally managed.[5] The advisory fee of externally managed DBCs typically runs between 1.75% to 2.50% per annum.[6] In addition to a base fee, the advisor is permitted by law to receive an incentive performance fee up to s maximum 20% of a BDC’s realized capital gains net of all realized capital losses and unrealized capital depreciation over a specified period.[note 1]

The SEC mandates that a mutual fund must account for the expenses of a BDC as an "acquired expense". Here is a list of Vanguard fund expenses adjusted for BDC costs.

"SEC rules nevertheless require that any expenses incurred by a BDC be included in a fund’s expense ratio as "Acquired Fund Fees and Expenses." The expense ratio of a fund that holds a BDC will need to overstate what the fund actually spends on portfolio management, administrative services, and other shareholder services by an amount equal to these Acquired Fund Fees and Expenses. The Acquired Fund Fees and Expenses do not impact a fund’s total return or index tracking error and are not included in a fund’s financial statements, which provide a clearer picture of a fund's actual operating expenses."[7]

Index exclusion

By 2014 a majority of major index providers removed BDC's from their US indexes.

Provider Includes DBC's
CRSP[8] No
MSCI[9] No
Russell[10] No
S&P[11] No
Wilshire Yes


Recent activity

On February 24, 2011, Wells Fargo & Company created the Wells Fargo Business Development Company Index, comprising 24 BDCs at launch.[12] The index currently consists of 26 stocks.

In April 2011, UBS launched an exchange traded note (ETN) tracking the index.[13]

On February 2 2013, Van Eck, parent company of Market Vectors, launched the Market Vectors Business Development Company/Specialty Finance ETF, trackinng the the Market Vectors Business Development Company/Specialty Finance Index.[14]

Index returns

Wells Fargo has calculated the return of the Wells Fargo Business Development Company Index from 2005 forward. The following table provides the returns data of the index along with the returns of the MSCI Broad Market Index. Both Wilshire[15] and S&P[16] also provide DBC indexes.[note 2]

Table 1. Wells Fargo Business Development Company Index Total Returns[17]
Year Wells Fargo Business Development Company Index MSCI Broad Market Index
2015 -4.12% 12.67%
2014 -7.99% 0.60%
2013 16.33% 12.66%
2012 34.48% 16.44%
2011 -7.18% 1.08%
2010 50.99% 17.28%
2009 42.78% 28.70%
2008 -45.07% -37.04%
2007 -14.17% 5.49%
2006 29.49% 15.51%
2005 7.16% 6.37%

Notes

  1. from FAQ Business Development Company
    Example incentive performance fee:
    • 0% of all net investment income earned at or below a “hurdle rate” of 7%;
    • 100% of all net investment income earned above the 7% hurdle rate but below a “catch-up rate” of 8.75%; and
    • 20% of all net investment income earned above the 8.75% “catch-up rate.”
  2. Returns for S&P and Wilshire DBC indexes.
    DBC index returns
    Year S&P Wilshire
    2016 24.18% 24.14%
    2015 -3.68% -2.67%
    2014 -6.90% -6.71%
    2013 17.07% 14.25%
    2012 33.81% 30.11%
    2011 -9.76% -8.11%
    2010 51.90% 35.75%
    2009 56.46% 61.93%
    2008 -51.81% -43.29%
    2007 -20.14% -17.24%
    2006 35.74%
    2005 7.65%

    See Business Development Company index returns,google drive.

References

External links

BDC Index and index tracking investment options