Today’s investing landscape might seem worlds away from that of the 1980s – but as they say, the more things change, the more they stay the same. That is certainly true for the financial sector, and it’s why business development companies (BDCs) have been going strong for the last 30+ years.
A Brief History of BDC’s
Although these tax-friendly specialty financials are just now becoming more widely known, the federal law that created them was actually a product of the dismal economic climate of 1980. With all the inflation, oil shocks and general malaise that was going on at the time, private equity and venture capital firms simply couldn’t provide financing to small, growing businesses. Because of tight regulations, that left small business with really only one option: getting funding from banks.
Just like today, though, traditional banks were playing defense and were extremely hesitant to make smaller loans with greater perceived risks. In response, Congress passed the Small Business Investment Incentive Act of 1980 that essentially created business development companies – a new kind of publicly-traded corporation that could sell stock on the major exchanges.
The law is still in effect, and the rules set up for BDC’s still hold for today:
- Required to invest 70% of their assets in the small companies in their portfolio.
- Must make available “significant management assistance” to those same portfolio companies.
- Must follow all the rules of publicly traded companies, including filing quarterly reports and having their books audited.
- Can use leverage in their own operations. For example, if one of these investment companies has $50 million in equity, it can borrow another $50 million to have a total of $100 million in investable funds.
- Can avoid taxes at the corporate level. As long as they distribute at least 90% of investment income to shareholders annually, these companies can qualify for “pass through” tax treatment of income and capital gains distributed to shareholders.
That second bullet feature is one of the biggest reasons why BDCs are viewed as a solid investment. Because BDCs are required to play a role in supporting the management of their small-business clients, they are devoted not only to picking the right companies to invest in – but in helping them succeed after writing them the loan.
While many of the big banks were hanging everyone out to dry in the 2008 financial crisis due to liquidity and pricing issues, these BDCs were quietly helping their clients work through their company’s issues, often attending board meetings or even serving as board members.
Another feature of BDCs that makes them so appealing to income investors is that they can charge 10% – 14% on their small-business loans. After all, the banks just aren’t lending, and in the current climate of wholesale budget cuts, the Feds aren’t either.
So it’s not hard to see why BDCs have been doing well in recent years, and in my view is the sector is fundamentally very sound, with rising backlog for loan demand.
Now is a great time to get in on the increasingly popular asset class of business development companies (BDCs) – and I’d like to share a few names with you now that I believe are just the ticket to add to your portfolio.