Why Do Business Development Companies Lose Money?
Business development companies (BDCs) are a type of investment vehicle allowing retail investors the opportunity to invest in the private sector. Private equity firms often create business development companies to loan money to privately owned small and medium-sized companies. BDCs provide loans to distressed companies that might not otherwise find funding and can therefore charge higher interest rates. Because of these higher interest rates, BDCs can offer investors higher rates of return on their shares. Some BDCs have boasted rates as high as 5% to 14%.
The same factors that make BDCs potentially high-yield investments also make them high risk. Because business development loans often go to companies that may be struggling financially, which means their loans come with a higher risk of default.
Business Development Company Definition
BDCs are regulated under the Investment Act of 1940 and the SEC.
- The SEC states that business development companies “provide financing to small, developing, or financially troubled” companies.
- Business development companies invest only in U.S. companies.
- BDCs are closed-end funds – meaning they offer a fixed number of shares.
The History of Business Development Companies
BDCs have existed since the 1980s, but they became more popular following the financial crisis of 2007 when many mid-sized companies struggled to find loans. When business development companies made their debut on the market, they could only acquire “any domestic operating company” whose securities were not listed on an Exchange. In 2006, the SEC expanded the definition to include any domestic operating company that sells shares on a public exchange and has a market capitalization of less than $250 million on any day in the 60-day period immediately before the BDC acquires its securities.
Business Development Company Taxes
As Regulated Investment Companies, BDCs aren’t considered taxable entities. Because of this favorable tax treatment, a BDC must distribute at least 90% of its taxable income to shareholders as ordinary dividends each year. Therefore, BDCs do not retain a lot of their earnings and are taxed at the shareholder level.
Business Development Company Investor Risks
Lack of Information. BDCs have been on the market for a short amount of time. There is limited research on how BDCs work, making it more difficult to understand their risks. Because they are not well-known investment vehicles, brokers may exploit investors’ lack of information and focus exclusively on their potential for excellent returns.
Fees: BDC investments can come with high commissions for brokers. Broker fees for non-traded BDCs are often as high as 10%, which cuts into possible returns for investors. For instance, many investors recently lost money on their investment in Cion Investment Corp, a non-traded BDC that came with a sales load of 10% along with an offering expense of 1.5%. According to the prospectus, the investment would have to see a return of at least 13% to make a return for the investor.
Leverage: BDCs often use leverage – aka debt – to loan money. Leverage amplifies any losses that investors suffer. One investor told The Wall Street Journal that he did not understand this aspect of the risk associated with his BDC investment.
Taxes: Interest on BDC stock is taxed the same way as ordinary income, often at a higher rate than other stocks.
Volatility: BDCs are accessible to retail investors – another factor that becomes a negative in an economic downturn. Retail investors tend to lose their nerve when shares dramatically decrease in price, leading them to sell their shares all at once, resulting in an even sharper price decline.
Business Development Company ETFs
Your broker may also have recommended BDC investments through exchange-traded funds and exchange-traded notes. These can underperform, depending on how the business development ETF or ETN chooses its investments.
Risks Associated with Non-Traded BDCs
Non-traded BDCs are even riskier than regular BDCs. These investments are only meant for sophisticated investors who can tolerate substantial risk. Non-traded BDCs offer loans to companies with especially bad credit. They do not trade on the public exchange, so if an investor wants to sell their share of a BDC, they may struggle to find a buyer. These investments are quite illiquid, meaning that you may not be able to access your investments until the company completes a “liquidity event.”
Non-traded BDCs may decide to limit redemptions, depending on the performance of their underlying securities. In 2016, a non-traded business development company changed its policy to only allow withdrawals twice a year rather than once a quarter. They also halted their redemptions, much to the chagrin of their shareholders.
Did You Lose Money with a Business Development Company Stock?
In the wake of the pandemic, even the top business development companies have lost money. Already struggling companies have defaulted on many loans, leaving BDCs without income to distribute to investors. Two of the largest business development companies, FS KKR and Ares Capital Corp, have lost huge amounts of money. Shares FS KKR declined by 60%, and Ares Capital Corp lost 45%. Both companies offered non-traded BDCs.
Following this massive decline in value, both Ares Capital Corp and FS KKR performed a reverse stock split. This maneuver consolidates the number of shares on the market while increasing the value of individual shares. If a company performs a 2-to-1 reverse split, an investor with ten $1 shares would have five $2 shares. The total value of an investor’s shares remains the same. Companies sometimes perform this maneuver to boost the value of an individual share of a plummeting stock.
Did You Lose Money on a Business Development Company?
Stockbrokers and financial advisors are required to recommend suitable investments. FINRA Rule 2111 defines suitability as investments that meet their investors’ financial goals and risk tolerance. If you feel your stockbroker failed to inform you of the risks of buying BDC shares, you should get in touch with a securities fraud lawyer.