The BDC — Business Development Company — A Rapidly Growing Industry

Smaller companies often face tighter lending requirements. They generally have non-investment grade ratings and therefore can struggle to obtain debt financing from banks. As a result, these higher risk companies look for alternative financing sources. There are a variety of alternative financing arrangements that help to fund smaller-sized companies. The Business Development Company (BDC) is one such alternative.

Once an emerging sector, BDCs have become a rapidly growing industry in recent years. They provide small-, mid-sized, and distressed companies access to capital by directly lending to them. Direct lending by BDCs became a fast-growing area following the 2008 financial crisis.

A Brief History of the BDC

Congress created the BDC concept in 1980 in an effort to stimulate economic growth. BDCs provide ordinary investors a chance to buy shares that contribute to the growth of middle market companies. In turn, middle market companies are able to deploy the capital from BDCs. They use this capital to expand their businesses, finance capital projects, and create jobs.

Congress set out the qualifications for BDC status and rules that govern it. Amendments to the Investment Company Act of 1940 included these items. This Act is often simply referred to as the 1940 Act. The 1940 Act regulates investment funds, or companies that are primarily in the business of investing and trading securities. BDCs fall under the regulatory authority of the 1940 Act. Accordingly, there are a number of restrictions on BDCs. For example, a BDC must’s board must have a majority of independent directors. However, BDCs are also exempt from many of the regulatory constraints of the 1940 Act.

The BDC Council oversees the industry. They attempt to create reforms that strike a balance between facilitating growth of the BDC industry and ensuring adequate investor protections exist.

The spending bill passed by President Trump in 2018 increased the maximum leverage limit for BDCs to a ratio of 2:1 total debt to equity. Before Congress passed the 2018 Small Business Credit Availability Act and the $1.3 trillion spending bill, the law capped the ratio at 1:1 total debt to equity. As a result, BDCs can now provide even larger amounts of debt financing to middle market businesses.

Attractive Features of BDCs

A BDC is a closed-end investment company, meaning it raises capital only once during an initial public offering (IPO). After the IPO occurs, they are “closed” or prohibited from issuing additional shares. A closed-end fund trades on a stock exchange similar to an individual stock. This contrasts with open-ended funds, which issues new shares and can initiate share buybacks. Another difference is that open-ended funds do not directly trade on a stock exchange. Rather, a fund company trades them. It then sells the shares to investors.

A BDC can provide management expertise to the middle market businesses they support. The middle market loan market consists of about 200,000 private companies. Today, BDCs have over $80 billion in outstanding loans in small- and-medium-sized businesses.

In addition to the benefits to the direct lending firm and company, BDCs enable individual investors to invest in smaller-cap businesses with relative ease. This has opened up to ordinary investors a highly-regulated investment opportunity once accessible only to institutional investors and wealthy individuals.

Categories of BDCs

BDCs broadly fall into one of three categories — publicly-traded, private, and non-traded BDCs. The most prevalent category, publicly-traded BDCs, usually trade on national stock exchanges and sell shares to individual investors. In contrast, only accredited investors that meet certain financial standards as determined by state regulations may purchase private BDCs and non-traded BDCs.

Largest BDCs

There are 99 BDCs in existence today, and the industry is quicky expanding. There are over 50 publicly-traded BDCs. Some of the largest BDCs by total market capitalization include Ares Capital Corp, Owl Rock Capital, Prospect Capital Corporation, FS KKR Capital Corp, Golub Capital BDC, Goldman Sachs BDC, Main Street Capital Corp, and New Mountain Finance Corp. External management teams manage the majority of BDCs.

Owl Rock, one of the leading BDC platforms, announced at the end of December 2020 that it signed a deal to combine with Dyal Capital Partners. “Blue Owl” will be the name of the newly named company. Blue Owl aims to be a behemoth asset management firm with particular strength in directing lending to small- and mid-sized businesses.

Taxation of the BDC

The IRS treat BDCs as regulated investment companies (RICs). RICs are defined under Regulation M of the Internal Revenue Code. A key characteristic of RICs is that they do not pay taxes on their earnings. These non-taxable entities are have pass-through or flow-through income. Aside from BDCs, other types of investment entities may also structure themselves as RICs. These include mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and unit investment trusts (UIT).

With pass-through tax treatment, a RIC avoids paying corporate income tax and passes on capital gains taxes to individual shareholders. In exchange for this benefit, a RIC must derive and distribute a minimum of 90% of its net investment income in the form of interest, dividends, or capital gains to its shareholders.