Everyone likes to take advantage of tax benefits whenever they can. But when new players start using tax-favored vehicles for questionable purposes, it threatens not just those new players but also those who've used the tax breaks for decades.
That's what Goldman Sachs (NYSE:GS) may be doing to business development companies. Last week, the investment bank said in an SEC filing that it was approaching an initial public offering of shares in its Goldman Sachs Liberty Harbor Capital unit, which it will structure as a BDC in part to "take advantage of specified reduced reporting and other burdens that are otherwise applicable generally to public companies." Those words should strike fear into investors in BDCs that lack those motives, as the scrutiny that a Goldman investment can bring could jeopardize the entire industry.
What's a BDC?
Business development companies are publicly traded entities that invest the bulk of their capital in privately held investments. Different BDCs hold different types of assets, ranging from term loans and closely held traditional and convertible bonds to unregistered equity securities. With a willingness to invest both in senior debt and subordinated debt, BDCs often help bridge the gap that a company faces between the time it gets its initial financing and when it's ready to turn to the public capital markets for the money it needs to expand further.
BDCs also get a tax break from the IRS. As long as they meet the requirements of their BDC status, they don't have to pay corporate-level tax.
The key requirement for investors is that BDCs have to distribute 90% of their income to their shareholders. That has produced extremely high yields for shareholders, with Prospect Capital (NASDAQ:PSEC) yielding more than 12% at current levels and rivals Ares Capital (NASDAQ:ARCC) and Apollo Investment (NASDAQ:AINV) in the 9% to 10% range.
What's at stake
These three BDCs and many others look like what lawmakers would have intended in creating the special BDC provisions. Ares provides capital to more than 150 different companies, with positions of various sizes. Prospect focuses largely on middle-market companies like Totes Isotoner, reaping higher yields but with arguably more risk by taking on equity exposure. Like Ares, Apollo tends to hold more loans and other debt, with some well-known companies like Ceridian and Aveta within its portfolio.
By contrast, Goldman's BDC is somewhat of an affront to lawmakers' intent. With a stated purpose to reduce disclosure responsibility, Goldman is likely to raise questions not just about Liberty Harbor Capital but the entire class of business development companies.
The move also comes at an unfortunate time, as the federal government looks for ways to cut its budget deficit. Other pass-through tax entities, such as master limited partnerships, have seen threats appear to their favored tax status. So far, Congress has taken no action, but the threat increases whenever an entity is arguably misused.
What BDC investors should do
For now, BDCs aren't likely to lose their tax-favored status. But you'll want to keep an eye open to developments on the tax front. If Goldman's BDC gets bad press, it could lead to an examination of the entire structure that could end up costing you money.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.