When you look at the highest-yielding investments in the stock market, you'll inevitably find BDCs. Business development companies give investors the ability to put their money into stakes of privately held businesses, and the cash that successful ventures pay off produces high yields and lucrative dividends for BDC shareholders. Yet there's also plenty of risk involved, and it's important to do research and conduct your due diligence before investing in a BDC. In particular, here's what you need to understand about BDCs:

  1. What kind of investments BDCs own.
  2. What tax advantages BDCs get.
  3. Why BDCs pay out such high yields to shareholders.
  4. How to assess the true value of BDC assets.

We'll look at each of these issues below.

What can BDCs invest in?

Business development companies typically focus on providing financing to small and midsize businesses that don't have full access to the capital markets. By offering private financing, BDCs allow the businesses that they invest in to avoid the necessity of filing registration statements with the U.S. Securities and Exchange Commission and other regulators. The BDC, however, is publicly traded.

BDCs vary in the investments they use and the industries they target. Some BDCs focus on a particular type of business, while others seek to build up diversified portfolios of assets. With some companies, BDCs will buy stock or other equity interests in exchange for providing capital. In other cases, BDCs will use debt financing to loan businesses money, sometimes receiving an equity kicker in the form of warrants or similar investment vehicles that can provide upside beyond that of a pure debt security.

What tax advantages do BDCs get?

Business development companies are eligible to qualify as registered investment companies under the tax laws, and doing so can lead to an important advantage: lack of taxation at the entity level. If the BDC pays out at least 90% of its annual income as distributions to shareholders, then it can claim status as a registered investment company. In that case, the shareholders end up paying taxes on the distributions they receive, but the BDC's profits are taxed only that one time rather than also being subject to corporate tax within the BDC itself.

Another type of tax imposed on BDCs is an excise tax on excess retained earnings. To avoid that excise tax, BDCs have to pay out slightly more than 98% of their income. Some BDCs meet this requirement, while others choose to pay the excise tax in order to avoid having to use costlier ways of raising further capital.

Notebook with the word "dividends" lying next to cash, calculator, and glasses.

Many investors buy BDCs to get dividend income. Image source: Getty Images.

Why are BDC yields so high?

The tax law requirements for BDCs to pay out the vast majority of their income as distributions leads to the more successful companies in the BDC universe having extremely high yields. Dividend distributions in excess of 10% of share value aren't uncommon, even in a relatively low-interest-rate environment such as we've seen in recent years. When other methods of financing get tight, BDCs can get even better terms from the companies in which they invest, and that can lead to even stronger yields.

The risk, however, is that if an investment goes bad, it can lead to a complete loss for the BDC. When that happens, the resulting loss can offset all the profits from other successful investments within the BDC. It's that risk that constantly exists for BDC investors.

How can you tell what a BDC is worth?

Business development companies provide values for the investments they make in their financial statements. You can look up the net asset value for a business development company in its quarterly reports, and although you won't get daily updates thereafter, you can have a sense of the current value of BDC assets just based on past fluctuations under similar market conditions. If a BDC's stock trades at a discount to net asset value, it might be a good value for investors.

One thing to consider, though, is that net asset value calculations are only as good as the assumptions that go into producing them. Because the investments that BDCs make aren't in publicly traded securities, there's typically no secondary market against which to value those investments. As a result, in some cases, a discount to net asset value for BDC shares might reflect skepticism about the way the BDC valued its assets, rather than a true bargain for potential investors.

A BDC is a great ways to produce income in a portfolio, but it also involves more risk than typical income-producing investments. As long as you know what your BDC's investment objectives are and are confident in its track record of being successful in achieving them, then business development companies can give your portfolio some added diversification that you won't get from most other investment vehicles.

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