Much like a frog in a third-grade biology class, business development companies appear opaque ... until you dissect them.
Investors who want to own a high-yielding BDC have plenty of reason to do so, but you should know what you're getting into.
The guts of a BDC
Business development companies like Prospect Capital (NASDAQ:PSEC) and Ares Capital (NASDAQ:ARCC) operate within the confines of the Investment Company Act of of 1940, also known simply as the 1940 Act, which sets the rules for closed-end funds. Remember that while BDCs are companies, they're really just actively managed funds that hold private equity investments.
By law, BDCs must invest 70% of their assets in qualified securities -- ownership stakes in private businesses and private-equity debt. Generally speaking, qualified assets are debt and equity investments that are not investment assets on their own, and which are based in the United States.
Examples help draw the line between qualified and unqualified investments. An ownership stake in a lemonade stand is a qualified asset. An investment in an investment company -- like a financier of automobiles -- is not a qualified asset, and would have to be limited to no more than 30% of the BDC.
Why it matters
BDCs have to operate as 1940 Act companies to receive preferential tax treatment in which not a single dollar of earnings is taxed at the corporate level. Because BDCs do not pay taxes, they have an inherent advantage over other financial firms, as profits pass through to the shareholders.
BDC managers aren't stupid; they're smart enough to hire lawyers to navigate the 1940 Act like the greedy private-equity managers you'd want running your investment dollars. I highlight Prospect Capital and Ares Capital in this article because they are the BDCs that actively attempt to "bend" the rules to make the most of their tax treatment. Prospect Capital and Ares Capital both speak in terms of "buckets," labeling qualified and unqualified assets in their presentations and annual reports.
Prospect Capital owns collateralized loan obligations as well as a personal loan (First Tower) and automotive finance company (Nationwide Acceptance). These CLOs and finance companies are not qualified for the 1940 Act. However, because they make up less than 30% of Prospect Capital's assets, the company is free to hold these investments as a BDC, and pay zero income tax on the profits.
Prospect Capital's management frequently speaks to how these assets are strategic. By owning a financier that generates double-digit returns on equity, it has an advantage on, say, a bank holding company like Bank of America, which would have to pay taxes on the profits if it were to own a similar, small financier.
Ares Capital owns several nonqualifying investments, including a partnership with General Electric's GE Capital (Senior Secured Loan Fund LLC), and its ownership of Ivy Hill Asset Management, a venture capital firm, along with a few smaller co-investment funds.
Surveying the BDC frontier
Knowing how a business development company must operate to maintain its beneficial tax treatment can help you better understand why BDCs make the investments that they do. When Prospect Capital acquired its financiers from a broken auction, it acquired ownership stakes in nonqualifying companies that can deliver tax-free returns to the parent company. The same is true of Ares Capital's acquisition of Ivy Hill to manage its venture capital investments.
Once you have this insight into the "guts" of a BDC, you can quickly see that the BDC setup isn't nearly as limiting as it appears. If anything, the ability to invest up to 30% of assets in nonqualified investments enables BDCs to act on opportunities that other companies can't access (tax-free profits from financial companies). In short, the 1940 Act as written today defines the anatomy of a BDC, and provides a huge benefit to BDCs, rather than a limitation.