Business development companies may earn a following for their hefty dividends, but it's important to remember that behind a BDC is an operating company. A place where people go to work, analysts analyze companies, and investments are made every single day of the week.
The business behind a BDC
Fifth Street Finance (NASDAQ:FSC) put out an excellent video that shows how a BDC makes money for its shareholders. The video below illustrates the connection between BDCs and private equity groups. It's a must-watch.
Read this after watching
The video isn't a perfect description of all BDCs. For one, it focuses primarily on the kinds of deals Fifth Street Finance takes part in -- competitive deals from private equity groups. Fifth Street Finance generates substantially all of its lending and investment volume from private equity investors.
Other BDCs participate in private equity deals, but not to the same extent as Fifth Street. Prospect Capital (NASDAQ:PSEC), for instance, sources more direct deals, like a recent purchase of apartment buildings and a subprime automotive financier. The same is true of a company like American Capital Ltd. (NASDAQ:ACAS), which invests the bulk of its cash in its own buyouts of other people's companies.
In any event, the video should help new investors understand what BDCs do -- invest in the debt and equity of small companies that are too small to tap Wall Street financing sources on their own.
Sometimes these deals come with a private equity sponsor, and sometimes they're direct origination deals that the BDCs sniff out on their own. But behind every BDC is an investment business that competes daily to get the best-quality deals with the highest potential for profits.