A business development company, or BDC, is a closed-end investment company that helps small companies meet their capital needs and grow. Many BDCs are publicly traded companies, and are popular among income-seeking investors because of their high dividend yields.
How does a BDC make its money?
Business development companies make investments in various companies, typically those that are smaller in size and/or don't have alternative ways of obtaining financing, such as through a bank or by issuing bonds. They invest for income as well as for capital appreciation, and BDCs often hold debt securities as well as stocks (private or public) in their investment portfolios. BDCs are often compared to venture capital funds, but instead of only being open to accredited investors, they are available to all investors.
Tax structure of a BDC
Most BDCs choose to be treated as regulated investment companies (RICs) for tax purposes, meaning that they must distribute at least 90% of their taxable income to shareholders. As long as the BDC meets the requirements to be treated as an RIC, it will pay no corporate income tax. Effectively, this is a "pass-through" tax structure – instead of being taxed on the corporate and individual level, BDC profits are taxed just once at the shareholder level.
However, it's important to point out that BDC dividends are generally not entirely taxable at more favorable "qualified dividend" rates. Rather, the BDC's ordinary income is taxable at investors' ordinary income rates, while the BDC's capital gains and qualified dividend income is taxed at capital gains rates.
An example of a BDC
One of the largest BDCs in the market, Apollo Investment Corp. (NASDAQ: AINV), has about $3 billion in capital under management. The company has a portfolio of 95 separate investments, the majority of which are debt securities, but there are significant equity holdings as well. Thanks to a leverage ratio of 5.6-to-one, the company pays an impressive 14.5% annual dividend yield.
Risks of investing in BDCs
Finally, it's important to mention that no type of stock that is capable of double-digit yields is without risk, and BDCs are no exception. BDCs have several types of risk that investors should be aware of.
First, BDCs use quite a bit of leverage. It's how they're able to generate such strong returns. As a result, this can amplify losses during bad times for the company's profitability. Interest-rate fluctuations can also affect BDCs -- if rates spike, it becomes more expensive for BDCs to borrow money to invest, and profit margins can narrow.
Also, the companies BDCs invest in are generally not of investment-grade credit, so there's the risk that the underlying companies will default. Of course, by investing in an ETF that spreads your money around to many BDC, you can reduce the potential impact of any one default, but it's important to realize that defaults do happen, especially during tough economies.
This isn't an exhaustive list of every type of risk BDCs face, but the takeaway is that BDCs aren't low-risk investments, and therefore may not be appropriate for investors without a high level of risk tolerance.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!