Wednesday, October 20, 2010

What is a BDC?

If you have stumbled onto this blog via Google or some other link, then most likely you have a basic idea of what a Business Development Company (BDC) is. Just in case you do not, here is a quick overview of a BDC.

A BDC is a closed-end, may or may not be diversified investment management company that has a class of its shares registered under the Securities Exchange Act of 1934. BDCs were established as a part of the Investment Company Act of 1940 Section 54 (page 105 on that link if you are curious).  They were established in part to spur investment in smaller business after the Great Depression that banks were not willing to provide. The main points of the law establish what a BDC may and may not do.

Some key examples - a BDC must maintain an asset coverage ratio of 200%. Most other publicly traded funds (mutual funds) must maintain a coverage ratio of 300%. What is an asset coverage ratio? Typically it is defined as a ratio of debt to total assets. This means if all of the firm's debt/liabilities came due at this exact time, would they be able to cover them? So, if a firm issued $10m in Equity, they could also issue $10m in Debt. This is also referred to as their debt to equity ratio.

Investment Restrictions - A BDC must have at least 70% of its portfolio invested in eligible portfolio companies. What is an eligible portfolio company? One, it must be a company that is organized and has its principal place of business in the USA, sorry foreign issuers. Two, it must be a non-investment company unless it is a SBIC (small business investment company) that is wholly-owned by the BDC. Finally, it must be a company that does not have a class of publicly traded securities. In plainer English, an eligible portfolio company is a small to medium-sized (rarely large) non-public business.

Investment Types - Most likely a BDC will extend some form of debt financing to a portfolio company. This financing comes in all shapes and colors, from a Senior Secured Loan all the way down to Common Equity. If you do not know what those are, Investopedia may be a decent help or you can wait for my next post.

Managerial Assistance - A BDC is expected to offer significant managerial assistance to a portfolio company. The reason for this is because a BDC is there to help a company thrive. The managerial assistance may take the place of balance sheet restructuring, recruiting and hiring a managerial team and exploring mergers and acquisitions (or divestitures) for the company.

Taxation - A major reason for a company to be organized as a BDC is to be classified as a “regulated investment company” (RIC). As a RIC, the company avoids having to pay corporate taxes on capital gains and investment income that is distributed to shareholders.  To be a qualified RIC, the BDC must distribute at least 90% of the above to shareholders in the form of dividends. If at any time a BDC fails to comply as an RIC for the year, they will be subject to corporate taxes as a regular "C corporation" under US Tax Code.

Dividends - Due to the Taxation treatment above, BDCs will tend to pay out most of their Net Investment Income in dividends to shareholders. The reason why NII is used is because it represents the money that a BDC is taking in from interest payments, capital gains or dividends (from a portfolio company). If a BDC overpays their dividend (shortfall - Dividend Amount > NII per Share), that means the company had to either sell assets, issue equity, take on more debt or some combination of the three. Other times a BDC will underpay their dividend. The reasons for underpaying are varied, but include times when a BDC is anticipating a dividend shortfall in the future or making a significant asset purchase.

There you have it, the quick overview of what a BDC company is. In my next posts I will expand on these topics and then begin an analysis of each BDC company. I plan on going in alphabetical order by ticker symbol so anyone hoping for a TCAP review may have to wait awhile.

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