Technically, a BDC is a pass-through tax structure, analogous to a REIT, allowing individual investors access to formerly institutional-only asset classes such as private debt. BDCs typically buy pools of corporate loans; the repayment of these loans creates the income paid out by the BDC.
"BDCs generate strong monthly investment cash flow. It's powerful for our clients to see that dividend payment hitting the account each month," says Todd Jones, director of investments at Gratus Capital Management in Atlanta. BDCs generate retirement income for his clients, but investing in BDCs is not yet mainstream among planners.
That's about to change, say Jones and other advisors. "The search for yield is leading people to the BDC destination," he says. Planners interested in BDCs, though, need to understand what's involved, including the risks that account for the high yields as well as the different flavors of their structures. "BDCs, like REITs, are a good structure,'' says Brad McMillan, CIO and vice president of Commonwealth Financial Network in Waltham, Mass. "But you have to look at actual implementation to make sure it makes sense."
CAPITAL FROM CONGRESS
While the tax-efficient pass-through structure of BDCs dates from 1990, the basic BDC model actually started in 1980. Congress saw the need for new ways to funnel capital toward the growth of small- to medium-size private American companies. Private equity managers lobbied for changes to the Investment Advisers Act of 1940 and the creation of a new model to allow small investors access to alternative investment classes that were previously off limits, except to large institutional investors.
The resulting structure, the BDC, lies at the midpoint on the investment spectrum, defined by mutual funds at one end and institutional-only private equity at the other. "BDCs are more regulated than private equity, but are permitted to have somewhat more leverage than mutual funds," says Cynthia Krus, a Washington-based partner in the BDC and alternative assets practice team of the law firm Sutherland Asbill & Brennan. BDCs have the same compliance structure as a mutual fund, she says, including custody arrangements and a code of ethics.
But there are substantial differences from a mutual fund in terms of allowed leverage and fees. As with private equity managers, BDC managers take a performance-based fee, usually 20% of gains above a certain benchmark, in addition to a 2% fee for assets under management. "A mutual fund manager would not be allowed to have this capital gains compensation structure," Krus says.
BDCs invest up and down the capital structure from senior debt to equity. Typically, the BDC manager uses his or her assets to structure senior or mezzanine loans to small- to medium-sized private firms. As these loans pay interest, the income is passed along to the BDC investors, who do not have to pay taxes at both the corporate and individual level. "The actual pass-through structure is substantially similar to a REIT," she says, only with BDCs, the investments tend to be in debt and equity securities instead of real estate.
Private equity managers that go public or form a public division are not BDCs. They are asset managers that may manage a variety of public or private funds. For a fund to be a BDC, it must directly hold or acquire over time a pool of eligible assets and elect to be regulated as a BDC.
BDCs are of two different types: traded and nontraded, just like traded and non-traded REITs. There are no investor suitability requirements for those that are traded. The requirements for nontraded ones vary by state. About 35 BDCs exist, Krus says, and the vast majority are publicly traded. Nontraded BDCs have fans as well, offering more choices to planners.
GOOD SUPPLY AND DEMAND
Since the financial crisis, investment supply and demand is uniquely favorable to BDCs, proponents say. "On the supply side, banks aren't lending and securitization pools have dried up. But demand for capital is very strong and companies have maturing debt that needs to be refinanced," says Jeff Shafer, group president of CNL Securities in Orlando, Fla. BDCs bridge the gap, providing much-needed financing and offering high yields. CNL Financial, an affiliate of the firm, sponsors a nontraded BDC, which "tend to be less volatile than their traded counterparts,'' he says.