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Source: Securities and Exchange Commission

Sept. 25, 2020

The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to provide investors information about business development companies, or BDCs, that are traded on national securities exchanges. It is important to understand them before investing.  

What are BDCs?

BDCs are a type of closed-end investment fund. They are a way for retail investors to invest money in small and medium-sized private companies and, to a lesser extent, other investments, including public companies. BDCs are complex and have certain unique risks. This Investor Bulletin discusses BDCs whose shares can be bought and sold on national securities exchanges, or “publicly traded” BDCs.

Read more about publicly traded closed-end funds at Investor Bulletin:  Closed-End Funds.

How are publicly traded BDCs similar to other SEC-regulated investment funds?

In some ways, BDCs are similar to other investment funds – like mutual funds, other closed-end funds, and exchange-traded funds (ETFs):

  • BDCs pool money from many investors and invest that money.
  • All types of investors, including retail investors, can own shares.
  • Investors own shares representing a pro rata or proportional part of the BDC.
  • BDCs’ offerings of shares are registered with the SEC, and BDCs are regulated by the SEC.
  • BDCs’ investment managers may be investment advisers that are registered with the SEC.

In some ways, publicly traded BDCs are also similar to other closed-end funds and ETFs:  their shares are typically bought and sold on national securities exchanges at market prices.

How are BDCs different from other SEC-regulated investment funds?

As a technical matter, BDCs are not registered investment companies but elect to be subject to many of the regulations applicable to registered investment companies.  The main difference between BDCs and other SEC-regulated investment funds is the type of companies they invest in. BDCs invest in debt and equity of small and medium-sized private, or some small public, companies. The companies BDCs invest in are typically in their early stages of development, or are distressed companies that may not be able to obtain bank loans or raise money from other investors. Sometimes BDCs may help manage the companies they invest in. BDCs are sometimes compared to venture capital funds or private equity funds, which provide exposure to private, often illiquid, investments and may provide assistance to the companies they invest in. However, BDCs are open to all investors, including retail investors.

In addition, BDCs are structured differently from other closed-end funds, mutual funds, or ETFs. BDCs also have more leeway to invest using debt and other leverage.

These differences create potential benefits and risks unique to BDCs.

What are some potential risks and benefits of investing in BDCs?

As with any investment, you could lose money investing in a BDC.

Investment Risks. BDCs invest in small and medium-sized companies that are developing and/or financially distressed. Many are private companies that don’t make public disclosures, and the shares of the companies do not regularly trade on a national securities exchange.

  • What this means for you: BDCs’ equity investments have potential for growth and their debt investments may earn higher interest rates than those of other debt investments, so BDCs may seek to achieve a higher return than other types of funds. But such equity or debt investments could also increase BDCs’ risks. There are risks in owning shares or loaning money to the small- and medium-sized companies that are different from, and in some ways more significant than, investments in larger public companies. These smaller companies may be more likely to go out of business or default on their debts. Also, it can be difficult to find information about the companies BDCs invest in and to know for sure what they are worth.

Different Investing Opportunities.  At least 70% of a BDC’s total assets must be invested in certain types of investments, including certain privately issued securities, distressed debt, and government securities.

  • What this means for you: BDCs can offer a different investing opportunity for retail investors than is offered by typical mutual funds, ETFs, or other closed-end funds. Investing in a wider range of assets can be a good tool for portfolio diversification and may mean that a BDC follows movements of the stock market less closely. But these investments can expose you to certain risks, as described in this Investor Bulletin.

Exposure to Leverage or Debt.  BDCs can and often do use more leverage or debt than other types of funds to purchase their investments.

  • What this means for you: BDCs’ use of leverage can increase your return but can also increase your losses. It can also increase risk and can make the price of BDC shares more volatile. In addition, it can be more expensive for BDCs to borrow to invest if interest rates go up. Higher interest rates can also reduce BDCs’ profits. 

Paying a Premium or Discount. The market price for BDC shares may be greater or less than the shares’ net asset value (NAV). Shares that sell at a price higher than the NAV are said to be sold at a premium, and shares that sell at a price lower than the NAV are said to be sold at a discount. BDC shares may sometimes trade at a discount, but may sometimes sell at a premium.

  • What this means for you: Trading at market price means you may pay more or less for BDC shares than the current value of the fund’s underlying investments. This pricing creates an additional layer of risk and opportunity when owning BDC shares. If you purchase shares at a premium, you are paying more than the current value of the underlying investments. If you purchase shares at a discount, you are paying less than the current value of the underlying investments, but you may not be able to sell the shares other than at a discount.

Potentially large distributions. BDCs’ distributions can include income generated by the fund – interest income, dividends, and/or capital gains – but can also include a return of capital. Because of their tax structure, most BDCs (that have elected a certain tax status) must distribute 90% of their taxable income to their investors each year.

  • What this means for you: BDCs may pay large distributions. If the distributions include a return of capital, BDCs may not be as tax-efficient as other investments. In addition, a return of capital means you are getting back some of your principal, which is the money you originally invested. A distribution that includes a return of capital reduces the BDC’s asset base (the money the BDC has available to invest) and may make it harder for the BDC to make money in the future. It also means that the value of your remaining investment in the BDC may decline. When a distribution includes a return of capital, the BDC will send you a written notice.

Higher Fees. BDCs often have higher fees than other investment funds, like mutual funds or ETFs. Typically BDCs that are managed by an investment adviser have an advisory fee, which is generally equal to 1.5% – 2% of the fund’s gross assets annually, plus certain incentive fees generally up to 20% of any profits earned. Because management fees are typically calculated on gross assets, which would include leverage, the actual management fee charged to investors may be higher depending on the amount borrowed by a particular BDC. Also, BDCs’ operating expenses may be higher than those of other types of funds. In addition, if an investor buys BDC shares in the initial offering, the investor will pay a sales charge or commission that will be a certain percent of the purchase price. If an investor purchases BDC shares on a securities market, the only transaction fees the investor pays are typical brokerage commissions.

  • What this means for you: These fees reduce the value of your investment. If you buy BDC shares in the initial offering, you will likely pay higher fees than if you were to buy the shares of the same fund later on a securities exchange. In addition, typically the price of BDC shares immediately decreases after an initial offering, and the shares sell at a discount. If you buy or sell BDC shares on a securities exchange, you will pay a typical brokerage commission, but not any sales loads or purchase or redemption fees.
  • Regardless of whether you purchase your shares in an initial offering or on a securities exchange, you will pay for the BDC’s operating expenses. These expenses – management fees, distribution fees and shareholder services fees – are paid indirectly by shareholders out of the BDC’s assets. For a list and explanation of fees associated with a BDC investment, you should review the fee table, which is available in the fund’s prospectus, or other relevant fund documents, or ask your financial professional.

Before you invest in a BDC

  • Carefully read all of the fund’s available information, including its registration statement, prospectus, and any recent 10-Ks, 10-Qs, and 8-Ks. You can get this information by looking at the fund’s filings on the SEC’s EDGAR database, from your investment professional, or directly from the fund.
  • Understand the fees and expenses you will pay for the fund, and compare them to other investment options.
  • Be sure that the fund’s investment strategy is consistent with your goals.
  • Ask Questions:
    • What kind of companies does the BDC invest in?
    • What kind of loans does the BDC make? Are they higher quality loans or lower-rated loans? 
    • How much debt has the BDC taken on to make its investments?
    • Has the BDC consistently paid distributions to its investors? A long and stable distribution history can show that the BDC has paid its loans and has money available to return to investors.
    • What fees and expenses are my investment dollars subject to?

Additional Information

Investor Bulletin: Publicly Traded Closed-End Funds

Investor Bulletin:  Interval Funds

Investor Bulletin:  How to Read a Mutual Fund Prospectus (Part 1 of 3: Investment Objective, Strategies, and Risks); (Part 2 of 3: Fee Table and Performance); (Part 3 of 3: Management, Shareholder Information, and Statement of Additional Information)

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