Most BDCs invest in small and middle market commercial loans, and in some cases equity, to businesses that have trouble raising cash from traditional banks or other lenders. Similar to REITs, BDCs must pay out 90% of their taxable income to investors and have become popular with retail investors seeking income.
Since BDCs invest in small and up and coming businesses, many people describe BDCs as "private equity" funds for the individual investor. And like private equity funds, the management company selecting the securities in the portfolio charges an average fee of 2% annually on the assets and then 20% of capital gains above a certain return threshold. In order to pay out an average yield of 9-11% after expenses, managers have to take additional risks and leverage in order to achieve it, no free lunches. As an example of how fees eat into potential investor returns, one of the most prominent BDCs, Apollo Investment Corporation has paid the manager an incredible 28% of the revenues in the first 9 months of 2012. In this low interest rate and yield chasing environment, how are BDCs able to pay the high dividend on top of the high management expenses?
One way is leverage, business development companies have a legal limit to their leverage, they're only allowed to be 2:1 assets to equity. Leverage was an issue during the credit crisis as many BDCs were hit especially hard, following the recovery many BDCs lowered their leverage significantly, however its been creeping up in the past several quarters signaling that managers are having to increase risk in order to meet investor dividend expectations. The "Baby Bonds" described in Jason Zweig's article is an example of how some BDCs are getting more creative in their financing and pushing more levers.
|Sample list of BDCs as of 11/24|
Lastly and more for amusement purposes, the chase for yield and the proliferation of new ever more thinly sliced ETFs has brought a 2x leveraged BDC ETN, BDCL, the ETRACS 2x Leveraged Long Wells Fargo Business Develop Company Index distributed by UBS (since it's an ETN, you'd be exposed additionally to the credit risk of UBS). The advertised leveraged yield is 18.71%, the 2x leverage is on top of the already leveraged underlying BDCs, and the annual ETN tracking fee is an additional 0.85% on top of the high fees of the underlying BDCs, creating an incredible amount of risk and leverage to pay out the sky high yield.
Investors should simply stay away from BDCs, and especially the BDCL.