After experiencing meager interest rates from their bond funds in the 2010s, a lot of investors have been seeking out more novel investment vehicles in order to obtain a healthy return. One option they’ve been investigating is business development companies (BDCs).

BDCs provide debt financing for small- and medium-sized business – often relatively new ones – that aren’t covered by a traditional rating agency. As a result, BDCs frequently collect much-higher-than-average interest income. Over the past few years (2015-17), yields on their underlying debt have hovered around 7% to 9.8%, according to the investment analytics firm FactRight.

But the firms also carry some serious risks, especially those that aren’t traded publicly on a stock exchange (hence the name "non-traded BDC"). It’s not uncommon for investors to face sales commissions of 10% that go to the brokers selling them. Many also encounter a “two and twenty” fee structure, similar to hedge funds', whereby the BDC charges 2% annually on the total value of your assets in addition to a 20% fee on any profits

In a good year, BDC shareholders can overcome those charges through generous distributions. When the net asset value of the company takes a tumble, however, those fees stick out like a sore thumb. These and other factors have caused non-traded BDCs' popularity to plummet since their 2014 peak when they received $5.9 billion in investor funds. But with interest rates on the rise in October 2018, are they poised for a turnaround?

Recent Retrenchment

The bloom went off the BDC rose in 2015. Using the most recently available data, a Wall Street Journal piece noted that shareholders withdrew $25.7 million from non-traded BDCs in the second quarter of 2015 and another $47.3 million in the third quarter. The sell-off was in part a reaction to pending regulatory rules that changed the way shares would be valued and require greater transparency regarding company fees. Another factor was the exposure of many non-traded BDCs to the energy market, which has been ravaged by the decline in global oil prices.

As a result, there was a rise in the increase in the number of loan defaults – and investors rushed to cash in their BDC shares. One investment firm, Business Development Corporation of America, had to freeze redemptions after reaching an internal threshold. Though most firms only allow redemptions once per quarter, it was perhaps the first time that one had to halt cash-outs in order to prevent destabilization the net asset value of BDC holdings fell 12.5% in 2015, exceeding the interest income those companies generated. The net result across the board was a 3.4% drop in their total return that year.

The pain continued in the next few years. Non-traded BDC fundraising in 2016 totaled only $1.9 billion. In 2017, it dropped 58%, down to $840 million equity raised, according to Summit Investment Research, a due diligence firm. As of the first quarter of 2018 (the latest figures available), $112 million has been raised by BDCs.

Liquidity Concerns

BDCs have been around since 1980, brought into being with an amendment to the Investment Company Act of 1940. Like real estate investment trusts (REITs), those that qualify as registered investment companies (RICs) don’t face corporate taxes if they distribute at least 90% of their taxable income to shareholders each year. Until recently most have been closed-end funds that trade on the New York Stock Exchange or other public exchanges. That changed around 2009, when interest in non-traded BDCs began to take off for the first time. By 2014 these companies were raising a record $5.9 billion per year in fresh capital.

For some brokers that the companies have actively courted, BDCs have been an opportunity to rake in sky-high commissions. For the public, they represent a rare chance to invest in young, promising companies. Unlike with venture capital funds, even small, non-accredited investors can buy shares. But non-traded BDCs are also notoriously risky, even compared to traditional junk bond funds. It’s not just the hefty – some would say scandalous – expenses. Because they’re not listed on an exchange, they’re also not particularly liquid.

The Financial Industry Regulatory Authority (FINRA), an independent regulatory body for the finance industry, has long been wary of these non-traded instruments. “Due to the illiquid nature of non-traded BDCs, investors’ exit opportunities may be limited only to periodic share repurchases by the BDC at high discounts,” the organization said in a 2013 letter.

BDCs aren’t the only debt vehicles that have taken a hit of late. The S&P High Yield Corporate Bond Index, a benchmark for junk bonds, fell 1.4% in 2015 and has been essentially flat since. Part of what makes BDCs unique, however, are the double-digit commissions that are so common across this niche sector. If a non-exchange-traded BDC charges a 10% upfront fee, you’re only getting $90 worth of shares for every $100 you invest. Consequently, the returns have to be that much better than other investment opportunities in order to make them a smart choice.

The Bottom Line

Non-traded BDCs have heavy fees, low liquidity and very little transparency. Those three strikes make it hard to justify keeping them in your investment lineup.

But they may be set for a comeback. The industry has consolidated – fewer, but better funds – and many BDCs have shifted to a more flexible interval fund structure and also lowered their fees. In addition, "the entrance of institutional managers and the acceptance of the interval fund structure may provide a much-needed turning point," noted a Real Assets Adviser report in June 2018. "The access to this caliber of manager and the unique strategies allowed in the interval fund structure give retail investors greater options within the nontraded space."