What Are Non-Traded Business Development Companies (BDCs)?
A business development company (BDC) is a closed-end investment company that invests in small- and medium-sized businesses, including new and distressed companies. The debt financing that BDCs provide allows these businesses to get on track with a sound financial base. As such, BDCs are required to register under the Investment Company Act of 1940.
BDCs can be both public and private. Both types of BDCs invest a minimum of 70% of their assets in private companies in the U.S. In order to trade on an exchange, public or traded BDCs must be registered with the Securities and Exchange Commission (SEC). As of May 4, 2021, there were just over 30 traded BDCs on the market.
Just like stocks, investors can buy and sell shares in traded BDCs on an exchange. Private BDCs are called non-traded business development companies and aren't privy to the risk of share price volatility the way their traded counterparts are on the public market. Non-traded firms, on the other hand, come with other, serious risks, including:
- high-net-worth requirements
- higher initial investments
- high sales commissions and fee structures
- long-term investment horizons
- redemption limits and suspensions
In a good year, shareholders can overcome these risks and high costs through generous distributions. But when a company's net asset value (NAV) drops, the high cost of these investments stick out like a sore thumb. These and other factors caused non-traded BDCs' popularity to plummet since their 2014 peak. But what's the landscape like for non-traded BDCs now?
- Non-traded business development companies invest in small- and mid-sized companies but aren't traded on an exchange.
- They are meant to provide investors with higher-than-average yields.
- These investments come with high fees, are generally illiquid, and come with redemption limits.
- Investors can generally only pull out money from a non-traded BDC once per quarter.
- Sales in BDCs dropped because of loan defaults, energy price volatility, regulatory changes, and the economic impact of the COVID-19 pandemic.
High Stakes, High Fees
BDCs have been around since 1980. Like real estate investment trusts (REITs), BDCs that qualify as registered investment companies (RICs) don’t have to pay corporate taxes as long as they distribute at least 90% of their taxable income to shareholders each year. Most were closed-end funds that trade on exchanges like the New York Stock Exchange (NYSE). That changed around 2009 when interest in non-traded BDCs increased for the first time.
Industry statistics show that investors piled in more than $22 billion into non-traded BDCs since 2009.
Part of what makes BDCs unique is the double-digit commissions commonly associated with this niche sector. Many investors pay their brokers a 10% commission while other BDCs are structured with 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. This means the returns have to be that much better than other investment opportunities to make them a smart choice.
Investors get a rare chance to invest in young, promising companies. BDCs traditionally promise higher-than-average interest income, which is why they often hold them in high regard. They generally return yields of at least 5%. That's because they're exposed to a great deal of credit risk and leverage. Yields on their underlying debt hovered around 7% to 10% between 2015 and 2017, according to investment analytics firm FactRight.
Unlike 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, it's also the fact that they're not listed, which makes them fairly illiquid.
The Financial Industry Regulatory Authority (FINRA) has been wary of these non-traded instruments, citing the limitations of exit opportunities afforded to investors. “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 Take a Dive
Once considered attractive investments, market conditions led to a drop in performance and sales. This was due, in part, to an increase in loan defaults, regulatory rules changing share valuation (for traded BDCs), and an increase in transparency about company fees. The non-traded BDC market's problems were also compounded by heavy investment in the energy market, which was ravaged by the decline in global oil prices.
The pain continued for this sector. As a result of the poor market conditions, non-traded BDC fundraising totaled only $1.9 billion in 2016 and dropped 58% the following year, down to $840 million equity raised. As of the first quarter of 2018, BDCs raised $112 million while bringing in only $362.3 million in 2019.
Sales continued to show signs of slowdown because of the COVID-19 pandemic, which spread panic throughout the global economy. Many investors were wary about putting money into such risky investments. Keep in mind that BDCs use capital that is pooled together from investors to lend to these high-risk companies. Given the circumstances, many investors felt as though these companies would default and they wouldn't receive their money back.
The non-traded BDC sector failed to mimic the returns of their underlying indexes, too. The Stanger Non-Listed BDC Total Return Index posted a return of -14.3% in 2019, compared to the S&P BDC Total Return Index, which returned -8.8%. But BDCs aren’t the only debt vehicles that took a hit. The S&P High Yield Corporate Bond Index, a benchmark for junk bonds, fell 1.4% in 2015 and remained relatively flat. The index returned only 7.18% in the five-year period between 2016 and April 30, 2021.
Investors Pull Out
Most firms only allow redemptions once per quarter, but some had to take the unusual step of freezing requests entirely. Business Development Corporation of America announced that it hit its prescribed limit of 2.5% of its outstanding shares in 2016. The firm only honored 41% of the 7.4 million share redemption requests from investors. The net result across the board was a 3.4% drop in the firm's total return that year.
So how much did investors pull out? According to reports, investors redeemed as much as $25.7 million in the second quarter of 2015 and another $47.3 million in the following quarter. Another $64 million was pulled out by investors in the final quarter of 2015.
The Bottom Line
Non-traded BDCs have heavy fees, low liquidity, and very little transparency when compared to other investments. These are three strikes that may make it hard to justify keeping them in your investment lineup.
But the industry has consolidated with fewer and better funds. Many BDCs shifted, taking on a more flexible, interval fund structure while also lowering 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."