To many investors, investing in private equityor privately held companiesis the sole domain of venture capital firms and private equity funds. To play in that game, you typically have to be an accredited investor (i.e., have a high income or a net worth exceeding $1 million).
But theres a way for the rest of us to join this club, too, and its just as easy as buying stocks: the business development company, or BDC.
On its surface, the role of the BDC is similar to that of a venture capital firm: to extend financing to small and mid-sized companies that would otherwise have trouble accessing it on their own. They do that by both lending money and taking equity stakes in client companies.
But what sets BDCs apart is that the average Joe can invest in them: many trade on the major exchanges, and there are also BDC-focused exchange-traded funds (ETFs).
BDCs can also help diversify your investments, because youre not likely to be familiar with the private or thinly traded public companies in which they invest, so there shouldnt be any overlap with the other stocks or funds you hold.
A Solid Choice for Income
At this point, you may be wondering what investing in privately held and start-up companies has to do with income investing.
Heres where that comes into play: BDCs typically choose to be treated as regulated investment companies (RICs). As such, theyre pass-through investments, much like real estate investment trusts (REITs) and master limited partnerships (MLPs). That means they dont pay income tax at the corporate level, provided they pay out to shareholders at least 90% of their taxable net income each year.
That gets rid of the double taxation most corporations have to deal with (i.e., corporate tax at the corporation level and income tax at the investor level). With less cash going to the government, BDCs have more to give to investors in the form of dividends.
Add it all up and you get an asset class that boasts growth potential and dividend yields higher than youll find just about anywhere else. For BDCs, annual dividend yields of 7% to 10% are typical.
As is the case with REITs, BDCs dividends are taxed as ordinary income and require filing a Form 1099.
Safeguards Help Limit Risk
BDCs were created in 1980, when Congress passed an amendment to the Investment Companies Act of 1940. The goal: to encourage the flow of private equity capital to private businesses.
To be sure, investing mainly in start-up and development-stage companies entails higher risk. To help mitigate that risk, BDCs typically invest across a large number of firms and a range of industries.
The fact that BDCs are open to average investors means they must meet certain statutory standardsand that includes sufficient diversification. For example, a BDC must hold at least half of its portfolio in investments that each represent less than 5% of the total portfolio. Whats more, no single investment can be greater than 25% of the total portfolio.
In addition, BDCs must limit their debt-to-equity ratio to 1 or less and revalue their private investments every quarter.
What Makes a BDC?
To qualify as a BDC, at least 70% of a companys investments must be in certain types of eligible assets, including companies that: (a) are based in the US, (b) dont have any of their securities listed on a public exchange, or (c) have securities listed on a public exchange but have a market cap of less than $250 million. (Thats generally regarded as the cutoff between small- and micro-cap stocks.)
In addition, BDCs must get 90% of their gross annual income from dividends, interest, and realized capital gains on securities. Theyre also required to assist the management teams of their portfolio companies. A BDC may be either internally managed or run by an outside advisory firmsomething that could result in higher costs for the company.
In the end, the choice of whether or not to invest in a particular BDC comes back to managementand whether youre confident the team in charge can make the right calls and value the BDCs portfolio accurately.
#1 Tech Stock Paying 9% (For Now) [sponsor]
I'm about to show you a tech stock that's breaking out to new highs as you're reading this. It pays a 9% dividend... No, it's not an AI stock or semiconductor. Actually it's a high-yielder that would've got you into companies like Pinterest and Zoom. If you take this stock and plug it into my most popular income plan... it could set you up to pay your bills for life.