Business development companies (“BDCs”) offer retail investors the allure of becoming venture capitalists, funding emerging enterprises with the help of professional asset managers. BDCs are investment companies that finance businesses traditionally locked out of conventional capital markets. Nearly forty years old, the BDC has remained virtually unexplored by academic researchers.
I begin by analyzing the laws that govern BDCs. To protect investors, BDCs are subject to the Investment Company Act of 1940. But to encourage the financing of smaller businesses, Congress excused BDCs from certain provisions of the Act, allowing them to engage more freely in leverage and related-party transactions. BDCs are neither fully regulated by the Act nor fully exempt.
Using a novel dataset constructed from hand-collected filings, I then study BDCs empirically. I find more than fifty exchange-traded BDCs are available to the public today. BDCs generally have attractive dividend yields. But they are risky investments with high leverage and volatile returns. BDCs significantly underperform their benchmark indices after I accommodate for the substantial risk that investing in a BDC entails.
A business development company, or BDC, is a type of investment company that invests in, and provides managerial assistance to, businesses that are small and growing or are financially troubled. BDCs came into existence by an act of Congress in 1980 to encourage the flow of capital to businesses that traditionally have difficulty accessing public markets or other forms of conventional financing. BDCs have largely stepped into a role that banks have vacated and become an important component of the financial system.1
BDCs obtain their capital from investors rather than depositors. To help BDCs acquire capital (and, in turn, provide smaller businesses with capital), Congress has encouraged BDCs to offer their shares to the public, essentially creating a public alternative to private venture capital firms. After raising equity in public markets, BDCs are encouraged to raise more capital by issuing debt, and then they fund companies considered too risky by traditional lenders. Congress takes the view that the more capital BDCs can obtain from investors, the more financing BDCs can supply to small and growing enterprises, thereby promoting job creation and economic growth.
Once obscure, BDCs have been growing rapidly. I find that there are more than fifty BDCs that are exchange-traded and available to retail investors today. The average traded BDC is twice as large as the average closed-end fund and these BDCs collectively manage nearly $64 billion in assets. In addition, there are dozens of BDCs that are public but not exchange-traded, and others that are private. Altogether, nearly one hundred BDCs exist today. With banks retreating since the financial crisis and investors hungry for dividends, BDCs have been “springing up like mushrooms in a rainforest.”2
This article is the first academic study to examine the modern BDC in detail. While there is a vast literature on investment companies in law, finance, and economics, virtually no attention has been paid to BDCs, even though they are a subset of closed-end funds. Only three studies of BDCs have been published (two in the 1980s and one in the 1990s) and each is outdated.3 In addition, the studies are devoid of any empirical foundation.
Why has the literature overlooked BDCs? One reason for the inattention may have to do with the complexity of the regulatory framework. On the surface, it appears that the Investment Company Act of 1940 regulates BDCs on a standalone basis, in the final twelve sections of the Act. But those sections import rules from elsewhere in the Act, applying much of the traditional investment company regulatory framework to BDCs, in modified fashion. Another reason the literature has overlooked BDCs is likely due to a lack of available data. The traditional electronic databases lack coverage of BDCs, deterring empirical work on the subject. This article addresses both obstacles.
I begin by dissecting the laws that govern BDCs, which are neither exempt from the Investment Company Act nor fully regulated by it. In order to fulfill their mission of assisting emerging enterprises, BDCs are highly restricted in their investments and activities. The Investment Company Act requires that BDCs finance primarily private or small public companies, which restricts their assets to illiquid or thinly traded securities. But to promote the growth of BDCs (and the growth of companies in which they invest), key provisions of the Act are applied to BDCs in a relaxed manner. The rules permit BDCs to engage more freely in leverage and related-party transactions than other investment companies. In these respects, BDCs resemble the closed-end investment companies that existed in the 1930s and motivated Congress to protect investors by enacting the Investment Company Act.4 With the BDC, in the name of promoting job creation and economic growth, Congress has permitted the emergence of a kind of investment company that it had outlawed earlier. Although Congress has shown concern about maintaining safeguards for investors in BDCs, it has not considered whether investing in BDCs is a worthwhile activity for the public.
I next conduct an empirical analysis of BDCs using a unique dataset built by hand-collecting information from BDC filings. I find that 311 BDCs have been created since 1980. BDC formation has come in two major waves, from 2004 to 2006 and from 2011 to 2015. I find that 212 BDCs have been terminated since 1980, some of which provided investors with a successful exit event, though others withdrew because of regulatory compliance costs.
I also examine the performance of publicly traded BDCs over a twenty-one-year period, by combining my BDC dataset with financial and stock data from traditional databases. I find that BDCs live up to their reputation for high dividend yields. Moreover, the total returns (stock returns plus dividends) of BDCs appear to match or beat the benchmark indices. However, BDCs incur substantially greater risk. BDCs are permitted to be highly leveraged, nearly all BDCs employ leverage, and their performance is highly volatile. On a risk-adjusted basis, BDCs significantly underperform the benchmarks, trailing by more than four to six percentage points per year. In other words, BDCs do not appropriately compensate investors for the additional risk that investing in a BDC entails. During the March, 2020 market crash related to the coronavirus crisis, shares of publicly traded BDCs declined by nearly four times as much as the benchmarks. Overall, I find that investors in publicly traded BDCs would have been better off putting their money in an index fund tracking high-yield bonds or leveraged loans. In a desire to spur job creation, Congress has been promoting an investment vehicle that may not be worthwhile for the investing public.
A few caveats, however, are in order. One caveat is that the article studies BDC performance on a stand-alone basis. BDCs allow the public to access a nontraditional asset class and gain exposure to small and emerging companies typically absent from the portfolios of retail investors. There could be diversification benefits that arise from adding a BDC to such an investor’s portfolio. Another caveat is that the article examines the performance of those BDCs that are traded on a national stock exchange. As such, it has not examined the performance of non-traded BDCs or private BDCs. Such BDCs might exhibit better performance than their publicly traded counterparts (although non-traded and private BDCs may be inaccessible to the average investor and provide significantly less liquidity). A final caveat is that article does not measure benefits that BDCs might provide to their portfolio companies. BDCs help fill a space in middle market lending from which traditional banks have pulled back. By providing financing and managerial assistance to help such smaller businesses grow, BDCs might promote job creation and economy vitality. Nevertheless, to accomplish those objectives, BDCs themselves need to be financed by outside investors. The evidence indicates that, from an investor’s perspective, publicly traded BDCs have yet to prove their worth.
Part I of this article explores the origin of the BDC. Part II analyzes the regulatory framework that governs BDCs. Part III performs an empirical analysis of BDCs using a novel dataset. Finally, the article concludes in Part IV.
During the 1970s, new and emerging companies were struggling to raise the capital they needed to survive and expand. Smaller businesses and startups had become virtually excluded from U.S. capital markets. In 1977, Business Week magazine reported that “access to U.S. capital markets has (for several years) been pretty much open to only the nation’s big corporations.”5 Problems faced by small, emerging enterprises in raising capital eventually attracted the attention of Congress, concerned about the damage it could have on job creation and economic growth. A congressional report stated:
The Committee is well aware of the slowing of the flow of capital to American enterprise, particularly to smaller, growing businesses, that has occurred in recent years. The importance of these businesses to the American economic system in terms of motivation, productivity, increased competition and the jobs they create is, of course, critical. Hence, the need to reverse this downward trend is of compelling public concern.6
Congress held a series of hearings during the late 1970s that focused on the capital formation problems of new and small businesses.7 Representatives of the venture capital industry maintained that the reason for the shortage of capital was the inability of venture capital companies themselves to access public markets for their own securities without subjecting themselves to heavy federal regulation under the Investment Company Act.8 Venture capitalists stated that they could not function efficiently under the Act, and the industry had become increasingly unwilling to operate under the regulatory burden it imposed. As a result, during the 1970s, no public venture capital firms were created and those in existence failed to grow or simply shut down.9
The Investment Company Act was intended to regulate any “investment company,” a term defined broadly to include venture capital firms and other entities different from traditional mutual funds,10 unless within one of the exceptions to the definition.11 Hence, a venture capital firm that wanted to avoid the Act had to fall outside the definition or qualify for an exception from the definition. Excluded from the definition are companies whose securities are beneficially owned by one hundred or fewer persons.12 A venture capital firm could thereby avoid the Act by funding itself from one hundred investors (or less) and forgoing potential sources of capital. The requirement, of course, prevented a venture firm from going public, unless willing to register under the Act. Participation was effectively restricted to a pool of wealthy investors rather than open to the broader public. By limiting the size of venture capital firms, the regulations were also limiting the amount of capital that could be channeled to small and midsize businesses.
Over the course of its hearings, Congress reached the conclusion that subjecting venture capital firms to the Investment Company Act was contributing to the shortage of small business financing.13 Congress responded by passing the Small Business Incentive Act of 1980,14 which amended the Investment Company Act and the Investment Advisers Act of 1940. These 1980 Amendments created a new kind of investment company, called a business development company or BDC.
BDCs are investment vehicles that are designed to channel capital to small and midsize businesses. The legislation established the BDC as a new breed of closed-end investment company under the Investment Company Act that was freed from certain regulatory restrictions in order to accommodate the special needs of venture capital companies.15 The result was a unique regulatory framework that would be more flexible for the BDC than for other investment companies.16 BDCs, for example, would have greater flexibility in dealing with businesses in which they invest, in issuing their own securities (including senior securities to achieve leverage), and in compensating their managers. The intent of the 1980 Amendments was to increase the flow of capital to small, growing companies.17
Congress had made earlier attempts to encourage venture capital financing of small businesses, going back decades before the 1980 Amendments. From World War II through the 1950s, venture capital and private equity investments were typically funded on an ad hoc, deal-by-deal basis by syndicates of wealthy individuals and corporations.18 As a result, Congress got the impression that small business financing was in short supply.19
Congress passed the Small Business Investment Act of 1958,20 creating small business investment companies or SBICs, which are venture capital companies licensed and regulated by the U.S. Small Business Administration (“SBA”). SBICs receive tax benefits and subsidized SBA loans.21 In return, SBICs have to comply with investment restrictions, including strict limitations on the size of the companies in which they invest and limitations on taking controlling interests.22 The SBIC program has largely struggled over the years.23 SBICs are regulated by the SBA under the 1958 Act and by the SEC under the Investment Company Act (unless within the exception for small, private investment companies).24 Rather than being liberated from regulation, SBICs face substantial regulatory burdens under two different frameworks. SBICs generally have been run poorly and many suffered from mismanagement and corruption in the past.25 In addition, SBICs are restricted to the smallest of businesses, leaving unmet the financing needs of those enterprises too large for SBICs and too small to access public markets and traditional bank loans.
On multiple occasions during the 1970s, Congress made attempts to reform the regulatory framework for venture capital, but was unsuccessful. Several hearings were conducted by the House26 and the Senate27 from 1977 to 1980 on the capital formation problems of smaller businesses. Several bills were introduced by the House28 and the Senate,29 none of which resulted in legislation. Strong opposition came from the U.S. Securities and Exchange Commission (“SEC”) on the grounds that exempting venture capital companies from the Investment Company Act would weaken investor protections.30
The SEC and the venture capital industry remained at an impasse until political pressure forced the two sides to reach a compromise in 1980.31 The resulting legislation, the 1980 Amendments, preserved some of the investor protections in the Investment Company Act while doing away with some of the burdensome restraints on venture capital activities. To succeed, reform ultimately required that a balance be struck between the competing policy objectives of promoting jobs and economic growth and maintaining investor safeguards.32 The stated purpose of the 1980 Amendments was to “encourage the mobilization of capital for new, small and medium-sized and independent businesses [and] to maintain the system of investor protection and investor confidence.”33
Since 1980, tension between these competing objectives has resurfaced, leading Congress to revisit the 1980 Amendments repeatedly. These reform efforts have tried to further liberate BDCs from the Investment Company Act.
From the outset, Congress believed that BDCs would become a widely used investment vehicle.34 It was anticipated that “approximately 20 to 50 firms may likely register as BDCs within the first year after the date of enactment.”35 However, BDCs did not catch on as quickly as anticipated. After one year, only seven companies had elected to be regulated as BDCs, with just two of them issuing securities to the public.36
By the mid-1990s, Congress conceded that “BDCs have drawn only limited public interest.”37 It declared that “giving BDCs more flexibility will encourage more investment in small businesses.”38 Hence, in 1996, Congress further loosened BDC regulation as part of the National Securities Markets Improvement Act (“NSMIA”),39 its effort to overhaul federal regulation of securities markets overall. Key provisions of NSMIA encouraged BDCs to raise additional capital by giving them greater flexibility with their capital structure,40 expanded the scope of companies in which BDCs were allowed to invest,41 and permitted BDCs to acquire securities more freely.42 Congress believed that “changing BDC regulation to make it easier and less costly for BDCs . . . will make this type of investment vehicle more attractive.”43 By tilting the regulatory pendulum toward job creation and economic growth, away from investor protection, Congress hoped the reforms would revitalize BDCs. The changes, however, were rather technical and failed to produce the desired results.44
Congress has re-visited the regulatory framework more recently. As before, these reforms attempt to make the regulations more flexible and less burdensome. In 2012, Congress passed the JOBS Act, which lessened the burden on “emerging growth companies” that want to go public to conduct an IPO.45 Although the legislation was not focused on them, BDCs are eligible to qualify as emerging growth companies and it was believed that the JOBS Act would encourage BDCs to go public.46 The JOBS Act also made the idea of forming a private BDC potentially more attractive by expanding the number of possible investors.47
In 2018, Congress focused attention on BDCs, declaring that “a static regulatory regime that has not been significantly updated in more than 30 years” was restricting the BDC industry.48 Congress responded by passing the Small Business Credit Availability Act (the “SBCAA”).49 The SBCAA made two specific changes to BDC regulations. First, it significantly increased the amount of debt that a BDC can incur.50 Congress believed that allowing BDCs to incur more leverage would enable them to provide additional capital to small and midsize businesses, which, in turn, would have “greater opportunity to grow and create jobs.”51 Second, the SBCAA allowed BDCs to rely on liberalized offering, proxy, and communications rules previously available only to operating companies.52 The two changes were intended to “fuel capital formation for small- and middle-market businesses . . . by providing BDCs some relief” from regulatory requirements.53
The lengthy history of the BDC program in the United States highlights the challenges of striking an appropriate balance between promoting job creation and economic growth and protecting investors. Each time Congress reassesses the BDC program, it generally concludes it can strike a better balance by loosening regulations. The regulatory framework governing BDCs has been loosened steadily through different Administrations, continuing even after the financial crisis as broader financial market regulations have been tightened. Absent from the discussion has been tangible evidence about whether BDCs benefit their investors and are valuable investment vehicles for the public.
A BDC is a type of closed-end fund that benefits from relaxed regulatory treatment under the Investment Company Act in exchange for financing businesses that traditionally have difficulty accessing capital. The Small Business Investment Incentive Act of 1980 created the statutory framework for BDCs.54 Overall, BDCs are regulated in a manner similar to registered investment companies, particularly closed-end investment companies. In fact, BDCs are required to be closed-end investment companies.55 But regulation of BDCs differs in two main ways from regulation of traditional closed-end investment companies.
First, the Investment Company Act imposes specific requirements on the investments and activities of BDCs. A BDC must be operated for the purpose of making certain types of investments that are enumerated in the Act.56 In this respect, the Act imposes substantive investment restrictions on BDCs. A BDC must also offer to make managerial assistance available to the companies in which it invests.57 The requirements reflect the intent of Congress that a BDC be a kind of venture capital company that exists to provide financial and managerial assistance to small or financially troubled businesses.
Second, in return, BDCs receive relaxed regulatory treatment whereby they are subject to some, but not all, of the provisions of the Investment Company Act applicable to registered closed-end investment companies. BDCs are not considered “registered” investment companies and therefore are not subject to the full regulatory framework that governs registered closed-end investment companies.58 In the 1980 Amendments, Congress modified the Investment Company Act to provide a general exemption for BDCs (in Section 6), exempting them from Sections 1 through 53 of the Act.59 Congress was persuaded that BDCs need a more flexible regulatory regime than the standard investment company framework. But Congress did not carve BDCs out of the Act’s definition of an “investment company” (in Section 3). Instead, while exempting them from Sections 1 through 53, Congress made BDCs subject to new Sections 54 through 65 of the Act, which were added specifically to regulate BDCs.60 Hence, BDCs occupy a middle position under the Investment Company Act, neither completely exempt nor fully regulated. In crafting the regulatory framework, Congress tried to provide regulatory relief for BDCs, while establishing some protections for those investing in BDCs.61
Nonetheless, reflecting the influence of the SEC, Congress agreed that “many of the Act’s provisions should remain applicable” to BDCs.62 Despite the appearance of regulatory relief, BDCs remain subject to many Investment Company Act provisions, which are applied to BDCs in a backhanded manner. Although BDCs are exempt from Section 1 through 53 of the Act, Section 59 then incorporates a host of the Act’s sections by reference and applies them in their entirety to BDCs. Section 59 provides that Sections 1, 2, 3, 4, 5, 6, 9, 10(f), 15(a), (c) and (f), 16 (b), 17(f) though (j), 19(a), 20(b), 32(a) and (c), 33 through 47, and 49 through 53 shall “apply to a business development company to the same extent as if it were a registered closed-end investment company.”63 Congress believed that these sections provide important investor protections.64 Further, Sections 60, 61, 62, and 63 of the Act then take Sections 12, 18, 21, and 23 and apply them to BDCs in an amended fashion (intended to make them somewhat less rigid with respect to BDCs).65 Similarly, Section 57 adopts conflict-of-interest provisions for BDCs that are analogous to those in Section 17 (and applies to BDCs SEC rules adopted under (a) and (d) of Section 17). Although Congress eliminated nine sections of the Act in their entirety with respect to BDCs, it added twelve new sections specifically for BDCs and had forty sections continue to apply to BDCs.66 Hence, despite the appearance of regulatory relief, BDCs must adhere to many of the regulatory requirements that registered investment companies must adhere to.
Nevertheless, I identify distinct advantages that BDCs have over registered investment companies. BDCs have greater flexibility than registered closed-end companies with respect to leverage, transactions with affiliates, valuation, and reporting (discussed below).67 The flexibility is intended to make the BDC structure preferable for investing in small, private businesses compared to the registered closed-end structure.
BDC status is not available to any closed-end investment company that desires such treatment. Rather, to qualify for BDC status, the company must fall within the definition of a “business development company,”68 which sets forth three criteria. First, it must be a closed-end company organized under and doing business in a U.S. state.69 Thus, only domestic companies can elect to be BDCs. Second, it must be operated for the purpose of investing in securities of certain companies (primarily, “eligible portfolio companies”) and must make available significant managerial assistance to those companies.70 Third, it must make an election to be treated as a BDC pursuant to Section 54 of the Investment Company Act.71 BDCs are not “registered” investment companies. Instead, they must “elect” to be treated as a BDC under the Act by filing a notice to that effect with the SEC on Form N-54A.72 As a prerequisite, the electing BDC must have a class of securities registered under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) (or have filed a registration statement pursuant to Section 12 of the Exchange Act for a class of its equity securities).73 As a result, BDCs must file reports required of public operating companies (such as Forms 10-Q, 10-K, and 8-K and proxy statements) and can be considered a hybrid between a closed-end fund and an operating company. A BDC may voluntarily withdraw its BDC election by filing a notice of withdrawal with the SEC on Form N-54C.74 A BDC cannot withdraw its election, or change the nature of its business so as to cease to be a BDC, unless authorized by a vote of a majority of its shareholders.75 The SEC may revoke a BDC’s election if it finds that the BDC has ceased to engage in the business.76
In return for relaxed regulatory treatment, BDCs must assist businesses that are small or financially troubled. A BDC must pass two tests with respect to its investments, which I characterize as a subjective test and an objective test. It must also offer managerial, not just financial, assistance. Together, these requirements ensure that the BDC is investing in small or financial troubled businesses and is actively involved in their affairs.
The definition of “business development company” requires it to be “operated for the purpose of making investments in securities described in paragraphs 1 through 3 of Section 55(a)” of the Investment Company Act.77 Those paragraphs describe three types of investments: the purchase of securities of “eligible portfolio companies” (in non-public transactions), the purchase of securities of eligible portfolio companies that are already controlled by the BDC (regardless of the nature of the transaction), and the purchase of securities (in non-public transactions) from financially distressed companies (regardless of whether it is an eligible portfolio company). In effect, the BDC must be operated for the purpose of investing in “eligible portfolio companies” (i.e., private or very small public companies) or financially troubled companies. The requirement is designed to ensure that BDCs pursue Congress’s objective of “making capital more readily available to small developing and financially troubled businesses.”78
Notably, the Act places no restrictions on how the BDC’s investment is used by the company in which the BDC invests. Congress assumes that companies will use the BDC’s investment to expand and create jobs. But the Act imposes no such requirement on the use of the funds and reports indicate that companies have used BDCs to pay special dividends, buy back stock, acquire other companies, and finance buyouts.79
In addition to that subjective “purpose” test, a BDC’s investment portfolio must separately meet an objective 70 percent test. A BDC must invest 70 percent or more of its assets in securities that are specifically enumerated in Section 55 of the Act.80 The eligible investments listed in Section 55 encompass those assets generally considered venture capital investments. The 70 percent/30 percent split between eligible and non-eligible assets was a compromise the SEC reached with the venture capital industry, which believed the split reflected the portfolios of public venture capital vehicles at the time.81
While Section 55 enumerates several categories of eligible assets, by and large most BDCs own securities that have been issued by an “eligible portfolio company.”82 Eligible portfolio companies were envisioned as small, developing American companies in need of financing but locked out of conventional capital markets. An eligible portfolio company is defined as one that:
The acquisition of the securities by the BDC may not involve a public offering.89
Notably, the definition of “eligible portfolio company” excludes companies that have issued marginable securities (unless within an alternative category). At the time it adopted the legislation, Congress believed that issuers of marginable securities were mature enough to have access to traditional public markets and hence were not intended to benefit from the legislation.90 Although the definition of eligible portfolio company includes other categories of companies, this category is the one BDCs have relied upon to the greatest extent.91 However, in 1998, the Federal Reserve expanded its definition of marginable securities to include all publicly traded equities and most debt securities, thus encompassing almost any public or private company and thereby narrowing the universe in which BDCs could invest.92 In 2006, the SEC responded by adopting two rules that clarify that private companies and certain public companies are eligible investments for a BDC, regardless of whether the companies issue marginable securities. In particular, Rule 2a-46 provides that a company may qualify as an “eligible portfolio company” if it does not have a class of securities listed on a national exchange, or if it has listed securities but its equity market capitalization is less than $250 million.93 As a result, the definition of eligible portfolio company now encompasses all private domestic companies, as well as public domestic companies below $250 million in market cap (assuming the other requirements are met).
Although BDCs invest mainly in eligible portfolio companies, certain other assets are eligible to satisfy the 70 percent requirement. The eligible assets are summarized in Table 1. First, pursuant to Section 55(a)(1)(B), eligible assets include securities of eligible portfolio companies that have lost “eligible portfolio company” status after the initial investment because they issued marginable securities, provided that the BDC retains a substantial interest in the issuer (that is, the BDC must own at least half the securities it held when the issuer was an eligible portfolio company and the BDC must be one of the twenty largest holders of the issuer’s voting securities).94 This provision enables the BDC to engage in “follow-on” financing of a portfolio company after it has grown to the point it no longer qualifies as an eligible portfolio company.95 In other words, it allows a BDC to purchase and hold securities of its prospering and seasoned portfolio companies.
Second, pursuant to Section 55(a)(2), eligible assets include securities of eligible portfolio companies that are “controlled” by the BDC, without regard to the nature of the offering (public or private) or the counterparty in the transaction.96
Third, pursuant to Section 55(a)(3), eligible assets include securities of financially troubled domestic companies.97 This category of eligible assets does not exclude companies with marginable securities and therefore large public companies are potentially eligible. Congress acknowledged that publicly held domestic companies on the verge of bankruptcy or in financial distress may have problems obtaining traditional financing and in this respect are similar to small developing companies.98
The above assets (in Sections 55(a)(1) through (a)(3)) are elevated in importance above other eligible assets, as they serve dual purposes. These assets count toward the 70 percent eligible investments test that the BDC’s portfolio must meet. They are also used to demonstrate compliance with the eligible purpose test—that the BDC is operated for the purpose of investing in small or financially troubled businesses. Certain additional assets may be used to satisfy the eligible investments tests, but not the eligible purpose test.
Fourth, under Section 55(a)(4), eligible assets include securities of an eligible portfolio company purchased from any person in a private transaction where no market exists for the securities and the BDC already owns at least 60 percent of the issuer’s equity securities.99 Fifth, pursuant to Section 55(a)(5), eligible assets include securities received as distributions on eligible assets and pursuant to the exercise of options, warrants, and rights relating to eligible assets.100 Finally, under Section 55(a)(6), eligible assets also include cash, cash equivalents, government securities, and high-quality debt maturing in one year or less.101 These assets were included as eligible assets to enable BDCs to make efficient use of liquid assets while analyzing potential investment opportunities.102 Although the assets listed in Section 55(a)(4) though (a)(6) constitute eligible assets for the 70 percent portfolio test, a BDC must not be operated for the purpose of investing in those assets.
As for the remaining 30 percent of its portfolio, a BDC has discretion to invest in any assets. BDCs have historically used the 30 percent basket for a variety of purposes. The basket is typically viewed as a liquidity source for the portfolio.103 It can be used to provide a source of cash flow to the BDC, particularly for equity-focused BDCs that otherwise invest in securities that generate little immediate income.104 BDCs have also used the 30 percent basket to diversify the portfolio. The industry has held the view that a BDC has complete discretion to use the 30 percent basket to invest in any type of assets, including securities of foreign companies and large, public U.S. companies, even though the investment might violate the intent of Section 55(a).105 The SEC, so far, has issued no formal guidance on the issue.106
|Subsection||Issuer||Seller||Type of transaction|
|55(a)(1) (A)||Eligible Portfolio Company||Issuer; Affiliate; Any other person||Does not involve a public offering (or such other transaction as the SEC may prescribe)|
|55(a)(1) (B)||No longer an Eligible Portfolio Company||Issuer; Officer or employee of the issuer||Does not involve a public offering (or such other transaction as the SEC may prescribe)|
|55(a)(2)||Eligible Portfolio Company controlled by the BDC||Any person||Any type of transaction|
|55(a)(3)||Financially distressed company||Issuer; Affiliate; Any person in a transaction incident thereto||Does not involve a public offering|
|55(a)(4)||Eligible Portfolio Company at least 60% owned by the BDC||Any person||Does not involve a public offering|
|55(a)(5)||Distributions on eligible assets; eligible assets from exercise of options, warrants or rights|
|55(a)(6)||Cash and equivalents, government securities, high-quality debt maturing in one year or less|
This table summarizes the requirements to be an eligible investment under Section 55(a) of the Investment Company Act.
In addition to investing in eligible assets, BDCs are expected to provide “significant managerial assistance” to their portfolio companies. The requirement is contained in the definition of a BDC, which is an entity that “makes available significant managerial assistance” to its companies.107 Significant managerial assistance refers to any arrangement whereby a BDC provides “significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company.”108 Managerial assistance may take many forms, such as arranging financing, managing relationships with financing sources, recruiting management and board personnel, and evaluating acquisition and divestiture opportunities.109 The requirement means that a BDC must have at its disposal the skill and talent to provide significant managerial assistance.110 It cannot be merely a passive investment vehicle. Notably, BDCs need only offer such assistance.111 Refusal by a portfolio company to accept the offer has no bearing on compliance with the requirement.
In return for assisting small or financially troubled businesses, BDCs receive relaxed regulatory treatment under the Investment Company Act compared to other investment companies. There are four key differences.
BDCs are subject to leverage limits under the Investment Company Act, but are significantly less restricted than other investment companies as to the amount of debt they can incur. A BDC may issue senior securities representing indebtedness (e.g., borrow money or issue bonds) if it would have “asset coverage” of at least 200 percent after giving effect to the issuance.112 In contrast, registered closed-end and open-end funds must have asset coverage of at least 300 percent on indebtedness, which allows for less leverage.113 Asset coverage for indebtedness is defined as follows:
where A is total assets, L is total liabilities (including debt), and D is aggregate debt.114 In other words, a BDC that raised $100 from equity investors could borrow $100, thereby increasing its total assets from $100 to $200 and producing an asset coverage ratio of 200 percent, or 2-to-1.115 A 200 percent asset coverage ratio enables a BDC to maintain a debt-to-equity ratio of 1-to-1 (assuming no other liabilities). In contrast to a BDC, a registered investment company that raised $100 from equity investors could borrow only $50, increasing its total assets from $100 to $150 and producing an asset coverage ratio of 300 percent, or 3-to-1. A 300 percent asset coverage ratio enables a registered fund to maintain a debt-to-equity ratio of 0.5-to-1 (assuming no other liabilities). Thus, the Act gives BDCs twice the leverage capacity it gives registered investment companies.
In 2018, Congress further reduced the asset coverage requirement for BDCs, enabling them to double their potential leverage.116 If it obtains certain approvals, a BDC may lower its asset coverage to 150 percent on its senior securities.117 The reduced requirement, for example, allows a BDC with $100 of equity to borrow $200 (instead of borrowing $100), increasing its total assets to $300 and producing an asset coverage ratio of 150 percent. The new 150 percent asset coverage requirement thus permits a BDC to have a debt-to-equity ratio of 2-to-1 (assuming no other liabilities). The regulatory change does not apply automatically. Rather, each BDC must elect to be subject to the reduced asset coverage requirement, meaning that 200 percent asset coverage is the default requirement for BDCs. To make the election, the BDC must obtain the approval of either its board of directors or its shareholders.118 This option has not been extended to other closed-end funds (or to open-end funds), which remain subject to the 300 percent requirement on debt that effectively limits their debt-to-equity ratio to 0.5-to-1. Hence, following the 2018 amendment, BDCs now have two to four times the leverage capacity of registered investment companies.119
The asset coverage requirement for a BDC (and any closed-end fund) is an incurrence requirement, not a maintenance requirement.120 A BDC, like any closed-end fund, must meet the asset coverage requirement only when it undertakes certain actions (issuing senior securities, paying dividends or other distributions, or repurchasing stock). The requirement is applied at the time the action is undertaken, and compliance generally does not have to be maintained thereafter. Once senior securities are issued, BDCs (and closed-end funds generally) must satisfy the asset coverage test only if they want to undertake one of the specified actions.121
In addition to the amount, BDCs are also less restricted than registered closed-end funds with respect to the classes of indebtedness they may issue. Registered closed-end funds may issue one class of debt only, while BDCs may issue multiple classes of debt.122
Overall, Congress granted BDCs substantially greater freedom with leverage than it granted registered investment companies. Greater flexibility in using leverage was intended to enhance a BDC’s ability to finance itself and, as a result, enhance its ability to invest in eligible companies.123 By allowing them to expand their capital base, relaxed asset coverage requirements would increase a BDC’s wherewithal to finance small growing businesses. In addition, it is possible that relaxed treatment of leverage would encourage, more indirectly, a BDC to invest in such businesses. Because the securities that a BDC purchases are fairly speculative and illiquid, the value of a BDC’s portfolio may fluctuate widely, particularly in its early years. A sudden downward valuation of the portfolio could cause a leveraged BDC to violate its asset coverage requirement, which would prohibit the BDC from issuing new senior securities, paying dividends to shareholders, etc., until the debt is paid down. The BDC would be incentivized to retain significant liquid assets, instead of investing them in small, private, or thinly traded public companies. Looser asset coverage requirements thereby encourage a BDC to make such investments.
Loose regulatory treatment of leverage, however, increases the risks associated with investing in BDCs. Prior work has found that borrowing by registered investment companies, within the legal limits of the Investment Company Act, is responsible for a significant increase in the volatility of their shares.124 Acknowledging the increased risk, Congress imposed disclosure requirements on BDCs that opt to reduce their asset coverage below 200 percent, and it imposed a repurchase obligation on those BDCs that are not traded.125 As an ongoing disclosure requirement, BDCs must annually provide shareholders with a statement that describes the risk factors involved in investing with the BDC, including those arising from its capital structure.126
Traditional investment companies are restricted in their ability to transact with affiliates in order to prevent self-dealing and overreaching by insiders. However, the venture capital industry claimed those restrictions imposed severe limitations on transactions typical in their industry, where deals often involve affiliates and are too time-sensitive to seek an SEC exemption.127 Accordingly, Congress adopted special affiliated transaction rules for BDCs in Section 57 of the Investment Company Act, which are somewhat less onerous than their counterparts in Section 17 for registered investment companies.128
Section 57 provides special procedures to facilitate certain beneficial dealings between BDCs and their affiliates. Sections 57(a) and (d) restrict transactions between a BDC and “upstream” affiliates by requiring that the BDC obtain prior approval before entering into the transaction. Sections 57(a) and (d) differ regarding to whom they are applied and how exemptions are obtained.
Section 57(a) is intended to prohibit transactions between a BDC and a controlling shareholder of the BDC or other person closely affiliated with the BDC (such as an officer, director, employee, or advisory board member).129 It is designed to regulate conflicts of interest that might arise in transactions with the BDC’s upstream affiliates who can control or influence the BDC. These transactions must be reviewed and approved by the SEC, a potentially lengthy process.130 In contrast, Section 57(d) regulates transactions involving the BDC’s upstream affiliates who are non-controlling shareholders of the BDC.131 These shareholders are considered affiliates of the BDC solely by virtue of holding between 5 and 25 percent (directly or indirectly) of the BDC’s voting securities.132 These transactions may be approved simply by vote of a “required majority”133 of the directors of the BDC.134 As a result, they can be entered into more quickly than those requiring SEC review. Director review substitutes for SEC review in 57(d) transactions because these affiliates are less closely related to the BDC and the potential for overreach and conflicts of interest is believed to be lower. Traditional registered investment companies that want to transact with such affiliates are required by Section 17 to pursue the lengthy SEC approval process.
In addition, BDCs are afforded more freedom to transact with “downstream” affiliates than registered investment companies are given. Unlike traditional investment companies, BDCs often take substantial and controlling interests in their portfolio companies. Also, BDCs may actively participate in the operations of these companies (for example, by having officers of the BDC sit on the boards of portfolio companies). Thus, while portfolio companies may constitute “affiliates” of the BDC, transactions between the BDC and its portfolio companies generally are not subject to Section 57’s limitations on affiliated transactions.135
There are benefits to allowing BDCs to transact with affiliates. For instance, many BDCs co-invest in portfolio companies alongside affiliates (subject to certain conditions).136 Co-investment enables a BDC to participate in loans originated by the BDC’s sponsor and rapidly build a loan portfolio. On the other hand, such arrangements invite potential conflicts.137
In contrast to registered open-end funds, which must value their assets daily, BDCs are permitted to value their assets quarterly, in connection with the issuance of their financial statements.138 BDCs are permitted to value assets quarterly because they invest primarily in illiquid securities of private companies, which are difficult to value daily.
Value is defined generally as the market value of securities for which market quotations are readily available.139 Absent a readily available market value, the board must determine in good faith the “fair value” of the asset.140 Because a BDC is required to have at least 70 percent of its investments in securities that are private or thinly traded, almost every calculation and disclosure by a BDC will be made at fair value. Thus, determination of fair value is significant for a BDC.
The fair value determination requires applying judgment to the facts and circumstances of each portfolio investment (as well as a consistent valuation process). Valuation, therefore, is time consuming, involving the BDC’s management and board of directors, and often auditors and valuation firms or pricing services.141 Each security and its value must be disclosed on a Schedule of Investments to the financial statements that are included in the BDC’s quarterly and annual reports filed with the SEC.142 Moreover, this discretion in valuing assets has brought BDCs some controversy in the past when valuations were questioned by investors or the SEC.143
Valuation has important implications for BDCs that wish to issue new shares of common stock. BDCs, like registered closed-end funds, are prohibited from issuing new stock at a price below its current net asset value (“NAV”) per share.144 Typically, shares of closed-end funds trade in the market at a price below NAV, which prevents them from raising capital through additional stock offerings (even if the new stock were sold at its current market price). However, BDCs are provided with an exception to the prohibition. A BDC may issue shares below NAV if it has the approval of the BDC’s board and its shareholders (so long as the share price closely approximates the market value).145
In addition to issuing securities below NAV, BDCs are also permitted to issue securities for the purpose of acquiring assets of another company. While registered closed-end companies are prohibited from issuing securities in exchange for anything other than cash,146 BDCs are exempt from that prohibition. BDCs may issue new securities to acquire assets of another company so long as, immediately after, the BDC controls the company.147
BDCs are generally exempt from the reporting requirements of the Investment Company Act. As a result, BDCs do not file Forms N-CSR, N-PORT, or N-CEN (or their predecessor, Form N-SAR), which registered closed-end funds are required to file.
Instead, BDCs are subject to the same reporting obligations of traditional public companies under the Exchange Act.148 As such, BDCs must file an annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all other forms such as proxy statements. Further, because all BDCs are required to have a class of securities registered under the Exchange Act, BDCs are subject to the requirements imposed on public companies pursuant to the Sarbanes-Oxley Act of 2002.149 BDCs are also required to make certain public disclosures of portfolio company information such as the value and cost of each portfolio company investment.150 In addition, if the BDC has its securities listed or traded on a national exchange, it must also comply with the corporate governance listing requirements of the exchange.151
Thus, BDCs must observe the Exchange Act in addition to complying with the Investment Company Act and the Advisers Act. BDCs must file the same periodic reports with the SEC as any public company. But BDCs are also subject to the additional regulatory constraints of the Investment Company Act and the Advisers Act, arguably making BDCs more regulated than typical operating companies.
Forming and operating a BDC requires important strategic decisions beyond the requirements of the Investment Company Act. These strategic decisions concern the BDC’s investor base, its management structure, and its investment objective.
BDCs can be either public or private. Public BDCs come in two varieties, traded and non-traded.
Traded BDCs. Most public BDCs issue shares that trade on a national securities exchange. The BDC lists its shares on an exchange through a firm commitment underwriting by investment banks, where the shares then trade. A publicly traded BDC provides shareholders with the liquidity of a publicly traded stock while investing in private companies. In this way, it resembles a publicly held private equity or venture capital fund.
The primary benefit for the BDC is that shares can be sold to anyone for whom the investment is suitable, not just to accredited investors or qualified purchasers. The BDC, thus, can obtain capital from a broader investor base, one that includes retail investors who would otherwise be prohibited from investing in a private fund.152 Correspondingly, the traded BDC allows retail investors to access a nontraditional asset class otherwise not available. Another benefit over a private fund is that a traded BDC has a permanent source of capital. The lifetime of such a BDC is potentially indefinite, as the BDC is not obligated to redeem its shares.153 Once it issues shares, it can invest the proceeds for the long term without needing to provide future liquidity to shareholders (who obtain liquidity by selling shares on the exchange). In contrast, a private fund typically has a finite life and must proceed into liquidation mode as it approaches the end of its life. Nevertheless, being publicly traded is expensive. There are costs associated with the IPO and ongoing compliance costs associated with satisfying listing requirements of the exchange.
Non-Traded BDCs. Some BDCs, while available to the public, choose not to list their shares on a national securities exchange. Non-traded BDCs offer their securities directly to the public pursuant to registered public offerings under the Securities Act of 1933 (the “Securities Act”), rather than through a firm commitment underwritten offering by investment banks. Securities are sold over an extended period through a network of broker-dealers and financial advisors, rather than through a one-time IPO. Non-traded shares are available only to investors who meet suitability standards of the state where they reside.154 In addition, the proposed sale must be approved in each state where solicitations occur. Securities of non-traded BDCs are not “covered securities” under the Securities Act and therefore are subject to state Blue Sky review, an expensive and time-consuming process.155 These offering and organizational expenses result in upfront fees that differ from sales loads of traded BDCs and can be high, ranging from 10 to 15 percent.156
While shares of traded BDCs are liquid, shares of non-traded BDCs have limited liquidity. Non-traded BDCs attempt to provide liquidity to investors by conducting periodic redemptions or repurchases of shares (based upon net asset value). BDCs typically offer to repurchase a portion of outstanding shares on a quarterly basis.157 In addition, investors in non-traded BDCs receive distributions on their shares as they would in a traded BDC. They may also receive capital appreciation in the event of a future liquidity event, either a sale of the BDC’s assets followed by its liquidation, a merger (in which shareholders receive cash or shares of a publicly traded company), or a listing of its shares on a national securities exchange.158 The non-traded model has also been used by real estate investment trusts.159
Despite the difference in liquidity, non-traded BDCs offer advantages over traded BDCs, for both the BDC and its investors. Shares of traded BDCs may sell in the market at a premium or discount to net asset value (“NAV”). By not being traded on an exchange, non-traded shares are not subject to market volatility, which might appeal to income-oriented investors who seek stable distributions without fluctuations in the market value of the shares.160 Moreover, a shareholder that needs to sell shares in the market to raise cash could lose significant value with traded shares, whereas the price at which non-traded shares are redeemed or repurchased by the BDC might provide more predictability to the shareholder.161 With respect to the BDC, a non-traded structure enables it to raise capital when traded BDCs cannot. Because a BDC (like a registered closed-end fund) cannot issue shares at a price below NAV, a challenging stock market environment might hinder the traded BDC’s ability to raise capital.162 Without traded shares, non-listed BDCs could potentially raise capital even when capital markets are effectively closed for listed BDCs. Raising capital during tough market environments might lead to better returns (e.g., by buying loans at discounted prices).
Private BDCs. Private BDCs offer securities pursuant to private placements that are exempt from registration under the Securities Act.163 To form a private BDC, a private placement memorandum and subscription agreement are prepared, and shares are sold to investors. The investors in a private BDC must be accredited investors; hence, they are marketed to institutional investors and high-net worth individuals. As a result, private BDCs are typically sponsored by large private equity firms with sizeable existing investor bases.164 Pursuant to the subscription agreement, the private BDC receives capital commitments from its investors. The BDC is funded by drawing down on the commitments through a series of capital calls.
Unlike traded BDCs, which provide liquidity in the secondary market, and non-traded BDCs, which typically provide liquidity via periodic repurchase offers, private BDCs generally do not provide liquidity to shareholders.165 Instead, a liquidity event will have to occur, typically a liquidation, merger, or exchange listing of the BDC. As a result, private BDCs do not provide investors with liquidity until such an event.
Private BDCs have advantages over public BDCs. With no trading market for private BDC shares, there is no concern that shares will trade at a discount to NAV and prevent the BDC from raising additional capital. That structure helps minimize the need to hold cash (which acts as a drag on performance), while the BDC identifies appropriate securities to purchase.166 Also, while public BDCs are required to hold annual shareholder meetings, there is no exchange or federal securities law requirement for a private BDC to do so, allowing it to avoid the associated expenses. Finally, private BDCs generally charge lower fees than public BDCs.167
BDCs can be managed externally or internally. BDCs can be structured with external management, like a traditional investment company, or with internal management, like an operating company. Compensation varies accordingly.
Internal Versus External Management. An externally managed BDC typically has no employees, but rather hires an investment adviser (a separate legal entity) to manage the BDC under the direction of the BDC’s board of directors.168 Pursuant to an investment advisory agreement, the adviser manages the BDC’s operations and investments in return for advisory fees from the BDC. In contrast, an internally managed BDC has no external investment adviser, but rather hires employees to manage the BDC under the direction of the BDC’s board. As a result, an internally managed BDC does not pay advisory fees, but instead pays the operating costs associated with employing its personnel.
Compensation for Externally Managed BDCs. The investment adviser to an externally managed BDC is permitted to charge a management fee based on assets under management, as can advisers to traditional investment companies.169 The management fee is typically assessed against the BDC’s gross assets.170
In addition, the adviser to an externally managed BDC is permitted to charge incentive fees (also referred to as performance fees) similar to those charged in the venture capital and private equity industries. Although the Advisers Act prohibits investment advisers from charging compensation based on the investment company’s performance,171 that prohibition was changed by the 1980 Amendments with respect to BDCs.172 To encourage venture capital and private equity managers to form BDCs, Congress carved BDCs out of the Advisers Act’s prohibition on incentive fees based on capital gains.173
There are conditions, however, to charging incentive fees on capital gains. First, the fee must not exceed 20 percent of a BDC’s realized capital gains over a period of time.174 Second, the BDC must not also offer an equity-based compensation arrangement or profit-sharing plan.175 The condition prevents a BDC manager from receiving performance-based fees when it has already being provided with incentive compensation.176
In addition to an incentive fee based on capital gains, external BDC managers may charge a second incentive fee, one based on income. The Advisers Act contains no prohibition on charging an incentive fee based on income.177 The income-based incentive fee is typically equal to 20 percent of net investment income (interest income, dividend income, and any other income, netted against operating expenses) over a period of time.178 The fee is often structured so that the BDC must first clear a “hurdle rate” before the fee is charged.179
Advisers to most BDCs charge both kinds of incentive fees.180 Recently, BDC advisers have begun charging a single “unified” incentive fee based on profits regardless of source, whether income or capital gains.181 This unified fee structure is more in line with the private equity model.182
Compensation for Internally Managed BDCs. Since it has no investment adviser, an internally managed BDC does not pay advisory fees but rather pays operating costs from employing investment management personnel. In addition to salaries and bonuses, internally managed BDCs are permitted to offer certain performance-based compensation to its managers. In passing the 1980 Amendments, Congress recognized that performance-based compensation was common practice in the business development world.183 Hence, unlike closed-end investment companies,184 internally managed BDCs may rely on stock option plans or profit-sharing arrangements (but not both) to incentivize their managers.185
BDCs may issue stock options (and warrants and rights) to its officers, employees, and directors as part of an executive compensation plan.186 Any issuance must be authorized by the BDC’s board of directors and its shareholders.187 BDCs are capped in the aggregate amount of such issuances.188 Internally managed BDCs that do not offer stock options as compensation are permitted to offer profit-sharing plans for officers, employees, and directors.189 The profit sharing plan must be authorized by the BDC’s board of directors.190 The aggregate amount of profits distributed under such a plan is capped at 20 percent of the BDC’s net after-tax income in any fiscal year.191
Evolution from Internally to Externally Managed BDCs. In its first two decades, BDCs were primarily managed internally. That began to change in 2003 with the successful IPO of an externally managed BDC, Technology Investment Capital Corporation (“TICC”).192 TICC compensated its external adviser using an incentive fee structured in a manner the industry had not seen before. TICC’s adviser was one of only a handful of advisers at the time to receive an incentive fee on capital gains and the first to receive an incentive fee on income.193 TICC’s IPO highlighted the fact that BDCs could legally charge two incentive fees, one on capital gains and one on income, which changed the financial markets’ perception of externally managed BDCs.194 In 2004, another externally managed BDC, Apollo Investment Corporation, was launched with a similar fee structure.195 A string of IPOs of externally managed BDCs then followed, with incentive fees designed after the TICC and Apollo model.196 Moreover, sponsors of these BDCs were leading fund managers (a “who’s who of Wall Street”),197 which attracted the attention of the financial press. Not all stories were positive.198 Nonetheless, it is generally believed that, since 2004, the industry has evolved from one initially dominated by internally managed BDCs to one dominated by externally managed BDCs.
A BDC might emphasize income investments, equity investments, or a flexible investment strategy that makes it difficult to classify the BDC.199 Income-focused BDCs seek high current income primarily by making loans to later-stage companies with more established operations and significant cash flows.200 Equity-focused BDCs seek high returns by investing in early-stage companies, primarily through equity investments (resembling pure venture capital companies).201
Historically, BDCs have been income-focused.202 They structure their investment portfolios to produce consistent interest or dividend income to the BDC, which enables the BDC to pay regular dividends to its shareholders. In the recent era of low interest rates, the dividend yields of these BDCs have helped them appeal to a segment of the market seeking income.203 In contrast, equity-focused BDCs are long-term growth plays with little or no dividends in their early stages. Pursuing capital gains, equity BDCs typically have no income stream until a portfolio company has an exit event (e.g., an IPO or acquisition). As an added drawback, the investment portfolios of equity BDCs are challenging for investors to evaluate, since portfolio companies are typically pursuing specialized technologies that require scientific expertise to understand.204
A BDC is a corporation for U.S. federal income tax purposes, but may elect to be taxed as a regulated investment company under Subchapter M of the Internal Revenue Code and thus avoid taxation at the company level on income and capital gains distributed to shareholders. The BDC must then comply with requirements imposed on regulated investment companies including, among other things, distributing at least 90 percent of its taxable income to shareholders every year. Most BDCs elect regulated investment company status.205
There have been no studies of BDCs to date from an empirical perspective. Yet there is much to be learned by examining data on BDCs, particularly now that they have a decades-long track record. This part performs an empirical examination of BDCs using a unique dataset derived from hand-collected information from BDC filings.
Conducting empirical work on BDCs is challenging because traditional electronic databases do not identify whether an entity is a BDC. Hence, I collect that information manually. Since a BDC must “elect” to be treated as a BDC, I identify all companies that have made that election by filing with the SEC a notification of election on Form N-54A.
Form N-54A filings are available electronically from the SEC since 1996. To identify BDCs that filed before 1996, I supplement my list by reviewing all electronic filings on Edgar that reference a company’s BDC status, and determine the date of its initial filing as a BDC, if prior to 1996. The number of BDCs in my dataset is similar to the number reported by Congress for the year 1995 (52 and 60 BDCs, respectively).206 In the empirical analysis that follows, I focus on the post-1996 period in order to minimize the effect of any potential omissions relating to those early years.
In addition, I identify all BDCs that have been terminated. Most terminations consist of BDCs that voluntarily withdraw their BDC election by filing with the SEC a notification of withdrawal on Form N-54C. Form N-54C filings are available electronically from the SEC since 1996, and I supplement that list by searching Edgar for references to earlier filings (as noted above). However, a BDC can be terminated in other ways besides a voluntary withdrawal of its election. A BDC could be terminated by withdrawal of its Exchange Act registration or by revocation, termination, or suspension. Examination of N-54C filings alone, therefore, would understate BDC terminations (e.g., some BDCs might not bother to file Form N-54C after they decide to cease operating).207 Thus, I include BDCs terminated in these other ways.
Results appear in Table 2. Column 1 displays the number of BDCs formed each year. There are BDCs being formed every year over the 1997 to 2017 period. The year with the most formations was 2004, when forty-six BDCs were created. It was around that time that TICC and Apollo launched successful IPOs of their BDCs, attracting attention to the industry. Before then, annual BDC formation averaged in the single digits. In the very early years (1980 to 1996), formation was even lower, averaging three per year. After picking up in the mid-2000s, BDC formation slowed in 2006 and remained subdued through the Great Recession. Since 2010, an average of twelve BDCs have been formed per year.
In addition to BDC formations, Table 2 also displays the number of BDCs that were terminated each year (column 2). In any given year, there is a positive number of terminations. The difference between formations and terminations (net formations) captures changes in the BDC population (column 3), which is generally cyclical.208 In 2017, the last available year of the dataset, the population of BDCs contracted for the first time since 2009.
Column 4 of Table 2 shows the number of BDCs in existence each year, which is the number of BDCs existing in the prior year plus net formations. In the most recent year of the dataset, 2017, there were ninety-nine BDCs in existence. The population of BDCs has nearly doubled since the late 1990s. Some of these BDCs are publicly traded, also shown in column 4. The number of publicly traded BDCs has increased steadily over time from seventeen in 1997 to fifty-three in 2017.
|(1) Formations||(2) Terminations||(3) Net Formations||(4) In Existence|
This table indicates the number of BDCs formed during the year (column 1), the number of BDCs terminated during the year (column 2), the net change in the number of BDCs during the year (net formations, equal to formations minus terminations) (column 3), and the number of BDCs in existence during the year (equal to the number of BDCs in the prior year plus net formations during the year) (column 4, for all BDCs and for publicly traded BDCs).
The population of BDCs from 1997 to 2017 is shown graphically in Figure 1. The overall number of BDCs spiked in 2004 and 2005 (following the IPOs of TICC and Apollo). The population began to shrink in 2006 and continued to contract through the end of the Great Recession. Steady, modest growth in BDCs resumed after 2010, as banks reduced middle-market lending209 and interest rates fell globally, likely encouraging investors to seek higher yielding products such as BDCs.210 More recently, the population has plateaued slightly above its mid-2000s peak of ninety-three. The number of publicly traded BDCs has similarly plateaued in recent years. It appears the JOBS Act of 2012 has not significantly boosted the population of publicly traded BDCs.
To assess the BDC program, it is useful to look at cumulative numbers since the program’s beginning in 1980. Table 3 indicates the total number of BDCs formed since 1980. A total of 311 BDCs have been created since the program commenced. Of these BDCs, ninety-one have been publicly traded. Further, Table 3 reveals that most BDCs have been terminated. There have been 212 terminations overall, amounting to over 68 percent of all BDCs. Among the ninety-one publicly traded BDCs, thirty-three have been terminated, amounting to 36 percent. Hence, 81 percent of non-traded BDCs have been terminated (179 out of 220).
In other words, of the 311 BDCs created since 1980, only 99 remained in existence by the end of 2017. That number of BDCs seems small given the attention BDCs have received from Congress and all of the advantages it has bestowed upon BDCs. It appears the BDC program has struggled to get off the ground.
However, for a BDC, termination does not necessarily mean failure. To the contrary, BDCs (of the non-traded variety) need to provide an exit for their investors, such as by liquidating or merging the BDC out of existence. To evaluate BDCs, one must examine the reason for the termination. And the reason is observable: a BDC must disclose a reason on its SEC filing (N-54C) when it opts to withdraw its BDC status.
Table 4 on page 96 shows the reasons BDCs terminate. The most common reason is the BDC has changed the nature of its business so as to cease to be a BDC. A total of seventy-two BDCs withdrew for this reason. In essence, these BDCs changed the nature of their business because they did not want to continue operating under the restrictions of the Investment Company Act.211 The regulations were considered too burdensome.
The second most common reason BDCs terminate their status is liquidation of the BDC. The third most common reason is the BDC is selling itself to, or merging with, another company. These two reasons constitute liquidity events for BDC investors and can indicate success for non-traded BDCs.212 Together, sixty-three BDCs terminated for one of these two reasons. However, that combined figure still trails the seventy-two BDCs that decided to change the nature of their business and cease to be a BDC. The primary reason BDCs withdraw seems to have more to do with burdensome regulation than with a successful exit event.
The fourth reason BDCs withdraw is that the BDC has fewer than one hundred investors. Such a BDC is exempt from the Investment Company Act and need not maintain a BDC election. Finally, fifteen BDCs declared “other” as the reason for withdrawal. The vast majority of these filings, however, cite compliance concerns. These BDCs elaborate in their filings that compliance is too expensive213 or too burdensome on their operations.214 Hence, the number of BDCs withdrawing due to compliance burdens is actually greater than the seventy-two that selected “changed the nature of the business” as the reason. Regulatory compliance is a primary reason BDCs withdraw.
|Number of N-54C filings|
|Never made (and does not propose to make) a public offering and does not have more than 100 security holders||21||0|
|Liquidating (not as part of a merger)||40||3|
|Merged with, or sold all assets to, another company||23||9|
|Changed the nature of its business so as to cease to be a BDC||72||19|
|Becoming a “registered” investment company||0||0|
This table shows the reason for withdrawal of BDC status listed on N-54C forms filed from 1997 to 2017, for all BDCs and for publicly traded BDCs.
Of the publicly traded BDCs, relatively few withdrew their status over the period. Only thrity-three of the ninety-one traded BDCs decided to withdraw. The most common reason for withdrawal by traded BDCs is change in the nature of the business, just as for non-traded BDCs. Next most common is merger or sale of the BDC. Finally, only three traded BDCs have liquidated, which makes sense intuitively—traded BDCs have permanent capital and an indefinite life, so they have no need to provide a liquidity event to investors. Rather, liquidation likely indicates the BDC failed.
To analyze further, I merged my BDC dataset with additional data obtained from three separate sources. First is financial statement data from Compustat. Second is stock data from CRSP. Third is information about each BDC that I collected by hand from public SEC filings that is not available in either electronic database (such as management fees and management structure). The resulting dataset contains BDC-level information on each individual BDC over more than two decades. However, by necessity, the dataset is limited to publicly traded BDCs.215
I obtain data from 1997 to 2017. The resulting panel spans twenty-one years and contains 705 individual BDC-year observations. Because the BDC industry expanded following the financial crisis, I also look separately at the 2010 to 2017 period. There are 396 BDC-year observations in this shorter panel.
My dataset has the distinct advantage of being free of survivorship bias. The dataset includes all publicly traded BDCs, including the histories of BDCs that have not continued to trade. Incorporating BDCs that have disappeared over time produces a survivorship-bias-free analysis. As a result, the dataset is superior to proprietary datasets that have emerged in recent years, as they go back only a few years in time or provide only a cross section of the market.
Table 5 on page 98 shows assets under management in the BDC industry. Industry assets are computed by aggregating the assets of each individual BDC. Since BDC assets are obtained from Compustat, the table displays assets for the publicly traded portion of the BDC industry. In the most recent year, 2017, the industry had nearly $64 billion under management. By comparison, the closed-end fund industry had $275 billion under management in 2017.216 But the BDC industry has grown substantially since 1997, when it had only $1 billion under management. The closed-end industry, which had $157 billion under management in 1997, has not grown at nearly the same rate.217
Figure 2 displays industry assets under management in graphical format. The figure shows two waves of growth, one after 2004 and a second after 2010. The trends are similar to those seen in Figure 1 with respect to the number of BDCs. In fact, we observe a plateau in assets under management beginning around 2014, similar to the plateau we observed with the number of BDCs. Before plateauing, the industry had grown substantially in asset size, doubling from its prior peak in 2007.
This table shows aggregate assets under management (in $ millions) by publicly traded BDCs, per year.
This subsection examines characteristics of traded BDCs. I examine a panel of BDCs from 1997 to 2017 and a panel focused on the post-financial-crisis period from 2010 to 2017. In the panels, BDC-year observations are pooled together.
Table 6 on page 100 shows statistics regarding the size of BDCs. In the 1997 to 2017 period, the average BDC managed $951 million in total assets. The median BDC was smaller, managing $405 million in total assets, indicating some large BDCs that skew the averages. In the 2010 to 2017 period, the pattern is similar. The average BDC managed just over $1 billion in total assets, while the median BDC managed $462 million in total assets. Compared to a typical closed-end fund, the average BDC is rather large. The average closed-end fund managed $485 million in total assets, about half the size of the average BDC.218
In addition to total assets, Table 6 also displays net assets. Whereas total assets includes assets derived from borrowing, net assets measures assets net of liabilities. BDCs are much smaller when their size is measured in terms of net assets. The difference suggests BDCs bulk up by incurring significant leverage.
Table 7 on page 100 shows statistics on BDC leverage, using the regulatory measure of leverage, the asset coverage ratio. The average BDC had an asset coverage ratio on debt of 428 percent in the 1997 to 2017 period and 389 percent in the 2010 to 2017 period. The decline in asset coverage indicates that the average BDC was taking on greater leverage in the more recent years than before. The median BDC, however, had a consistent asset coverage ratio of 257 percent in both periods (comparable to a debt-to-equity ratio of 0.64 to 1, assuming no other liabilities). The asset coverage ratio for the median BDC is much lower than that for the median registered closed-end fund, estimated in prior work to be 421 percent over a similar period of time.219 Overall, these results indicate that BDCs assume a high degree of leverage.
|(a) Total Assets|
|1997 to 2017||951||405||12,347||1|
|2010 to 2017||1,047||462||12,347||1|
|(b) Net Assets|
|1997 to 2017||560||241||7,098||−4|
|2010 to 2017||629||269||7,098||−4|
Total Assets is total assets (in $ millions). Net Assets is total net assets, computed as total assets minus total liabilities (in $ millions). This table shows summary statistics for BDC-year observations in the 1997 to 2017 period and the 2010 to 2017 period.
While BDCs use substantial leverage, they do not completely exhaust their leverage capacity. Over the period studied, BDCs were permitted to have asset coverage ratios as low as 200 percent.220 While BDCs approach their asset coverage limits, they maintain some spare capacity to take on more leverage. Maintaining a buffer around the asset coverage requirement helps ensure that the BDC will be able to incur additional leverage opportunistically and will be able to make dividend distributions to shareholders.221
|1997 to 2017||428||257||9,813||129|
|2010 to 2017||389||257||9,813||129|
Asset Coverage Ratio is the asset coverage ratio (in percent), computed as total assets minus total liabilities plus long-term debt plus liquidation preference on preferred stock, all divided by long-term debt. This table shows summary statistics for BDC-year observations in the 1997 to 2017 period and the 2010 to 2017 period.
|Senior Securities Issued||1997 to 2017||2010 to 2017|
This table shows the percentage of publicly traded BDCs that report outstanding debt, outstanding preferred stock, or neither senior security. The table displays figures for BDC-year observations in the 1997 to 2017 period and the 2010 to 2017 period.
BDCs can leverage themselves by issuing either debt or preferred stock. Which senior security is more popular?
According to Table 8, BDCs exhibit a clear preference for debt over preferred stock. In the 1997 to 2017 period, 79 percent of BDCs had debt outstanding, while only 21 percent of BDCs had preferred stock outstanding.222 This preference for debt over preferred stock has also been observed in registered closed-end funds.223 BDCs exhibited an even greater preference for debt over preferred stock in the 2010 to 2017 period. About 83 percent of BDCs used debt while only 6 percent used preferred stock. Finally, Table 8 indicates that BDCs are highly likely to use leverage. The vast majority of BDCs employ leverage in some form. More than four out of five BDCs (81 percent) employed leverage during the 1997 to 2017 period. During the 2010 to 2017 period, BDCs were even more likely to employ leverage, with 4.25 out of five BDCs (85 percent) choosing to do so.
Next, Table 9 on page 102 displays management fees. BDCs charge steep management fees. The average BDC charged an annual management fee of 1.83 percent of total assets. The median management fee was about the same, at 1.80 percent of total assets. In the 2010 to 2017 period, management fees were somewhat lower, at 1.75 percent for the mean and median BDC, but they remained high. These fees do not include incentive fees that may be earned by the investment adviser in addition to the management fee.224 I find that nearly every externally managed BDC offered incentive fees for the adviser.
With high management fees plus the potential to earn incentive fees, external management is assumed to have great appeal for BDC sponsors. That assumption is supported by the data. Figure 3 on page 103 shows the percentage of BDCs managed internally and externally, by year.
The figure corroborates the common perception that external management gained popularity following the IPOs of TICC and Apollo in 2003 and 2004, which promoted the incentive fee structure for external managers. Before 2003, only a quarter of all BDCs were managed externally. Following the IPOs of TICC and Apollo, we observe a spike in external management, surging from one-quarter of all BDCs in 2003 to about one-half of them by 2007. The figure also reveals that another spike in external management occurred in the aftermath of the financial crisis. Externally managed BDCs jumped from about one-half of all BDCs in 2009 to three-quarters of them by 2012. Since then, external management has continued to gain in popularity, reaching 80 percent of BDCs by 2017. Once a small fraction of the industry, externally managed BDCs now dominate.
Traded BDCs are marketed as income vehicles.225 Accordingly, Table 10 presents statistics on dividend yield. Dividend yield is computed for each BDC at year end, using aggregate dividends paid over the year divided by its year-end stock price. The yield displayed in the table includes both cash and non-cash distributions. The average yield for a BDC over the 1997 to 2017 period was 9.91 percent per annum. To give a sense of relative performance, I computed the yield on below-investment-grade (i.e., high-yield) U.S. corporate bonds over the same period. High-yield bonds yielded 9.28 percent per annum, on average. Therefore, the average BDC yielded slightly more than high-yield bonds (63 basis points more). But the median BDC had a yield of only 9.10 percent, slightly below that of high-yield bonds (18 basis points less).226
In the post-financial crisis period, BDCs yielded more than high-yield bonds. From 2010 to 2017, the yield on the average BDC was 10.15 percent and the median BDC was 9.63 percent. In contrast, high-yield bonds generated an average yield of 7.21 percent over the period. Hence, BDCs have out-yielded high-yield bonds since 2010. In the low interest rate environment of the post financial crisis period, BDCs have earned their reputation as yield plays.227
While dividend yield is important, so too is return on the principal amount invested. Therefore, in addition to yields, I also examine total returns. Total returns combine stock price appreciation with reinvestment of dividends paid. For each BDC, an annual total return is computed for each calendar year using its monthly total returns.228
|1997 to 2017||9.91||9.10||220||0|
|2010 to 2017||10.15||9.63||220||0|
Yield is the dividend yield (in percent), computed at year end as aggregate dividends paid over the year divided by year-end stock price. This table shows summary statistics for BDC-year observations in the 1997 to 2017 period and the 2010 to 2017 period.
To judge relative performance, I benchmark BDCs against two proxies for private loans, a high-yield bond index and leveraged loan index. For the high-yield bond index, I use the Bloomberg Barclays U.S. corporate high-yield index, which represents the total returns for publicly traded non-investment grade corporate bonds of U.S. companies. For the leveraged loan index, I use the S&P/LSTA leveraged loan index, which represents total returns for traded syndicated non-investment grade loans. Although they are primarily yield instruments,229 a BDC might invest in equity securities in addition to or instead of debt securities.230 Hence, I tried a third index, one focusing on equity securities of microcap companies. The results, however, were generally similar to those using the two debt indices.
Results appear in Table 11. We see some evidence that BDCs outperform. In the 1997 to 2010 period, the average BDC produced total returns of just over 11 percent per year. In comparison, the average total return was about 8 percent per year for the high-yield bond index and under 6 percent for the leveraged loan index. The average BDC outperformed each benchmark, beating leveraged loans by more than 5 percentage points per year and high-yield bonds by nearly 3 percentage points per year. However, the outperformance was statistically significant only with respect to leveraged loans. Moreover, the median BDC underperformed each benchmark.
In the more recent period, from 2010 to 2017, the average total return for BDCs declined by nearly 2 percentage points, to 9.25 percent per year. Relative to the benchmarks, the pattern is similar. The average BDC continued to significantly outperform leveraged loans. Relative to high-yield bonds, the average BDC did not outperform to a statistically significant degree, and the median BDC underperformed. In short, BDCs exhibit mixed performance relative to the benchmarks.
BDCs, however, might outperform simply by incurring greater risk than the benchmark. That is, higher total returns of BDCs might simply reflect a premium for higher risk taking. Hence, I next study risk, by examining the volatility of total returns. For each BDC, volatility is computed as the standard deviation of its monthly total returns in the calendar year. Volatility is computed similarly for each benchmark index. Results appear in Table 12 on page 106.
In the 1997 to 2017 period, total returns of BDCs exhibited significantly greater volatility than those of each benchmark. Volatility for the average and median BDC exceeded 8 percent and 6 percent, respectively, compared to about 2 percent for high-yield bonds and 1 percent leveraged loans. The differences are statistically significant. BDCs incurred substantially greater volatility than each benchmark. In the 2010 to 2017 period, volatility declined somewhat for the average and median BDC, but it remained significantly higher than the benchmarks. Thus, a BDC is a riskier investment than a basket of high-yield bonds or leveraged loans.
|1997 to 2017||2010 to 2017|
|High Yield Index||8.08||8.25|
|Leveraged Loan Index||5.79||5.22|
I separately gathered information on BDC performance during the March, 2020 market crash related to the coronavirus crisis. I find that shares of publicly traded BDCs declined by 42 percent on average, versus declines of 12 percent for the leveraged loan index and 12 percent for the high-yield bond index. Investors seeking steady income from BDCs had their investments decline nearly four times as much as the indices. Although not part of my main dataset, the dramatic drawdown in BDC shares during the coronavirus crisis is consistent with the pattern of excessive riskiness documented over the twenty-one-year sample period.
The high volatility of BDCs is consistent with their heavy use of leverage. BDCs are permitted to be highly leveraged and nearly all BDCs employ leverage (Table 8). I find that BDCs with a high degree of leverage have greater volatility than BDCs with little leverage (sorting into quintiles on the basis of asset coverage). BDCs with little leverage, nonetheless, have greater volatility than the benchmarks, indicating some of the riskiness of BDCs is due to their investment portfolios, which are concentrated in private or very small public companies.231
|1997 to 2017||2010 to 2017|
|High Yield Index||2.06||1.61|
|Leveraged Loan Index||0.95||0.83|
Because BDCs are riskier than the benchmarks, I next examine BDC performance on a risk-adjusted basis. While we observed evidence that BDCs outperformed at least one benchmark on a total return basis, do BDCs continue to outperform after we take into account their greater risk? Are investors in BDCs appropriately compensated for the additional risk they incur when investing in a BDC?
Here, I examine BDC performance after adjusting for the risk taking of the BDC. To compute risk-adjusted returns, I use a market model (CAPM) and regress BDC monthly returns (in excess of the risk-free rate) on monthly returns of a market proxy (in excess of the risk-free rate). For the market proxy, I use each benchmark, the high-yield bond index and the leveraged loan index, alternatively. The intercept in the model shows the over- or under-performance of BDCs relative to the market index. Risk-adjusted returns (i.e., “abnormal” returns or “alphas”) are calculated separately for each fund in each year using the following model:
where Ri,t is the one-month return of BDC i in month t, Rf,t is the risk-free rate (one-month treasury bill rate) in month t, RMKT,t is the one-month return on the market index in month t, and αi is the risk-adjusted monthly return of BDC i.232 Estimates are obtained using monthly returns over the calendar year for each BDC i.233
|1997 to 2017||2010 to 2017|
|High Yield Index||Leveraged Loan Index||High Yield Index||Leveraged Loan Index|
The average monthly risk-adjusted return appears in Table 13 for each time period. Over the 1997 to 2017 period, BDCs generated negative risk-adjusted returns on average. BDCs underperformed the high-yield bond index by twenty-seven basis points per month, although the underperformance was not statistically significant. BDCs underperformed the leveraged loan index by thirty-three basis points per month, and the underperformance was statistically significant (at the 10 percent level). On an annualized basis, BDCs underperformed leveraged loans by 403 basis points, or 4.03 percentage points, after adjusting for risk. The underperformance is sizeable economically, and sizeable statistically with respect to leveraged loans.
In the more recent period from 2010 to 2017, BDCs continued to underperform on a risk-adjusted basis. In fact, the value destruction increases in economic magnitude and statistical significance. BDCs underperformed high-yield bonds by thirty-six basis points, and leveraged loans by fifty-one basis points, per month on average. The underperformance is statistically significant (at the 1 percent level) in both cases. Moreover, the underperformance is economically substantial. On an annualized basis, BDCs underperformed by 441 to 630 basis points, or 4.41 to 6.30 percentage points. Hence, the value destruction by BDCs has become more pronounced in the post-2009 period. Once we accommodate for their greater risk, we find that BDCs significantly underperform.
Additionally, very few individual BDCs were able to generate significant positive risk-adjusted returns at any point. Over the twenty-one-year period, fewer than 4 percent of observations showed significant outperformance. Over the period studied, an investor that invested randomly with a BDC for a year had a less-than 4 percent chance of picking a winning investment. The odds of picking a losing investment were far greater (more than twice as likely). Also, no BDC that was successful in one year was able to outperform in any other year.
To encourage financing of small and growing businesses, Congress passed legislation in 1980 providing for the creation of business development companies, or BDCs. The financing of smaller businesses has attracted Congress’ attention because of the potential these enterprises have to create jobs and promote economic growth. In designing the regulatory framework, Congress blessed BDCs with advantages over other regulated investment companies so that they would increase the flow of capital to businesses that have traditionally struggled to obtain financing. BDCs have become an important component of the financial system. BDCs today manage more than $64 billion in assets and the average BDC is more than twice as large as the average closed-end fund.
Yet Congress has demonstrated consistent dissatisfaction with the BDC program since its inception in 1980, believing there are too few BDCs supplying too little financing to small, growing businesses. To encourage BDC formation, Congress has further loosened the regulatory framework over time, most recently in 2018 to permit BDCs to incur greater leverage. BDCs in many respects now resemble the investment companies Congress outlawed in 1940 when it passed the Investment Company Act—highly leveraged closed-end funds that hold illiquid or thinly traded securities and that engage in related-party transactions.
Although Congress has been concerned about protecting the interests of investors in BDCs, it has not examined how the public has fared when investing their money in a BDC. I compile a unique dataset of BDCs over multiple decades and perform such an empirical analysis. I find that BDCs live up to their reputation for high dividend yields. However, I find that investors in publicly traded BDCs would have been better off putting their money in an index fund tracking high-yield bonds or leveraged loans. While the total returns (stock returns plus dividends) of BDCs appear to match or beat the benchmark indices, BDCs incur substantially greater risk. BDCs are permitted to be highly leveraged, nearly all BDCs employ leverage, and their performance is highly volatile. I find that, on a risk-adjusted basis, BDCs significantly underperform the benchmarks, trailing by more than 4 to 6 percentage points per year. BDCs destroy significant value for investors once one accounts for their riskiness. In other words, BDCs do not appropriately compensate investors for the additional risk that investing in a BDC entails. In a desire to spur job creation, Congress has been promoting an investment vehicle that may not be worthwhile for the investing public.