The White Law Group represents investors in FINRA arbitration claims against brokerage firms. In that capacity, the firm has handled a number of cases involving business development companies (or BDCs). The following is some of the firm’s observations on the good, the bad, and the UGLY involving these high-risk, illiquid investments.
What is a BDC?
A Business Development Company (“BDC”) is a form of investment company that invests in small and mid-sized businesses. Investors can buy shares in a BDC, and the money from their investment are used to fund the businesses. In turn, investors can profit from dividends paid on their investments, or, in some cases, the sale of their shares.
BDCs were created in 1980 after Congress approved a series of amendments to the Investment Act of 1940. Section 2(a)(48) of the 1940 Act defines a BDC as (A) closed-end company that is organized under the laws of, and has its principal place of business in, any State or States; (B) is operated for the purpose of making investments in securities specified within Section 55(a) of the 1940 Act and, makes available “significant managerial assistance” with regards to the issues of such securities, and (2) has elected business development company status.
In order to comply with BDC regulations, a BDC must also maintain at least 70% of its investments in eligible assets before investing in non-eligible assets. The creation of BDCs was meant to attract investments in smaller companies that couldn’t attract traditional forms of capital. BDCs have become increasingly popular in recent years, in part due to their ability to create strong returns on investments. However, BDCs are not without their risks and pitfalls.
According to section 55(a) of the 1940 Act, a BDC must have at least 70% of its total assets in the following investments:
- Privately issues securities purchased from issuers that are eligible portfolio companies
- Securities of eligible portfolio companies that are controlled by a BDC and of which an affiliated person of the BDC is a director
- Private securities of companies subject to bankruptcy, insolvency, or a similar proceeding where they are unable to meet their financial obligations.
- Cash, cash items, government securities or high quality debt securities
- Office furniture and equipment, interests in real estate and leasehold improvements and facilities maintained to conduct the business of the BDC.
Qualities of a BDC
BDCs operate much in the same way as non-traded REITs (Real Estate Investment Trusts). BDCs pool investor money and use those funds as capital to investment in various businesses. The goal of a BDC is to investment in small and medium sized-businesses and help sustain and develop growth in those underlying businesses. When those businesses are profitable, the BDC can be a strong investment. Additionally, certain BDCs offer a desirable tax structure for investors.
A BDCs can be formed as a regulated investment company (RIC). As a result, the BDC must distribute at least 90% of their investment company taxable income to shareholders each year. To continue to be treated as a RIC for tax purposes, the BDC must also (1) continue to qualify as a BDC within the Investment Company Act of 1940; (2) derive at least 90% of their gross income from dividends, interest, payments on securities loans, gains from the sale of stock or other securities, or other income derived from their business; and (3) satisfy quarterly RIC diversification requirements by not investing more than 5% of their assets in any single security and no more than 10% of a given security’s total voting assets. Additionally, they must not invest more than 25% into businesses they control, or businesses within the same industry.
Benefits of a BDC
Business Development Companies may seem more attractive than other types of investment funds. First, BDCs provide investors with the same degree of liquidity as other publicly traded investments. Unlike open-ended investments, or mutual funds, investors can do more than only buy and sell shares directly to and from the fund itself.
Second, managers of BDCs have access to capital that isn’t subject to shareholder redemption or the requirement that capital be distributed to investors as investments are realized or otherwise generate income. Third, managers of BDCs may begin earning management fees immediately after the BDCs have gone public. Fourth, BDCs have flexibility that is not found in other types of registered investment funds.
BDCs use this flexibility to leverage and engage in affiliate transactions with portfolio companies. Along with these benefits, a BDC is similar to venture capital because they are required to offer significant managerial assistance to their portfolio companies, similar to a venture capitalist. Like a venture capitalist, a BDC assumes more risk and consequently gets to invest at a much lower valuation that would be available in the public markets. This means that BDCs are open to the average net worth investor, not only a high net-worth investor.
What are the risks?
These investments are not without risk, however. Within the BDC’s prospectuses are risk factors that investors should be wary of. One risk found when investing in a BDC is how relatively new these businesses are. Because these companies are newly formed, there are many uncertainties that come along with any new business, and these BDCs run the risk that the investment objectives will not be achieved, and as a result, the value of the stock could decline substantially.
Another risk that investors may encounter when dealing with these new investments is because the new companies have relatively few investments, the public offering may be deemed to be a “blind pool” offering. This means that there may be no stated investment goal for the funds raised from the investors.
Additionally, investors may not be able to evaluate any historical data or assess investments prior to the purchasing of any shares within a BDC. Companies that have been able to establish themselves within other investment areas still hold no guarantee that there will be any success when operating as a BDC. By way of example, a new BDC, Newtek, mentioned this risk in their investor prospectus.
“Although Newtek has operated since 1998, we have no operating history as a BDC. As a result, we can offer no assurance that we will achieve our investment objective and that the value of any investment in our Company will not decline substantially. As a BDC, we will be subject to the regulatory requirements of the SEC, in addition to the specific regulatory requirements applicable to BDCs under the 1940 Act and RICs under the Code. Our management has not had any prior experience operating under tis BDC regulatory framework, and we may incur substantial additional costs, and expend significant time or other resources, to do so. In addition, we may be unable to generate sufficient revenue form our operations to make or sustain distributions to our stockholders.”
These are not the only risks a BDC is subject to. Another BDC, Carey Credit Income Fund I, says, “We may invest in securities that are rated below investment grade (e.g., junk bonds) by rating agencies or that would be rated below investment grade if they were rated. Below investment grade securities, which are often referred to as “junk,” have predominantly speculative characteristics with respect to the issuer’s capacity to pay interest and repay principal. They may also be illiquid and difficult to value.” These private investments are not suitable for an investor who seeks liquidity as Carey Credit Income states, “An investment in our Shares is not suitable for you if you might need access to the money you invest in the foreseeable future.”
Junk Bond Exposure
BDCs also invest a large percentage in junk bonds, and some BDC’s such as the Corporate Capital Trust II may fluctuate heavily with the use of junk bonds. From the prospectus it appears that Corporate Capital Trust has a lot of junk bond exposure:
Standard & Poor’s rating Fair Value Percentage of Portfolio
BB- $503,326 13.0%
B+ $280,540 7.2%
B $516,757 13.4%
B- $1,326,361 34.2%
CCC+ $1,023,344 26.4%
CCC $200,000 5.2%
CCC- $24,274 0.6%
Total $3,874,602 100%
The use of these lowly graded junk bonds may have an adverse affect on an investor’s share, as the market volatility is highly affected by the concentration in mostly B- to CCC+ junk bonds, compared to investment grade bonds.
Interest Rates Play a Part
Additionally, interest rates can play a large role in the profitability of BDC investments. BDCs are most effective when interest rates are higher. This is because smaller companies seek out lenders who can offer them lower or more flexible rates when interest rates increase. Unfortunately for BDC investors, interest rates in the US remain at historic lows, and a growing bear market threatens the likelihood of any future rate increases. As a result, fewer companies seek out BDC lenders, and BDCs lose negotiating leverage, resulting in lower payouts for investors. When investments go wrong with BDCs, they can go very wrong.
Additional risks associated with a Business Development Company depends greatly on the structure and underlying investments of the BDC in question. The main distinction between the riskier and safer classes of BDCs is their liquidity. Many BDCs are set up much like closed-end investment funds and are public companies that are listed on the NYSE, Nasdaq, and other exchanges.
Some of these BDCs include, BlackRock Capital Investment, Rand Capital Corp., Crossroads Capital Inc., and Full Circle Capital Corp. These publically traded BDCs allow for a level of transparency and liquidity that makes them less risky investments than their privately-held counterparts. However, publicly traded BDCs are, like any investment product, not without risk. The value of a BDC depends entirely on the value and health of the underlying business investments.
For example, many BDCs invest in oil and gas ventures that are unable to secure bank loans. In the current market, these smaller oil and gas companies are at great risk for bankruptcy. The failure of just one of a BDCs’ underlying assets can mean significant losses for investors. Not only are risks within the market present, but high management fees are attached to the BDCs when purchased. A publicly traded BDC, Full Circle Capital (with a proposed merge into Great Elm Capital Corp.), exemplifies how many fees are added onto a BDC.
Basic Fees Associated with BDC Full Circle Capital
|Management Fee||1.5% of average gross assets, excluding cash|
|Income Incentive Fee||20% subject to a 7% hurdle, a full catch-up provision up to 8.75%, and 20% of returns thereafter|
|Capital Gains Incentive Fee||20% of cumulative realized capital gains, net of cumulative realized losses and unrealized capital depreciation, less prior Capital Gains Incentive Fee payments.|
|Total Return Test||Income Incentive Fee will be deferred unless GECC achieves a 7% total return on net assets on a rolling three-year basis.|
Along with these fees, financial advisors are paid by selling these products, which usually amounts to a 7-10% commission fee. When you add up all these fees it is difficult for the investments to be successful.
Non-traded BDCs are Risky
In addition to publically traded BDCs, there is also another class of BDCs that are not listed on exchanges. These BDCs often carry much higher yields and can be a tempting investment option, however they are generally a much riskier investment than indexed BDCs.
Non-traded BDCs include, Business Development Corporation of America, Carey Credit Income Fund, FS Energy and Power, and Sierra Income Corp. The first major component in the non-traded BDC’s risk profile is its lack of liquidity. Without an open market to trade on, owners of non-traded BDCs can be stuck holding their investments for years, sometimes without ever getting the opportunity to sell.
Additionally, the actual value of a BDC is not always clear or available. The SEC requires non-traded BDCs to be valued just once a quarter. Furthermore, this valuation is not a market-value, and thus not a reflection of what the BDC shares could be sold or redeemed for. Rather, the quarterly calculation is a “good-faith” valuation conducted by the BDCs board of directors and is based on the assets and overall financial well-being of the underlying companies.
Are non-traded BDCs suitable investments?
For these reasons, non-traded BDCs have not been deemed suitable for all investors. Suitability standards generally require an investor to have either a net worth of at least $250,000, or a net worth and an annual gross income of at least US $70,000. These standards are a minimum threshold, proper discussion of liquidity, risk, and diversification needs should be discussed with a financial adviser before investing. In order to qualify as a non-listed BDC there are requirements that need to be met.
What are the requirements?
- Must be sold to accredited investors only
- Must be reviewed by FINRA
- Must be approved to sell in each state where solicitations will occur, requiring compliance with the National Association of State Securities Administrators.
- Continuous offering over a period of time
- There must be a liquidity event usually within five to seven years of the initial offering.
Performance of these non-traded BDCs has been slipping as of late. Investors pulled $47.3 million out of non-traded BDCs in the third quarter of 2015, up from $25.7 million in the second quarter, according to an analysis by Summit Real Estate Advisory Services. Across the industry the value of non-traded BDCs assets at the end of September 2015 was on average 16% lower than their initial offering price to investor, according to an analysis by investment-banking firm Robert A. Stanger & Co.
Many of these non-traded BDCs were promised to provide steady growth, and invulnerability from volatile markets, which has not happened. According to Wall Street Journal, FINRA’s Vice President for Corporate Financing has said these products are an “ongoing concern” for the regulator and that “firms must ensure they are suitable for an investor’s risk profile and investment strategy.”
What about the unregistered BDCs?
Aside from traded and non-traded Business Development Companies, there is a third category of BDCs that can present a unique set of risks to investors. While most BDCs are registered with the SEC and subject to regulation and reporting requirements, one subset of BDCs are not. Certain BDCs are offered through a Regulation E (Reg E) exemption of the Securities Act of 1933.
This exemption precludes BDCs from having to conduct regular valuations or report their financial status if they meet a loose set of requirements. These requirements include an absence of past regulatory issues and a limit on the amount of money that can be solicited for investment. The exemption allows a company to raise up to $5 million in a 12-month period without registering with the SEC.
Unregistered BDCs are also more likely to be carrying non-secured debt in companies that have a higher risk of bankruptcy. Most BDCs seek to have their loans protected by receiving a property interest or equity in the companies they invest in. By doing this, the BDCs increase their chances of salvaging some of the investment’s value in the case of a bankruptcy.
Unfortunately for investors in unregistered BDCs, not only are they likely investing in weaker and less stable companies, they are most likely not adequately protected in the case of a bankruptcy. Investors in Business Development Companies should make certain that they are investing in BDCs that carry as few of these unnecessary risks as possible. Losses in unregistered BDCs can be catastrophic and extremely difficult to mitigate. Remember, the higher the purported return on a BDC, the riskier the underlying investments are.
Questions to Ask
Regardless of what kind of BDC you are being offered, there are several questions that you should ask. The first concerns the fees and commissions associated with the investment. Much like REITs, BDCs boast high returns, but the devil is often in the details when it comes to how much money you’re actually making.
BDCs often charge both a management fee and a performance fee that is deducted from dividend payments. The management fee is normally around 2%, however, the performance fee can often meet or exceed 20%. These fees are not common with most closed-end investment products, however, a special exception to the Investment Act’s prohibition against such fees is applied to the operators of BDCs. Additionally, these products are often a very profitable sale for brokers and investment advisors.
It is not uncommon for a BDC to be sold with a commission of 10% or more. All of these additional costs should be taken into account when analyzing the profitability and suitability of such an investment.
In addition to a discussion on fees and costs, investors should also know that they are entitled to certain information about most BDCs prior to making an investment. The offering materials for a BDC and/or the adviser selling the product should share the following information with potential investors:
- A description of the offering’s objectives and its investment methodology
- The types of companies and securities in which it plans to invest
- The amount of capital the BDC seeks to raise, and how it plans to spend the money
- The liquidity of the BDC and the rules that govern redemption and sale
- If distributions are guaranteed in frequency or amount and the source of these payments
- The operating history of the BDC and any potential conflicts of interest.
Overview of BDC Sponsors
Some of the sponsors of these riskier BDCs include: American Realty Capital, AR Capital, BDC of America, CION Investment Management, CNL Securities, Corporate Capital Trust, Franklin Square (FS Energy and Power, FS Global Credit Opportunities, FSIC I (FS Investent Corp I), FSIC II (FS Investment Corp. II), FSIC III (FS Investment Corp. III), and FSIC IV (FS Investment Corp. IV)), ICON Investment, Hines Securities (HMS Income Fund), NorthStar Securities, and the Sierra Income Corp
(1) Business Development Corporation of America
Business Development Corporation of America (BDCA) has its main office in New York City. Founded in 2010, this non-traded BDC is sponsored by AR Global Investments. AR Global, founded in 2007 as a small asset manager, actively sponsors both traded and non-traded alternative investments, most notably REITs. AR Global is also involved in open and closed-end mutual funds.
BDCA invests mainly in first and second lien senior secured loans and mezzanine debt issued by middle market companies. As of March 2016, BDCA has 62.7% of funds in senior secured first lien debt, while 14.3% is invested in senior secured second lien debt. 81% of investments are put into middle market businesses, while 14% and 4% are classified as other, and large corporate loans, respectively. A prospectus for this investment can be found here.
BDCA II, invests mainly in first and second lien senior secured loans issued by middle market companies. On March 25, 2016, BDCA II filed a proxy solicitation recommending that stockholders approve multiple proposals at a meeting on April 5, 2016. The proposals include: approve the liquidation of BDCA II’s assets and dissolution of the company; authorize BDCA II to withdraw its election to be treated as a BDC; and to remove the obligation to prepare and distribute quarterly reports to stockholders. A majority of shareholders approved the dissolution and liquidation of BDCA II.
(2) CION Investment Corporation
CION Investment Corporation is located in New York City. Found in 2011, this non-traded BDC is sponsored by ICON, which provides alternative investment products to individuals and institutional investors. ICON, the sponsor company, has been an alternative investment manager for around 30 years. They manage REITs, equipment finance funds, and provide advisory services for middle-market companies.
CION seeks to invest in companies with an EBITDA of $50 million or less. The fund primarily invests in senior secured debt, as well as private and thinly-traded U.S. middle market companies. This fund has 16.1% of its holdings in business services, while 14.5% of its holdings are within the high tech industries. CION has around $907 million in total assets, while the total equity raised by the Fund has been around $937 million.
A prospectus and marketing literature can be found here.
(3) Franklin Square
Franklin Square Investment Corporation (FSIC) has its headquarters in Philadelphia. FSIC is sponsored by Franklin Square Capital Partners. Founded in 2007, Franklin Square Capital Partners manage a variety of BDCs including non-traded, as well as a publicly traded BDC on the NYSE. Besides managing BDCs, Franklin Square manages a global credit opportunities fund.
Franklin Square has various BDCs, both traded and non-traded. The first, FS Investment Corporation, is publicly traded and focuses on providing customized credit solutions to middle market companies. This BDC seek to invest in the senior secured debt, as well as the subordinated debt of private middle market US companies. FSIC launched this publicly traded BDC in 2009 and has 23% of investments in capital goods, while 11% is invested in consumer services. More information can be found here.
FSIC II is a non-traded BDC that was started in June of 2012. FSIC II focuses on investing in first lien senior secured loans, as well as second lien senior secured loans. FSIC II has the majority of its holdings in the energy sector (15%), with consumer services (11%) and software and services (10%) being the second and third most invested industries. A prospectus can be found here.
FSIC III is a non-traded BDC that formed in April of 2014, with 400 million registered shares. FSIC III focuses primarily on debt investments in private U.S. companies, including middle market companies. 71% of FSIC III’s funds are invested in senior secured loans, while 15% of these companies are in the software and services sectors.
A prospectus can be found here.
FSIC IV is a non-traded BDC which was formed in January of 2016. This BDC focuses on debt investments in a variety of private middle-market U.S. companies. A prospectus can be found here.
FS Energy and Power Fund was founded in July of 2011. This fund invests a majority in second lien senior secured loans (31%), as well as first lien senior secured loans (27%). This fund invests 56% of its funds in upstream energy companies, which means that the companies find, and 3xtract energy resources. 20% of investments are also found in service and equipment companies, which supply services and materials to help with extracting/developing various energy sources. A prospectus can be found here.
Sierra Income Corporation has its headquarters in New York City. Founded in 2012, this non-traded BDC is sponsored by Medley Management, and invests in mid-market businesses. Medley Management was formed 14 years ago, and focuses on credit-related investment strategies, primarily originating senior secured loans to private middle market companies in the US that have revenues between $50 million to $1 billion.
The main focus of this fund is on senior secured debt, as well as focus on subordinated debt, with a low priority on preferred and common equity. The fund invests 15% of its total portfolio in business services, while 10% focuses on the automotive sector. The investment portfolio of Sierra Income can be viewed here. The prospectus can be found here.
(5) Hines Securities
Hines Securities, founded in 2003, has its main office in Houston, Texas. The Firm oversees the sale of sponsored investment products to individual investors through broker-dealer firms and their financial advisors. Along with the BDC, Hines Securities has three non-traded REITs that they manage. Their main BDC offering is HMS Income Fund. A prospectus can be found here.
HMS Income Fund is a non-traded BDC, launched in 2012. The Fund has targeted investments with senior secured loans, second lien loans and mezzanine debt, and selected equity investments of private companies with annual revenues between $10 million and $3 billion. As of March 31, 2016, the Fund has debt investments in 117 companies and equity investments in 23 companies representing 42 business sectors in the middle-market and lower-middle market.
Business Development Companies have garnered a lot of attention in recent years given their associated high distribution yields compared to more traditional fixed income investments. However, many people have invested into this product without conducting or being advised of the potential risks, as higher yields are associated with higher risks. BDCs can give individuals the chance to purchase shares in a managed portfolio made to private US companies. Added benefits include institutional portfolio management and potential protection from rising interest rates.
Like all investments, BDCs do not come without risks. Limited liquidity, distributions that may not be guaranteed in frequency or amount, and limited operating history are just a few risks that investors take on when investing in a BDC. Business Development Companies can be a good investment for the right investor, along with a diversified portfolio and sufficient due diligence. BDCs should only be recommended to those investors who are able to both weather substantial losses and those who are not in need of immediate liquidity. Investors should be particularly cautious of riskier non-public and non-traded BDCs.
If you invested in a BDC and would like a free consultation with a securities attorney, please call The White Law Group at 888-637-5510.
The White Law Group is a national securities fraud, securities arbitration, and investor protection law firm with offices in Chicago, Illinois and Vero Beach, Florida. For more information on the firm and its representation of investors, visit https://www.whitesecuritieslaw.com.