BDCs: Lending to Small Businesses for Income

A business development company is, at heart, a lender. It lends money to mid-sized private companies, the kind too big for a local bank but too small to sell bonds on Wall Street, and passes nearly all the interest it collects on to its shareholders. That’s why BDCs often yield 9% to 13%.

What a BDC is

Congress created business development companies in 1980 to get more capital to smaller American businesses. A BDC is a closed-end investment company that must put most of its assets into private or small public US companies. Like a REIT, it gets a special tax deal: as long as it distributes at least 90% of its taxable income, it pays no corporate income tax on what it hands out.

Most BDCs trade on the stock exchange like any other stock. You can buy Ares Capital or Main Street Capital in any brokerage account.

How they make money

Since 2018, BDCs have been allowed to borrow up to about $2 for every $1 of equity, though most keep leverage near 1×. Most of their loans are first lien, meaning they get paid back first if the borrower runs into trouble, and most are floating rate, so the interest charged moves with short-term benchmark rates.

Rates help them, until they don’t

Because their loans are floating rate, BDCs earned noticeably more when the Federal Reserve raised rates in 2022 and 2023, and many raised their dividends or paid extra “supplemental” dividends. The flip side is that falling rates shrink their income. A BDC that raised its dividend when rates were high may have to trim it as rates come down. That’s the opposite of REITs, which usually like falling rates.

Well known BDCs, live

Look at the yields against the five-year returns. Some of the highest yielding BDCs have poor long-term total returns, because their net asset value per share has shrunk over time. A BDC paying 16% while its NAV falls 5% a year is really earning about 11%, and maybe less.

The risks