Sorting Out The Few Good BDCs From The Many Bad Ones

Years ago, an Air Force Academy classmate and a close friend went on a rant about how he disliked the widespread use of jargon and acronyms in the Air Force. To this day, my memory can’t unstick “ficknip” (flight navigation and control panel), and I haven’t used one for over 30 years.

The investing world is also full of jargon and Wall Street types, and the financial press, throw that stuff out like everyone is familiar. I work in the investment world and find myself regularly looking up new acronyms. I can’t change the world, or people trying to show how smart they are by throwing out obtuse jargon. What I want to do is to explain investment ideas in an understandable way.

Our acronym for today is BDC. It refers to Business Development Company, a special type of business that results in sometimes very attractive income stocks.

Business development companies operate under the Small Business Investment Incentive Act of 1980, which was an amendment to the Investment Company Act of 1940. The 1940 Act is the primary law governing investment products such as mutual funds, closed-end funds, and exchange-traded funds –ETFs.

The 1980 Act provided some exceptions to Investment Company Act rules. The purpose was to open a new source of financing for small to medium-size businesses that do not have access to the public debt and equity markets. In structure, a BDC is closely related to a closed-end fund. See my recent thoughts on select closed-end funds.

A BDC operates under a strict set of rules. First, a BDC can only make loans or equity investments in small to medium-sized corporations that meet the criteria of the law. The next rule is that a BDC can only have debt equal to the equity capital of the company. For example, a new BDC sells stock and has $500 million from the sale.

The company can then borrow another $500 million, bringing the company’s total investment capital to $1 billion. By law, a BDC cannot over-leverage itself. Finally, a BDC must payout at least 90% of net income as dividends to investors. If a BDC pays out 95%, it gets an additional tax break. BDCs are “pass-through” companies which means if they pay out the 90% of income they don’t pay corporate income tax.

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Disclaimer: The information contained in this article is neither an offer nor a recommendation to buy or sell any security, options on equities, or cryptocurrency. Investors Alley Corp. and its ...

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