Why Business Development Companies are Right for Your Portfolio

New investors tend to focus on low-risk and mega-cap stocks when building a financial portfolio. These are often safe bets, but in return, they can be low-yield. As the current market hits a period of volatility, it becomes even less clear what investments will pay off or where higher risk resides. Soaring inflation and rising interest rates in 2022 have everyone worried, with some predicting another recession.

But many financial experts view the latest economic downturn as a ripe opportunity for investors to capitalize on overlooked opportunities and beat out their hesitant competitors. At a time like this, one way to grow a portfolio is to turn to business development companies (BDCs).

The unique nature of BDCs makes them a good hedge against market volatility. They also yield consistently high dividends and help small businesses gain a foothold in the economy. Here we will explore what sets BDCs apart from other investments and how they can contribute to a diverse portfolio.

What is a Business Development Company?

A business development company is a publicly traded or non-traded company which provides financial solutions for small to medium-sized enterprises (SMEs). These typically come in the form of debt or equity capital. A BDC not only loans to small businesses, but can offer support and guidance during their early — and defining — years.

In 1980, Congress decided to create business development companies as a way for Wall Street to recommit to “Main Street” America. The decision passed with overwhelming bipartisan support. Since then, BDCs have loaned to “small, developing and financially-troubled companies” that lacked access to conventional financings, such as bank financing.

Some BDCs focus on a specific sector, like tech, healthcare, or manufacturing, whereas others simply stick to companies that fall within a certain revenue range. Traditional banking institutions typically turn away the companies that receive loans from BDCs because they are considered an unsafe bet. This is especially true in the wake of the 2008–09 recession. Thus, BDCs invest in promising private enterprises and issue loans with higher-than-average interest rates.

Accessible to All

Just as loans from BDCs are available to all sorts of expanding companies, investing in a BDC is possible for nearly anyone, especially in the case of publicly traded BDCs such as Saratoga Investment Corp (NYSE:SAR). It also gives investors the chance to catch waves of cutting-edge companies, founders, and products before they make an initial public offering (IPO), by investing in the BDC which is the direct lender to these companies. Several powerful tech companies got their start or made major expansions with the help of mezzanine or subordinated debt financing from a business development company.

In recent decades, private equity firms have made already wealthy investors into billionaires. In comparison, BDCs can offer high returns to investors at every level of the investing spectrum. This is because many BDCs are publicly traded on the stock market, making them more transparent and easier to access. Anyone can buy and sell shares of these companies. In many cases, BDC investors gain exposure to appealing private companies without burdensome lockups or minimum investments.

So what can one expect after choosing to invest in a BDC?

High Dividends and Floating Rates

The greatest appeal of adding a business development company to one’s portfolio is the historically high dividends it can produce. BDC dividend yields have been known to enter the double digits, and a majority of publicly traded BDCs reached 9.8 percent or higher in 2022.

This is thanks to BDCs favorable tax structure. So long as a BDC pays out 90 percent or more of its net profits as dividends, the company pays no income tax. This requirement makes BDCs a steady and predictable source of income for young investors and retirees alike.

BDCs can also be considered inflation-resistant because a majority of the loans (if not all) that a BDC offers are floating-rate loans. This means BDCs make more money when the Federal Reserve rate rises. As the stock market stagnates and volatility increases, adding BDCs to one’s portfolio may well guard investors against sudden losses.

A 2019 legislative change has enabled BDCs to grow further and increase the amount of loans they can issue to portfolio companies. Now, the leverage cap for BDCs is doubled, allowing them to take on greater debt to pursue more credit-worthy investments.

How to Choose the Right BDC For You

There are more than one hundred BDCs currently investing in small to medium-sized enterprises in the United States. At least 57 of them are publicly traded, so anyone can purchase their shares in the middle market.

So how does one find the right investment?

First, it’s important to understand what risk level you are willing to take on. Next, think about which SMEs you wish to invest in. Are you focused on a specific economic sector? Interested in investing in widely-applicable digital services or medical devices? Or eager to find companies already boasting a significant revenue level?

Once you determine these investment goals, you can track publicly traded BDCs on a site like Business Development Company Universe. There it is possible to review up-to-date information about market prices, debt percentages, average loan rates, and more.

Another aspect to mull over is how much time and capital you are willing to dedicate to BDC investments. The average investor has historically allocated 5 to 10 percent of their overall portfolio to BDCs. This allows for access to high dividends without risking the bulk of one’s wealth.

At the end of the day, business development companies are a unique way to evolve as an investor. Their accessibility, tax structure, floating rate loans, and transparency make for a rare opportunity to support growing businesses and simultaneously bolster your financial portfolio.