Alternative Investing

Q: How do you evaluate the risks and rewards of Business Development Corporations?

A: Business development companies, or BDCs, invest in or lend to small or newer companies. There’s growing interest in BDCs, partly because they can pay sizable dividends. BDCs also are finding more areas to invest and lend, given the ongoing weakness of many banks that can serve as competition, especially in the small-business market.

Some BDCs don’t trade on an exchange and are available only to wealthy, accredited investors. But BDCs often are structured as closed-end funds, trade on a stock exchange and accept smaller investors as shareholders. As such, a BDC can allow an investor to bet on smaller companies—much like a venture-capital fund—but still enjoy the liquidity of an investment that actively trades.

Lorraine Monick, managing director of Harris myCFO Investment Advisory Services LLC, says the average publicly traded BDC has a yield of about 8.3%.

There are dangers to these investments, however. For one thing, many use borrowed money, or leverage, to generate returns, something in the past that proved dangerous to some BDCs.

Also, BDCs can invest in the debt of young, growing companies which can have a higher risk of failure and can be more economically sensitive, Ms. Monick notes. Many of the companies that BDCs invest in also don’t have other access to capital, making them more dangerous.

“Because BDCs rely upon capital markets for continuous access to funds, they can take investors on a harrowing ride when the market swoons” and their access to capital dries up, says Darren Pollock, who helps run Cheviot Value Management LLC, an investment firm in Santa Monica, Calif. “Dividends get slashed when tough times prevail,” which sometimes can send shares tumbling.

At the same time, “BDCs possess great flexibility in valuing the loans that they’ve made,” Mr. Pollock notes. That has brought some BDCs controversy in the past as some have questioned how they value their holdings.

BDCs that don’t trade publicly are even more dangerous, says Mr. Tuttle, who says brokers sometimes emphasize the high dividends paid by some BDCs, while glossing over their risks.

Stick with those with proven management teams, and read the fund’s prospectus to make sure it can’t use huge amounts of leverage, says Ms. Monick. Investors should make sure BDCs are just one part of a diversified portfolio, adds Ms. Monick, who says investors should “visit brokerage or research sites such as the Closed End Fund Association to obtain analyst reports on specific BDCs before investing.”

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