While young and fast-growing companies have historically sought to raise fresh growth capital through an initial public offering, many are now eschewing the IPO market and instead seek the financial backing of a new crop of financiers known as business development companies (BDCs).
BDCs are typically closed-end investment entities that focus on “middle market” companies with revenues between $10 million and $1 billion. Their business model can be quite advantageous: they earn income from high-interest loans and they also gain a chunk of equity through warrants and options.
Of course these BDCs can run into trouble if the capital markets seize up and they are left holding the bag with a portfolio of stuck investments. American Capital (ACAS), the nation’s largest BDC, saw its shares fall roughly 90% in 2008 as cash flow pressures mounted. These days, ACAS is back in good shape, as is the rest of the BDC universe. For example, the Wells Fargo Business Development Company Index has surged roughly 40 percent since the start of 2012.
BDCs are treated as regulated investment companies under the Investment Company Act of 1940, which means they get favorable tax treatment in return for distributing at least 90% of their taxable earnings to shareholders. As such, BDCs currently crank out dividend yields that range from the high single digits to the low double digits.
At last count, there were more than 40 publicly traded BDCs in the U.S. ETF sponsors have taken note and have been moving into this space.
The Market Vectors BDC Income ETF (BIZD) launched on February 11 and its BDC holdings are weighted in relation to their market values, according to Market Vectors product manager Brandon Rakszawski. American Capital and Ares Capital (ARCC) each comprise roughly 14 percent of the fund, while Prospect Capital (PSEC), Apollo Investment (AINV), and Fifth Street Finance (FSC) round out the top five.
BDC-focused ETFs bring broad-based diversification. For example, through its ownership stake in 25 BDCs, this ETF has indirect stakes in more than 500 companies across a range of industries.
Investors who read BIZD’s fact sheet will be floored when they see the fund’s gross expense ratio is 7.7 percent. This ETF is classified as “funds of funds,” but investors in BIZD actually pay just a 0.40 percent expense ratio. Rakszawski says Market Vectors is required to clearly state the average management fee of its holdings.
The yield on the BIZD is a sturdy 30-day SEC yield of 7.3 percent, and Rakszawski notes that when you consider BDCs take another 7 percent to 8 percent in annual fees, it’s clear that the BDC investing approach is capable of 15 percent annual returns on a pre-expense basis.
And that highlights an irksome flaw for investors in the BDC space. Namely, the management teams are keeping roughly half of their hefty annual gains for themselves. So even if BIZD doesn’t ask you to cough up those stated expense ratios, it’s still roughly the amount that’s being skimmed off the top by BDC insiders.