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.

Indeed, some investors see the high management fees and sometimes murky relationships between the BDCs and the companies they invest in as yellow flags. And earlier this year, the Financial Industry Regulatory Authority included BDCs on its list of complex investment products that it will scrutinize closely in 2013.

Tracking the BDC index

Despite these concerns, BDCs are attracting investor attention. Fund managers at UBS’ E-Tracs program got an early start in this niche when it launched a pair of exchange-trade notes in the spring of 2011. Both carry expense ratios of 0.85 percent, and both are based on the Wells Fargo BDC index noted earlier.

Even as that index has posted strong recent gains, the yields on these funds remain impressive. For example, the UBS E-TRACS Wells Fargo BDC Index ETN (BDCS) sports a current annual yield of 7.6 percent.

In a sign of the appeal of high-yield plays, investors have been more squarely focused on the UBS E-TRACS 2x BDC Index ETN (BDCL), which has far higher trading volumes and a vastly larger asset base than its unlevered peer, surely reflecting the stunning 15.6 percent yield that this exchange-traded note offers.

Of course any time you see a nearly 16 percent yield, you should flinch. After all, such high yields often signal that a deep cut (or the outright elimination) of a dividend is looming. Yet in this instance, such fears may be unwarranted. The U.S. economy continues to grow—albeit at a moderate pace—and dividend streams would likely only be vulnerable if the economy slipped into recession.

This especially juicy yield is due in part to very low borrowing costs: The leveraged ETN borrows at Libor (London InterBank Offered Rate), and it’s wise to assume that as the economy strengthens, Libor will rise from its current 0.7 percent (one-year) rate to the 3 percent to 5 percent range. Still, that would only shave a commensurate amount of percentage points off of the BDCL’s projected yield, pushing it down to a still robust level.

Newest Player

The folks at ProShares took a slightly different approach when they launched the ProShares Global Listed Private Equity ETF (PEX) on February 26. “We wanted to provide globally diversified exposure to the category,” says ProShares CEO Michael Sapir.

The PEX portfolio tracks the LPX Listed Private Equity Index, which is a mix of domestic (55 percent) and foreign entities (45 percent). 

Why both BDCs and private equity firms? BDCs are purely a U.S. financial vehicle, so this fund’s foreign holdings are classified as private equity, which are not subject to the same regulations as BDCs. As is the case with the BIZD fund, PEX has a seemingly high expense ratio (2.54 percent) as required by SEC disclosure mandates, but the annual expense ratio that investors actually pay is capped at 0.60 percent, according to Sapir.

Private equity firms tend to retain more of their profits because they don’t have to pay out 90 percent of their taxable earnings to shareholders like BDCs do, which explains why the fund’s SEC 30-day yield of 4.75 percent is smaller than the yield of the BIZD fund. 

BDCs surely carry risk in a weak economy, as we saw in 2008, but they are now settling into a steady annual groove with more predictable quarterly distributions. These ETFs, some of which were only recently launched, highlight the growing investor awareness of this alternative asset category.