Legal Hurdles of Investing in Business Development Corporations
When investing in business development corporations (BDCs), make sure you're aware of the legal constraints BDCs are subject to. Here are just a few.
8 September 2014
In our last post, we discussed why people invest in business development corporations (BDCs). These BDCs are on a rebound, and are frequently making risky debt purchases that yield relatively big returns. But alas, there’s a catch — BDCs are subject to certain legal constraints.
To achieve tax-free status, at least 70 percent of BDC investments must be in “eligible assets.” These can include:
- Small companies that are either not listed on any national securities exchange, or with a market cap of under $250 million.
- Government or debt securities
- Securities of eligible portfolio companies that are controlled by a BDC (they own more than 25 percent of securities) and with a BDC-affiliated director
Additionally, at least 50 percent of a portfolio must be in individual assets, none of which can:
- Make up more than 5 percent of total assets
- Own more than 25 percent of any company’s total assets
Most interestingly, BDC investors must also provide “significant managerial assistance” to those companies that allow them to meet the 70 percent eligible assets standard (mentioned above). This assistance includes guidance and counsel concerning the management and operations of these companies — meaning the investor must take an active role in the BDCs it invests in.
The amount of leverage a BDC is able to have is highly regulated in comparison to banks or real estate investment trusts (REITs). Business development companies must maintain a debt-to-equity ratio below 1-1. Many argue this limits the returns BDCs are able to provide investors. Mostly, BDCs thrive in rising interest rate environments — approximately 60 percent of assets are floating-rate, while debt is typically fixed-rate. If you’d like to learn more about BDCs, you can check out our recent post, “Business Development Companies on a Middle Market Upswing.”
Michelle Wu is a Product Marketing Director for the Intralinks Banking and Securities vertical and is responsible for all aspects of the go-to-market strategy for the debt capital markets business. Prior to joining Intralinks in 2011, Michelle was an investment banker at HSBC focused on capital markets origination working across various product groups in New York, Hong Kong and Japan.