In the search for higher yields in this ultra-low interest environment, some investors are being directed to non-publicly traded Business Development Corporations (BDC’s) as an investment option. While these might seem like good alternative investments at first glance, investors should be aware of the risks and costs involved. Along with the high yields that they promise, they also come with high up-front fees, limited liquidity and limited transparency.
What you should know about BDCs
A BDC typically provides investment backing to a small or medium-sized business with limited financial leverage because they have credit ratings that are usually below investment grade. BDCs were created in 1980 by the government as an attempt to stimulate investment in middle-market U.S. companies. Not all BDCs are publicly traded. Some are bought only through brokers, which can severely affect their liquidity. BDCs must pass through at least 90% of their profits to their shareholders. They do so without paying corporate income taxes, leaving the investor responsible for paying any required taxes.
In addition to the high up-front fees (commissions) that come along with non-publicly traded BDC’s, the private nature of this investment is cause for concern. The investor does not have the daily liquidity of a publicly traded investment and there is less disclosure required. This murkiness makes it easy for businesses to manipulate the numbers and delay showing losses. This means there is the danger that the value that they are estimated at may differ significantly from their actual value. Finding a market to sell your non-publicly traded BDC can be a challenge and a significant risk that you are willing to accept. As with any “high return” investment, you must be aware of the higher risks you are taking.
What does this mean to you as an investor? First and foremost, you must do your homework. If your advisor or broker is suggesting a non-publicly traded BDC as part of your portfolio, take the time to investigate the associated fees and consider how long it might take to recoup the cost of those fees. Some analysts suggest the front-end fees on these investments are as high as 12%. Additionally, there might be other fees and incentive structures associated with the management of these investments.
Our second and most important recommendation is to find an advisor that you trust. One that will not benefit from the fees associated with their investment recommendations. We suggest a fee-only advisor because they are not paid based on the products they sell. This means they have your best interests in mind, not those of their bottom line.