Business Development Companies (BDCs)
The latest “hot” product being offered from Wall Street to Main Street investors is an investment in Business Development Companies (BDCs) which are either publicly registered or non-traded entities that provide financing to small and mid-sized businesses – some of which are experiencing significant financial or business difficulties.
BDCs seek to generate a higher amount of current income and, to a lesser extent, capital appreciation, through direct originations of secured debt, including first lien, first lien/last-out unitranche and second lien debt, unsecured debt, including mezzanine debt and, to a lesser extent, investments in equities.
Unfortunately, many financial advisors have pitched these products to their retail clients without having conducted the necessary due diligence on them or, of equal importance, without having an informed appreciation for the potential pitfalls of BDCs as their higher yields are typically also associated with significantly higher risks – many of which are being concealed from investors.
Notwithstanding the sales pitch that an investor may receive, it should be clear that investing in BDCs involves a high degree of risk, including credit risk, derivative risk and the risk of the use of leverage which could potentially magnify losses, and that they are, without exception, highly speculative. The securities in which BDCs invest will generally not be rated by any rating agency, and if they were rated, they would be below investment grade. Moreover, these securities carry a high degree of credit risk which may be referred to or analogous to “junk bonds” and have speculative characteristics in connection with the issuer’s capacity to pay interest and repay principal.
One of the most immediate concerns associated with BDCs, however, is the potential impact that the much anticipated increase in interest rates later this year by the Federal Reserve will have on both their business activities and their valuations since the majority of their debt investments will be long-term and will be tied to various floating rates such as the London Interbank Offer Rate (“LIBOR”), the Euro Interbank Offered Rate (“EURIBOR”), the Federal Funds Rate or the Prime Rate.
In fact, it is widely recognized that general interest rate fluctuations may have a substantial negative impact on many BDC investments (as increased interest rates from their historically low present levels may make it more difficult for their portfolio companies to service their debt) and, accordingly, this may also have a material adverse effect on the rate of return on invested capital, net investment income and the fair value determination of the net asset values of BDCs.
If you are an individual or institutional investor who has any concerns about BDC investments having been recommended for purchase in either your retirement or non-retirement accounts, please contact us for an evaluation of your specific facts and circumstances.