A Business Development Company (BDC) is a form of publicly traded closed-end investment company that invests in small- and medium-sized private U.S. businesses.
BDCs are regulated by the U.S. Securities and Exchange Commission (SEC) under specific provisions of the Investment Company Act of 1940 and the Small Business Investment Incentive Act of 1980, which are distinct from the rules for traditional investment funds.
Here are the key rules governing BDCs, from investment mandates to operational structure.
Investment requirements
To qualify and maintain its status as a BDC, a company must adhere to strict rules concerning its investment portfolio.
- Qualifying assets: At least 70% of a BDC's total assets must be invested in "eligible portfolio companies," a category defined by the Investment Company Act of 1940. Eligible assets include:
- Securities of private U.S. companies.
- Securities of U.S. public companies with a market capitalization of less than $250 million.
- Securities of financially distressed U.S. companies.
- Cash, cash equivalents, and certain high-quality, short-term debt.
- Non-qualifying assets: The remaining 30% of assets may be invested in a wider range of securities, including those of larger public companies, non-U.S. companies, and other investment funds.
- Managerial assistance: BDCs must also offer significant managerial assistance to their eligible portfolio companies. This can include providing business and financial advice and may distinguish BDCs from passive investment vehicles.
Financial and operational rules
BDCs operate under specific financial and structural regulations that provide a framework for their business model and shareholder protection.
- Publicly traded shares: A BDC must register a class of its securities under the Securities Exchange Act of 1934, making its shares publicly tradable on a stock exchange like the NYSE or Nasdaq. This public listing provides liquidity for investors, a key difference from private equity or venture capital funds.
- Corporate structure: A BDC is legally structured as a domestic, closed-end investment company. This means it issues a fixed number of shares in its initial offering, which are then traded on the open market, rather than being continuously issued or redeemed like a mutual fund.
- SEC reporting: BDCs are subject to the same periodic reporting and disclosure requirements as other public companies. They must file regular reports, including Forms 10-K, 10-Q, and 8-K, which provides transparency into their financial performance and portfolio.
- Valuation: BDCs must regularly value their portfolio investments, including illiquid or private assets, at fair value. An independent valuation agent and the BDC's board of directors typically oversee this process.
- Board of directors: The majority of a BDC's board of directors must be "disinterested persons," or individuals not affiliated with the company's management.
- Fiduciary duties: BDCs and their investment advisors are subject to fiduciary duties to act in the best interests of the company and its shareholders. A code of ethics must also be adopted to guide the conduct of personnel.
- Fidelity bond: BDCs are required to carry a fidelity bond to protect against larceny and embezzlement.
Leverage limits
While BDCs have more flexibility to use leverage than traditional closed-end funds, their borrowing is restricted to prevent excessive risk.
- Maximum leverage: Following the Small Business Credit Availability Act of 2018, BDCs can maintain a maximum leverage ratio of 2:1 debt-to-equity, or 150% asset coverage. This is more aggressive than the 3:1 asset-to-debt ratio previously required of other investment companies.
- Board approval: Any debt-to-equity ratio above 1:1 typically requires approval from the BDC's board of directors or shareholders.
Tax regulations
BDCs are typically structured as Regulated Investment Companies (RICs) under Subchapter M of the Internal Revenue Code, which determines their tax obligations.
- Pass-through taxation: Qualifying as a RIC allows a BDC to avoid corporate-level income tax on earnings distributed to shareholders. The income is taxed only once, at the shareholder level, which enhances tax efficiency.
- Distribution requirement: To receive this tax treatment, a BDC must distribute at least 90% of its taxable income to shareholders each year in the form of dividends.
- 90% income test: BDCs must also derive at least 90% of their gross income from investment-related activities like interest, dividends, and capital gains.
- Diversification tests: The tax code also imposes quarterly diversification requirements to limit risk, such as restricting the amount invested in any single issuer.
Investment advisory fees
The fees paid to an investment adviser for an externally managed BDC are subject to regulatory oversight.
- Board review: The BDC's board of directors must annually review and approve the advisory agreement and fees.
- Fee structure: BDC advisory fees are typically composed of a base management fee and an incentive fee based on performance. The structure and reasonableness of these fees are considered by the board during its review.
Prohibited and restricted transactions
To prevent conflicts of interest, BDCs are restricted from engaging in certain transactions with affiliates.
- Affiliate transactions: Certain transactions between a BDC and its affiliates, such as officers, directors, and the investment adviser, are generally prohibited unless an exemptive order is obtained from the SEC.
- Related persons: The rules on related-person transactions apply to officers, directors, employees, and the investment adviser, but not to the BDC's control affiliates.