What is a BDC

A closer look at BDCs

A business development company (BDC) can be viewed as a wrapper or vehicle for investors to access ownership in a diversified pool of private credit assets. A BDC is a closed-end investment company, created by Congress through an amendment to the Investment Company Act of 1940 under Section 54 called the Small Business Investment Incentive Act of 1980. As the name suggests, the intention of the legislation was to promote capital investment by closed-end funds to an important part of the U.S. economy—small and middle-market businesses, which were struggling for access to debt and equity capital following the recession in the 1970s.

How BDCs operate

Most BDCs elect to be treated as a regulated investment company (RIC), which provides for pass-through tax treatment of net income. BDC dividend payments to shareholders are not subject to entity-level tax on distributed income. In this manner, a BDC operates like a real estate investment trust (REIT) or master limited partnership (MLP) that offers access to the ownership of real estate assets and energy assets, respectively, and passes through investment income. This flow-through treatment creates tax efficiency by avoiding double taxation, provided the BDC meets periodic asset, income, and distribution requirements. BDCs must distribute at least 90% of taxable income to shareholders.

BDC objectives

BDCs have varying investment objectives and strategies,¹ but most BDCs provide financing solutions to U.S. domiciled middle-market businesses by raising equity capital from retail and institutional investors and deploying the equity capital in the form of senior secured, floating rate loans. BDCs can typically lever equity capital from investors up to 2.0x debt-to-equity under the passage of the Small Business Credit Availability Act of 2018, although the median publicly-traded BDC leverage remains well below this threshold.

^{1. While the classification of private credit strategies differs across stakeholder, most are commonly categorized at BDCs according to sub-types of direct lending, specialty lending, venture lending. As portfolios increase in size, diversified BDCs are adding niche strategies to the portfolio.}

^{This is for informational purposes only and is not an offer or a solicitation to sell or subscribe for any fund and does not constitute investment, legal, regulatory, business, tax, financial, accounting, or other advice or a recommendation regarding any securities of Blue Owl, of any fund or vehicle managed by Blue Owl, or of any other issuer of securities. Please consult your tax and financial professional.}

Why BDCs provide greater transparency

Investors have often struggled with the limited information available with private markets investments, but the unique requirements associated with the election of a BDC provide greater disclosure and transparency. BDCs are required to invest no less than 70% of total assets in private U.S. companies or public U.S. companies with market capitalizations of less than $250 million. Companies that meet these criteria are considered “eligible portfolio companies,” more colloquially known as good assets. Portfolio companies that fit this profile typically have fewer options to raise capital to facilitate growth and support daily operations when compared to their larger, public counterparts.

SEC requirements for BDCs

As an SEC registered company, BDCs are subject to many of the same requirements of U.S. mutual funds like periodic public reporting (10-K, 10-Q, 8-K), internal control and board governance requirements, and are supervised and regulated by the investment management division within the SEC. This collective oversight can provide investors with greater transparency and visibility than private funds.

BDC management

The management of investments held on the balance sheet of BDCs requires significant investment expertise, sourcing relationships, due diligence, and portfolio management, which collectively serve as the greatest competitive advantage for private credit managers to achieve attractive risk-adjusted returns. BDC investments are often valued by independent valuation agents and must be approved by a BDC’s board of directors or determined by a “valuation designee” appointed by the BDC’s board of directors.² The “valuation designee” must be the BDC’s investment adviser, other than a sub-adviser, or, in the case of an internally managed BDC, one or more officers of the BDC. The investments are disclosed on a cost/fair value/par value basis on a BDC’s quarterly filings. Yield and maturity dates are also provided. For loans trading at a discount to par, one can view material discounts at individual loans akin to reserves or embedded unrealized loss, which might suggest future realized losses at a BDC. These enhanced disclosures, if monitored appropriately, can collectively provide early signals in changing fundamentals at a BDC. This transparency is a key benefit compared to the level of information available at other private credit vehicles.

^{2. Blue Owl Capital Corporation’s board of directors has appointed Blue Owl Credit Advisors LLC as valuation designee.}

Tax advantages of a BDC

Tax-exempt investors like public pension funds, endowments, foundations, and sovereign wealth funds were some of the early adopters of BDCs. Private wealth managers and registered investment advisors (RIAs) are also recognizing the benefits of owning BDCs in tax-deferred retirement accounts for their retail clients and the power of compounding returns from the distribution of current income to grow capital and provide income replacement in retirement. Beyond the pass-through benefits BDCs provide investors as registered investment companies (RICs), the structure of a BDC provides some lesser-known tax advantages, which has resonated with both tax-exempt US investors and many non-US investors.

One of the most obvious tax differences between the BDC and private credit fund is that BDCs provide tax reporting from 1099s instead of K-1s. K-1s are often received late in the tax season and can be complex to read and understand. The receipt of 1099s highlights the user-friendly characteristic commonly associated with ownership of a BDC.
The structure of BDCs may also appeal to non-U.S. investors, given that they will not incur “effectively connected income” (commonly referred to as ECI) or be required to file U.S. tax returns solely as a result of an investment in a BDC, as BDCs are organized as corporations rather than partnerships for U.S. tax purposes.
Non-US investors are exempt from the 30% withholding tax that is normally applicable to most dividends from other U.S. corporations (subject to reduction or elimination under U.S. tax treaties with many jurisdictions). In 2014, changes in the U.S. Tax Code removed withholding tax on dividend payments to foreign investors.
For BDCs with a total return objective, investors can benefit from the distribution of dividends from realized gains at the lower capital gains tax.

While these tax advantages provide immediate value to private credit investors today, it should be noted that BDCs may also benefit from future structural reforms to BDCs that could put the vehicle’s benefits on par with similar structures such as REITs. More specifically, currently, BDCs do not receive the same tax parity as REITs under the Tax Cuts and Jobs Act of 2017, which allows for a 20% pass-through deduction of qualified business income. BDCs are also adversely impacted by the application of acquired fund fees and expenses to expense ratios for the ownership by investment companies.

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