A potential provider of the yield that investors are hungry for, business development companies may play a much bigger role in funding medium-sized companies in the US in future. However, having only been launched in the 1980s, institutional and retail investors – as well as legislators – still have a lot to learn about this burgeoning area of investment.

PDI caught up with Cynthia Krus, a Washington, DC-based partner at law firm Eversheds Sutherland and an advisor to BDCs and small business investment companies, to find out more about their background and prospects.

What is the immediate outlook for the BDC market in your view?

We believe that the industry will continue to grow, but the focus will be on private BDCs. Since the beginning of 2016, 92 percent of the 25 newly formed BDCs were structured as private BDCs. During that time, three of the four that have conducted initial public offerings began as private BDCs. And private BDCs have raised more than $13 billion in aggregate assets since the first was launched in 2011.

The private structure allows the BDC to ramp up its investing and build a portfolio. Then, the BDC can more easily prepare for an IPO or strategic transaction. As a result, we expect to see more strategic transactions and consolidation in the industry as BDC operators, especially with private BDCs, continue to recognise the enhanced flexibility of a larger platform.

What’s the biggest benefit of BDC investing?

From the operator perspective: when Congress created the companies in 1980, the primary goal was to provide additional access to capital for mid-market US companies. At that time, the federal funds rate was over 19 percent and access to the capital markets was restricted to only the most highly qualified borrowers. So, in addition to accessing funding for the middle market, the structure allows retail investors the opportunity to invest in private mid-market US companies in a highly regulated fund structure with the protections of the 1940 [Advisers] Act. The 1940 Act regulates, among other things, transactions with affiliates, use of leverage and conflicts of interest, and offers significantly more disclosure about the BDCs’ investments than other vehicles.

From the investor perspective: yield, yield, yield. As investors search for yield, the BDC is a product that has consistently provided quarterly dividends. Since BDCs typically elect Regulated Investment Company status, they are required to distribute substantially all of the fund’s taxable income to shareholders annually. Investors typically receive quarterly dividends that enhance the fund’s total return in addition to stock price growth.

Some investors have referred to an investment in a BDC as “the bond that grows”, bringing together the benefits of current income and long-term growth when the BDC’s performance is strong. In the private model, this offers a current dividend without the gyrations of the market.

And what’s the biggest challenge?

Despite significant growth in the industry over the last 10 years, BDCs are still not well known or understood. While many financial institutions are limited in the type and structure of their investments, BDCs are not typically limited in the structure of their investments. So, depending on market demands, the current economic cycle and competitive alternatives, BDCs can structure investments with senior debt, subordinated debt, preferred or common equity, or any combination thereof up and down the balance sheet. Their disclosure obligations provide unparalleled transparency to investors, who can make their own judgments on the quality and structure of the investment portfolio.

This is quite different from other funding sources, particularly for private companies, which means the industry is required to spend considerable time educating institutional and retail investors, as well as SEC regulators and members of Congress about BDCs and the important financing role that they play in the mid-market.

The more we can educate our legislators and investors and provide a better understanding of the vehicle, the more people will take advantage of it and infuse capital into mid-market companies.

Is the BDC investor base likely to grow, and how?

Yes, I think as more retail investors, investment advisors and portfolio managers become more familiar with the BDC model, more will be attracted to the opportunity to invest in a portfolio of private companies that generate, in some cases, significant yield and long-term growth. As with all investments, investors will gravitate to funds offering attractive performance returns.

The growth of the industry has also largely been through more recognised private equity fund managers who have launched BDCs. This increased visibility and recognition of the industry is likely to encourage more institutional investors and investment advisors to learn more about the model.

What’s the most interesting thing about BDCs that people may not be aware of?

I have a two-part answer to offer for this one. Since the formation of BDCs in 1980, the model has proven to be highly resilient. Whenever the economy has experienced a negative credit cycle, BDCs have continued to operate, and unlike the banks, there has never been money used to bail one out.

The second part is the history of how BDCs came about. A venture capitalist was close to exceeding the 100-investor limit for a private fund and did not want to register with the SEC and be required to operate within closed-end fund leverage restrictions or the limitations on carried interest for the manager.

He lobbied Congress to create a new structure that would address these issues, which turned out to be the Small Business Investment Incentive Act of 1980, which paved the way for BDCs. Not only did Congress pass the Act, but they required that the SEC implement the Act immediately.

The Securities and Exchange Commission’s division of investment management spent the summer putting together the regulatory structure to accommodate this new fund structure that was effectively a hybrid between closed-end funds and a traditional public company.

According to testimony by the Congressional Budget Office in 1980, the SEC expected they would need to increase their staff by up to 10 people to accommodate the up to 50 firms predicted to take advantage of this new fund structure.

Needless to say, it took a bit longer for the BDC structure to catch on, but it seems that it has finally become nearly as mainstream as closed-end funds.