By Samuel Taube Written Aug 09, 2020
There’s a special type of investor who has consistently outperformed the major stock indexes for the last few decades.
Their strategy is relatively simple: They buy shares in privately held small or distressed businesses, take an active role in their management, and then earn spectacular profits on their growth or recovery.
These investors — and their uncomplicated strategy — have notched an average annual return of nearly 20% over the last 30 years, while the S&P 500 has returned an average of just under 10% each year over the same period.
They’re called venture capitalists, and unfortunately, a variety of regulations prevent the vast majority of us from joining their ranks. Venture capitalists must be accredited investors with a net worth of at least $1 million (primary residence excluded) or an income of at least $200,000 a year.
Fortunately, there’s an easier way to access the profit potential of private equity, and it’s available to anyone who can buy a stock.
Business development companies (BDCs) allow retail investors like us to act like venture capitalists and earn similar returns. But like any investment, they have their nuances.
What Are Business Development Companies (BDCs)?
In short, BDCs are publicly traded investment vehicles that make loans to or buy ownership stakes in small or distressed companies, including privately held firms.
They help small companies through their initial growth stages and help distressed companies turn their financial situations around. Due to the relative riskiness of their investments, BDCs can charge unusually high interest rates on loans or take unusually large stakes in companies on the cheap, thereby priming themselves for very high returns.
And they’re required by law to pass at least 90% of those returns on to their investors, not unlike real estate investment trusts (REITs).
As a result, BDCs can provide investors with almost unmatched income-generating capabilities, even during times of low interest rates. The average BDC currently yields around 10%.
And they can get investors in on the ground floor of some exciting opportunities. Hercules Capital (NYSE: HTGC), one of the largest BDCs, once funded Pinterest, Postmates, and DocuSign.
The Advantages of Investing in BDCs
It’s hard to overstate how valuable BDCs can be for income investors.
As you can see in the graph below, the three largest BDCs — Ares Capital Corp (NYSE: ARCC), Owl Rock Capital Corp (NYSE: ORCC), and FS KKR Capital Corp (NYSE: FSK) each yield far more than the S&P 500. Ares yields over 10 times more.
BDCs also offer investors the chance to diversify their holdings with private equity, but they’re far more liquid than such assets usually are. Ares currently sees roughly 3.7 million shares change hands every day — a higher volume than many popular stocks.
Ares also provides a shining example of another characteristic of many BDCs: their ability to outperform the major indexes during and after recessions. By investing heavily in tech startups in the years after the Great Recession, Ares set itself up to trounce the S&P 500 over the following decade…
But of course, the risky investments that can make BDCs so lucrative can also come with significant drawbacks…
What to Watch Out For
It should be obvious, but it merits mentioning anyway, the volatile loans and equity stakes which BDCs purchase come with greater chances of capital appreciation but also greater chances of losses.
To that end, BDCs tend to swoon when the market dips as the three largest ones did during the COVID-19 crash earlier this year…
This volatility leads many BDCs to underperform the major indexes during downturns, even if they’re poised to outperform afterwards.
And while BDCs are highly liquid, and highly transparent about their overall financial position, their portfolio companies often aren’t. This can make it difficult to perform proper due diligence on a BDC’s portfolio unless you’re willing to dig deep and locate data from portfolio companies that may not be publicly traded.
In sum, business development companies offer almost unbeatable yields during low-interest periods like the current one, and they allow ordinary investors like you and me to buy stakes in private, up-and-coming businesses that are usually closed off to everyone except venture capitalists.
But there are high risks that come with those high rewards, and investors who are looking to buy BDCs should be prepared to scour the more obscure corners of the financial internet to find due diligence information on them.
One way to solve these problems is by choosing which private equities to invest in yourself — by forming your own BDC, in a manner of speaking.
As we discussed at the beginning of this article, it’s difficult to invest in private equity if you’re not an accredited investor. But it’s not impossible. Angel analyst Jason Williams is teaching Main Street Ventures subscribers how to use a series of legislative loopholes to buy their own stakes in companies before they go public. Click here to learn more.
