Some say a business development company (BDC) is a must-have in an investment portfolio seeking steady income. A typical BDC is a publicly traded company that provides investors high dividend yields (it pays you to own its stock) and capital appreciation (as a company grows, so does its stock price).

What makes a BDC special is its investment strategy. Investors get exclusive exposure to promising ventures both private and public. These are often small and mid-sized businesses that lack the ability to get proper financing or sell bonds to raise money for operations. As risky as these bets can be, the trade-off is huge.

How Does a Business Development Company Compare to Other Investments?

Think of mutual funds and exchange-traded funds (ETFs), which are pools of money that invest in an assortment of stocks, bonds, and other tradable securities while issuing new shares to meet investor demand.

Some mutual funds are classified as open-end funds. In contrast, some business development companies are closed-end funds in which the amount of stock issued is capped and the shares can’t be redeemed. But unlike mutual funds, BDCs have a much larger investment playing field to work on.

BDCs also get compared to private-equity funds and venture-capital funds, as they too invest in promising up-and-comers. But those products are only available to accredited investors, or individuals or groups that have lots of money. Namely professional investors.

Furthermore, private-equity and venture-capital funds don’t allow immediate access to your money. Publicly traded BDCs do.

And anyone can invest in BDCs, which give small investors access to opportunities that were once only available to wealthy individuals and institutional investors.

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How Does a BDC Work?

Most BDCs make money investing in companies via debt financing (buying bonds and providing loans) to a company. The interest payments on these securities are collected by the BDC and passed onto to shareholders purchasing part of the company or taking over (or counseling) the company’s management.

If they hold stock in the companies they invest in, the BDCs profit if the stock price (or net asset value) increases. BDCs also make money by investing in senior secured bonds and loans. That means when a company defaults, the BDC is among the first in line to get its investment back for investors.

The Structure

BDCs come in three flavors: publicly traded, non-traded (avoid these), and private.

Most investors deal only with publicly traded BDCs, and most of these hold either equity (stock) or debt (bonds) in their portfolios of targeted companies. These BDCs invest 70 percent of their total assets in public or private companies valued at $250 million or less.

BDCs focus on bonds that offer higher dividend yields, recurring income, and less volatility than stocks.

But equity-focused BDCs can give investors a much bigger upside than bonds, as stocks can appreciate in value.

BDCs are typically operated in one of two ways. Most are run externally. In other words, an outside firm makes the investment decisions for a fee. However, a handful of BDCs are run by internal staffers.

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Why Investors Love the BDC Tax Structure

Congress created BDCs in 1980 to help ignite the creation of new businesses and jobs at a time when the U.S. economy was souring. One special feature that lawmakers gave BDCs was an exemption from corporate income taxes.

However, BDCs in exchange pay out at least 90 percent of their taxable income within a calendar year to investors (or shareholders) in the form of “ordinary dividends.” These can be as high as 15 or 20 percent (sometimes more) in a given year.

Real estate investment trusts (REITs) — another congressional product, which provide investors direct exposure to real estate like shopping malls and office buildings — have the same tax structure.

Of course, a shareholder ends up paying taxes on the dividends she earns each year. And since those dividends are deemed “ordinary,” they’ll be taxed as ordinary income like employment income.

BDCs, liked REITs, are classified by the IRS as regulated investment companies (RICs). This RIC designation also requires BDCs to remain diversified. They can’t put more than 5 percent of their assets in any single security like stocks; they’re forbidden from buying more than 10 percent of a company’s voting securities (special stocks that allow shareholders to vote for a company’s board of directors); and they can’t put more than 25 percent of their assets into any business they control or any business that’s in the same industry.

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Why BDCs Can Be Risky

It’s all about the trade-off. BDCs typically pay high yields on their dividends. But high yields also mean high risks. Investors need to understand that BDCs use a lot of leverage (borrowing money) to generate high yields. And when things go wrong, losses get amplified.

Another risk is the companies themselves in which the BDC invests. Many of these companies don’t make money, have erratic cash flow, and aren’t of investment grade. This makes them prime candidates for default. Interest rates also can affect BDCs, as high rates make more it more expensive to borrow money to invest (leverage, again).

Another thing to keep in mind: BDCs can cut or eliminate dividend payouts to investors.

And since BDCs are young investment products (most were created in the early 2000s), they don’t have long tracks records that prospective investors can research and analyze to make the best-informed decisions.

Should You Invest?

About 90 BDCs, which hold some $80 billion in assets, are available today to the public.

Most investors turn to BDCs because they can provide a steady stream of income, especially if they do their investing through individual retirement accounts (IRAs). If you have a Roth IRA that holds a BDC, you won’t have to pay any taxes when you sell it. Something to think about.

The largest BDC is Ares Capital Corp (ARCC), which has more than $7 billion in assets and pays a dividend yield of almost 9 percent. Or you can buy the VanEck Vectors BDC Income ETF, which gives investors broad exposure to the top BDCs.

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It’s clear that investing in BDCs is fraught with risk. They’re not for conservative investors looking for steady-eddy dividends year after year. But for those investors who do their homework and invest with their eyes wide open, BDCs can make a smart contribution to a well-diversified portfolio.