Business development companies (BDCs) are a special type of investment entity that makes investments in small to medium sized developing and distressed companies. They have features of publicly traded companies and closed-end investment vehicles. Many BDCs are publicly traded on a national stock exchange.

Investors may be attracted to invest in BDCs because of the numerous benefits they can potentially offer, including high dividend yields and tax advantages. They offer investors exposure to assets in various tiers of a private company’s capital structure, from senior secured debt to common stock. Different BDCs have different investment strategies and objectives.

BDCs are subject to strict regulations. They are registered and regulated under the Investment Company Act of 1940. Under Section 2(a)(48) of the Investment Company Act, a BDC is defined as a domestic closed-end company that operates for the purpose of making investments in certain securities. A BDC is required to invest at least 70% of its assets in “eligible portfolio company” securities. Eligible assets are defined to include (i) the securities of private companies that are not publicly listed on a national stock exchange or (ii) the securities of publicly traded companies that have less than $250 million in aggregate market value of outstanding common equity and satisfy other criteria.

Many BDCs elect to be treated as a Regulated Investment Company (RIC) under Subchapter M of the Internal Revenue Code. In order to qualify for RIC status, a BDC must distribute at least 90% of its net income to shareholders as dividends. This status provides tax benefits, including pass-through tax treatment of net income.

BDCs have a number of similarities to real estate investment trusts, or REITs. Like REITs, BDCs were created by Congress to promote capital investments in smaller U.S. companies. Also similar to REITs, BDCs provide potential tax benefits to investors. Both entity types avoid paying corporate level income tax if they pay out at least 90% of their net income to shareholders as dividends.

The Investment Company Act of 1940 imposes a number of restrictions on the activities of BDCs, including limitations on related party transactions. Under the Investment Company Act, an “affiliate” is defined as anyone that owns more than 5% of the BDC’s outstanding securities. Transactions with affiliates of the BDC, such as co-investments, will face heightened scrutiny.

Most BDCs operate by raising equity capital from institutional and accredited investors, and then using the equity capital raised to lend to companies at higher interest rates. For example, a BDC may provide a small or developing company with senior secured floating rate loans.

As a result of recent legislation, BDCs can take on increased leverage. The passage of the Small Business Credit Availability Act of 2018 permits BDCs to take on a 2-to-1 debt-to-equity ratio. Most BDCs maintain leverage ratios far below this maximum level.

A number of major investment firms manage BDCs. Examples of BDCs include Ares Capital Corporation, Main Street Capital Corporation, TriplePoint Venture Growth BDC, FS KKR Capital Corp, Blackstone Secured Lending Fund, and several entities managed by Blue Owl Capital.