Understanding BDC Investing with CFO Henri Steenkamp

Business Development Companies, while potentially offering eye-opening investment opportunities, should be examined with eyes wide open as well.

They present a wonderful risk-adjusted scenario, but any good investor should want to understand this model inside and out. It is essential for an investor to be selective before aligning oneself with such entities.

So what, exactly, are BDCs?

They are closed-end investment companies that finance small businesses -- businesses that are not big enough for Wall Street banks, yet too small or complicated for local banks or other lenders.
BDCs like Saratoga Investment Corporation, for which Henri Steenkamp operates as its CFO, operate in much the same way as venture capital or private equity firms do: They raise funds from investors and offer loans or investments to companies that are looking to grow. Where BDCs differ with VC or PE firms is that they are publicly listed on stock exchanges and as a result can be accessed by any investor who so chooses. And very importantly, they pay out all their earnings quarterly, in the form of dividends.
This offers a potential windfall for investors -- witness that the monthly dividend to those investing in BDCs stood at 9.7 percent in mid-2018, as compared to 2.5 percent for S&P 500 companies -- as well as a potential boost to companies looking to get on their feet.

That tends to be a lengthy list, as some 40 percent of new businesses fail within their first five years of operation, a whopping 96 percent within the first 10 years. So yes, there is risk here. These are loans to companies that are small and growing, and often unproven. And so when you invest in a BDC, you are investing in the ability of a BDC’s management team to underwrite strong credits.

Henri Steenkamp writes that BDCs are also well-positioned to help with those companies in the vast middle market -- a sector comprised of some 200,000 private businesses, accounting for 33 percent of the Gross Domestic Product (GDP) -- that are forever looking to grow.

That’s because, Steenkamp points out, that while banks are limited by certain requirements and regulations, BDCs face no such restrictions.

BDCs came about in 1980, when Congress amended the Investment Company Act of 1940, which had been enacted in the wake of the Great Depression. There are 92 BDCs in the United States. The industry had increased tenfold over the previous decade.

One BDC owner, John Daniel, writing for Forbes, went so far as to say that such a company is not unlike “a really good friend who hangs around your circle of friends (but not all the time),” with whom “you have great talks and a lot of fun.”

And who will write you a check every now and then, with the expectation that you will always pay him back -- with interest.

Others have referred to BDCs as “jockey bets,” since the manager has considerable influence over how profitable the arrangement might turn out to be. Determining how good or bad a manager might be is difficult, and central to whether an investor might want to get involved in a BDC. As an investor, picking your manager is critical.

There are, in fact, two types of BDCs -- those that are externally managed (which are far more common), and those that are internally managed. The benefit is that an externally managed BDC offers greater access to potential customers and deals.

The bottom line when investing in a BDC, then, is to be informed and be selective. And as Henri Steenkamp points out, that cuts both ways: A business owner must be cautious about aligning him or herself with a BDC, but the converse is also true: An investor must do his or her due diligence before taking the plunge with any BDC.