If you’ve been tempted to buy alternative investments you may run across the option of putting your money into a Business Development Company (BDC) but after you read this I hope you’ll decide to just stay clear.
What are BDCs and what is the appeal?
“BDC” is an abbreviation for “Business Development Company”. When you invest in a BDC, you provide capital to small growing companies. In exchange for your cash investment you own equity and debt. Sometimes the debt is secured. Other times it’s not and no different from junk bonds.
Why do people invest in BDCs?
Like REIT investing, people buy BDCs because they are desperate to earn more interest than what is otherwise available. The yields on Business Development Companies can be as high as 7%. And that high interest coupled with the opportunity for equity growth is attracting many investors – especially those trying to maximize retirement income.
Last year BDC’s gathered $1.5 billion in assets which was more than 3 times the 2010 level and 15 times sales in 2009. That has regulators worried. FINRA is rumored to be about ready to release an investor advisory statement very soon warning investors about these investments.
What are the problems with BDCs?
1. Illiquid.
These investments are not traded. That means it will be tough for an investor to get her money out of the investment if she needs the money before the sponsor of the program is ready to sell. Basically, investors are stuck.
2. Pricing
Since these investments are not publicly traded, nobody really knows what the values are. I am not against all illiquid investments. Real estate is illiquid and I think it’s a great time to buy property. But it’s not hard to know what the value of a property is. You can see what other similar properties are selling for and/or you can estimate the value based on the rental income the property generates.
BDCs are another story. These are equity investments in small companies that may be difficult for you to evaluate. That’s why only “sophisticated investors” are allowed to invest. But those qualifications are very lax. You only have to have income of $75,000 and a net worth of over $250,000 in order to be considered a qualified investor.
That is certainly a respectable income and net worth level. But it doesn’t mean that just because you qualify you have the ability to evaluate the investment appropriately. I know people with 10 times those income and net worth figures who couldn’t do so.
3. Fees and Commissions
Every deal is different of course but typically deals like these have sky-high fees. You’d have to read the prospectus in order to know the particulars of your deal. But the commissions for BDCs are typically in the range of 7%. That’s kind of steep for me.
4. Bubble
The final nail in the coffin is the irrational exuberance investors are showing as evidence by the explosive growth in dollars flowing to these deals.
Over the last 28 years I’ve spent in this business I have seen countless “can’t miss” ideas come and go. This is a very complicated investment with lots of variables moving behind the scenes. Investors will find it hard to understand these propositions and even harder to track the progress the companies are making.
In my opinion, this is an investment to just say no to. How do you stand on BDCs?
Neal says
May 24, 2012 at 9:15 AMI would never buy a REIT – the fees are ridiculous and you have no control. NO THANKS!
If possible, look for friends/family that you trust and respect in other areas. There are companies that do this but I am leery of them too. I was fortunate to find a very close friend who has a real estate company in Florida and I am doing business with him. I don’t think I’d do this blindly.
I do pay a lot to have it managed but I never get phone calls….just checks! Nice.
Mark says
May 24, 2012 at 8:53 AMYeah I also looked into a BDC investment for a friend and found that the lack of liquidity and high fees made it something that was not a worthwhile investment.
I know you’ve been mentioning real estate a lot lately but only in certain areas of the country. I’m right there with you and would love to own positive cash-flow properties somewhere in the midwest/southwest/southeast where this is possible, but I live in the northeast where it’s nearly impossible to find a positive cash-flow property. Any ideas for an investor that lives in a high-cost area to find these kind of investments (due to the distance, I would obviously pay a company to manage the properties), or am I better off just owning REITs?