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New Paper Questions the Safety and Reward of Investing in Business Development Companies
A new paper by Syracuse University Professor Joseph Warburton offers compelling new evidence of the risk of business development companies (BDCs).
Warburton, who holds dual appointments as professor of law in the College of Law and professor of finance in the Whitman School, writes in the new Business Lawyer paper “Venture Capital for Retail Investors” that while BDCs may have attractive dividend yields, they are risky investments that significantly underperform market benchmarks.
“This paper is the first of its kind offering empirical evidence that BDCs are not the safe and fast way to grow your investments,” says Warburton. “The fact that many retail investors are encouraged to invest in BDCs due to their high dividends is worrisome, especially since BDCs are often seen as providing extra income for retirees or those living on a fixed income.”
Warburton writes in his paper that BDCs offer retail investors (e.g., nonprofessional investors) the allure of becoming venture capitalists by funding emerging enterprises with the help of professional asset managers. Congress created BDCs to encourage the public to finance American businesses that banks tend to overlook.
Warburton’s study finds that BDCs live up to their reputation for high dividend yields and their total returns (stock returns plus dividends) appear to match or beat the benchmarks.
“However, BDCs incur substantially greater risk than their benchmarks,” said Warburton. “They are highly leveraged and their performance is volatile. On a risk-adjusted basis, publicly-traded BDCs significantly underperform the benchmarks, trailing by more than four to six percentage points per year. In other words, BDCs do not appropriately compensate investors for the risk of a BDC. This study found that investors are better off putting their money in an index fund tracking high-yield bonds or leveraged loans.”
In his research, Warburton says that retail investors and their financial advisors should consider the paper’s findings before investing in publicly-traded BDCs.
“While their high dividend yields are attractive, BDCs are risky investment vehicles that significantly underperform once one accommodates for their greater riskiness. Investors should instead put their money in an index fund tracking high-yield bonds or leveraged loans,” says Warburton.
Warburton also recommends that Congress—which has been promoting BDCs as a vehicle for job creation and economic growth—should consider hard evidence whether they are valuable investment vehicles for the public. Warburton says that this paper contributes much-needed empirical evidence to that policy debate.
Reporters looking to interview Professor Warburton on this new research, please contact Ellen James Mbuqe, director of media relations at Syracuse University, at email@example.com or 412.496.0551.
Key Findings and Questions:
01What are BDCs?
A BDC is a type of investment company that finances small and growing American businesses. Many BDCs are open to retail investors. After raising capital in public markets, BDCs then fund companies considered too small or risky by traditional lenders. BDCs offer main street investors an alternative to private venture capital firms.
02Why do BDCs exist?
BDCs came into existence by an act of Congress in 1980 to encourage the flow of capital to businesses that traditionally have difficulty obtaining conventional financing. BDCs have largely stepped into a role that banks have vacated, becoming an important component of the financial system for small and mid-size businesses.
Investors in BDCs are attracted to the high dividends that BDCs pay. BDCs have become popular in today’s low-interest rate environment.
03How are BDCs regulated? How does it differ from regulation of traditional mutual funds and investment companies?
To protect investors, BDCs are regulated by the Investment Company Act of 1940, as are mutual funds and other investment companies. But Congress excused BDCs from key provisions of the regulations, in order to incentivize BDCs to fund small businesses and thereby promote job creation and economic growth. For instance, BDCs may engage in leverage, related-party transactions and illiquid investments more freely than other regulated funds.
04How do BDCs perform? Are BDCs worthwhile investments for the public?
The study finds that BDCs live up to their reputation for high dividend yields. Moreover, the total returns of BDCs (stock returns plus dividends) appear to match or beat the benchmark indices. However, BDCs incur substantially greater risk than their benchmarks. BDCs are highly leveraged and their performance is volatile. On a risk-adjusted basis, publicly-traded BDCs significantly underperform the benchmarks, trailing by more than four to six percentage points per year. In other words, BDCs do not appropriately compensate investors for the risk of a BDC. Investors are better off putting their money in an index fund tracking high-yield bonds or leveraged loans.
05How did BDCs perform during the early 2020 market crash related to the pandemic?
During March 2020, shares of publicly-traded BDCs declined by nearly four times as much as the benchmarks. Why did BDCs perform so poorly? BDCs invest in small businesses that were hit hard by the pandemic-induced shutdowns. In addition, many BDCs employ leverage, which amplifies broader market movements.