Professor Joseph Warburton: Business Development Companies Are Risky Investments for Consumers
New research by Professor A. Joseph Warburton, Professor of Law at Syracuse University College of Law and Professor of Finance at Syracuse University Martin J. Whitman School of Management, shows that consumer investments in Business Development Companies (BDCs) are at risk. The paper—“Venture Capital for Retail Investors”—was published in The Business Lawyer (Vol. 76, No. 1), a leading peer-reviewed business law journal.
A BDC is a type of investment company that finances small and growing American businesses. After raising capital in public markets, BDCs then fund companies considered too small or risky by traditional lenders. Many BDCs are open to retail investors and offer an alternative to private venture capital firms that are often out of reach. BDCs are favored by Congress, which excused them from key provisions of the regulations that govern mutual funds and other investment companies. BDCs are allowed, for example, to incur greater leverage through borrowed money.
Warburton’s research shows that BDCs live up to their reputation for paying high dividend yields to their investors and that their total returns—stock returns plus dividends—appear to match or beat the benchmark indices.
These high yields mean that BDCs are attractive to those seeking income in today’s low interest rate market, particularly among retirees or those about to retire. However, the study also finds that BDCs are risky investments. The average BDC incurs substantially greater risk than the market benchmarks and significantly underperforms the benchmarks once you take into account the extra risk.
“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, on average, over time,” says Warburton. “In other words, the typical BDC does not appropriately compensate investors for their risk. Investors would be better off putting their money in an index fund tracking high-yield bonds or leveraged loans.”
The performance of BDCs was significantly impacted by the COVID pandemic and subsequent market adjustment, explains Warburton. During March 2020, shares of publicly-traded BDCs declined by over three times as much as the benchmarks, on average.
“Many BDCs employ leverage, which amplifies broader market movements,” Warburton adds. “In addition, BDCs invest in small and mid-size businesses that were hit hard by the pandemic-induced shutdowns.”
The figure shows the performance of $10,000 invested in an index of publicly traded BDCs during 2020, compared to two market benchmarks (high yield bonds and leveraged loans). The $10,000 investment in BDCs was worth $9,115 at the end of 2020, versus $10,711 if invested in high yield bonds and $10,312 if invested in leveraged loans. BDCs were also more volatile over the year than the benchmarks, which themselves are among the riskiest parts of the fixed income market.
While Congress has championed BDCs as a way for small and mid-size businesses to obtain financing and grow, it has not analyzed whether BDCs are worthwhile investments for the public. Warburton recommends that “retail investors and their financial advisors should consider the paper’s findings before investing in publicly traded BDCs.
So, while their high dividend yields are attractive, BDCs are risky investment vehicles that can significantly underperform once you adjust for their greater risk-taking. “If you want to add a BDC to your portfolio, be sure to consider its track record because performance varies by BDC,” advises Warburton. “Avoid BDCs with a history of negative risk-adjusted performance.”