Private equity has always had a great appeal to investors, as returns in this industry have historically outperformed those of financial markets and other investments. The National Venture Capital Association reported the following data on private equity returns:
It shows a better performance than public equities on a risk-adjusted basis too, confirming private equity’s potential and profitability.
Unfortunately, only a limited number of investors can afford to enter this market. In fact, private equity funds are often structured as private rather than public companies. This means the funds are only available to high net worth individuals called “limited partners” and active investment managers called “general partners” that contribute respectively quantitatively and qualitatively to the management of the fund.
This has to do with the nature of private equity, which consists mainly of large-scale investments in growth industries aimed at having a direct impact on the governance and on the business model of the acquired firms. The capital gains from private equity investments are mostly received in the long run with the exit from the firm’s capital, to be executed through an IPO, a trade sale, a secondary buyout or a leveraged recapitalisation.
These funds are therefore not open to individual investors, who do not have the means to contribute to the investments and cannot bear the risk of long holding periods.
A similar business model can be found in the so-called Business Development Companies (BDCs), organisations that invest in small-medium sized firms through equity, debt and hybrid financial instruments. BDCs typically operate in the US middle market, covering the segment left aside by investment banks, which require larger capital transactions and are subject to stricter regulations regarding leverage.
These closed-end investment companies started to become popular after the Small Business Incentive Act of 1980, and are officially classified as Regulated Investment Companies (RICs). This fact alone constitutes a big incentive to invest in BDCs, as RICs are exempt from corporate taxes if they distribute at least 90% of their earning to shareholders. This is directly reflected in their dividend yield ratio, which ranges on average from 10% to 15%.
Given these similarities between PE and BDC, two major differences need to be highlighted: BDCs are often publicly traded on the US stock market and, contrary to PE, BDCs’ investments are channelled mainly through traditional or mezzanine debt, in order to provide a shorter-term and more liquid investment strategy.
For these reasons, BDCs are considered a more suitable asset for private investors. It allows them to achieve returns comparable to those of PE funds while avoiding the barriers of the minimum investment requirement. It means they are made available to a wider public.
As commonly said in Wall Street, “there’s no such thing as a free lunch” in financial markets, so investors must be aware of the risks that they bear when investing in these companies.
BDCs promise sky-high dividends due to their tax benefits and the unique positioning in the US middle market, but this comes with considerable risks.
Although BDCs listed in the stock market might seem liquid at first glance, investors should be aware that they invest in risky and illiquid assets. During a period of crisis, these underlying assets are the first ones to be sold, endangering the liquidity of the BDC itself. Furthermore, the valuation of these assets is the result of an accounting estimate, not of an actual market value.