What Are Business Development Companies (BDCs) and How Do You Analyze Them?

If you have just completed the previous page on REITs, you already know one way of generating passive income through listed property.

At this new stage of the Cashflow journey, we will explore a lesser-known asset class: Business Development Companies (BDCs).

BDCs allow us to broaden our strategy to a source of income beyond property and continue the progressive diversification of our cash flow.

This type of asset generally offers high dividends, but also has particular characteristics and risks that we need to understand before investing.

What is a Business Development Company (BDC)?

These businesses generally belong to what is known as the middle market and may use BDCs to finance growth, acquisitions, refinancing or other capital needs.

For the investor, BDCs provide a way to gain exposure to this segment of the private market through publicly traded companies.

Why do BDCs exist?

BDCs emerged in the United States in 1980 to make capital more accessible to small and medium-sized businesses, while allowing investors to participate in this market through regulated, listed companies.

This made a segment traditionally dominated by banks, private funds and institutional investors more accessible to individual investors.

How does a Business Development Company work?

A BDC finances different businesses and earns income mainly from interest on the loans it provides. This interest is its principal source of revenue.

Finances businesses

→

Receives interest

→

Distributes dividends

Some BDCs may also invest directly in the equity of the businesses they finance or receive warrants, meaning rights that allow them to acquire shares in these companies under certain conditions and benefit from their potential growth.

After covering their expenses and financing costs, they can distribute a significant share of the income generated to shareholders as dividends.

Why do BDCs pay such high dividends?

One of the main reasons is their tax structure. Most BDCs operate under a regime requiring them to distribute at least 90% of their taxable income to retain certain tax advantages.

This partly explains why BDCs generally distribute a high proportion of their profits to shareholders.

Their high dividends also have another explanation: the businesses they finance generally carry greater credit risk than large listed companies. In return for this risk, BDCs can charge higher interest rates on their loans.

A high dividend paid by a BDC should therefore not automatically be interpreted as an advantage. It also reflects the level of risk assumed to generate that income.

Advantages and disadvantages of investing in BDCs

Investing in BDCs can be very interesting for those seeking regular income, but it is also important to understand the risks.

Advantages

High dividends

BDCs generally offer higher dividend yields than many other income-producing assets.

They can sometimes reach double-digit levels, although a higher dividend is also generally associated with a higher level of risk.

Access to private credit

Private credit is traditionally dominated by banks, specialist funds and institutional investors.

BDCs allow individual investors to gain exposure to this market simply through publicly traded shares.

Floating-rate loans

Many BDCs make a significant share of their loans at floating rates, meaning that the interest charged can change in line with market reference rates.

When rates rise, these loans can produce more interest income. However, this effect must be analysed in the context of the BDC’s own financing costs and the borrowers’ ability to bear higher interest.

Portfolio diversification

A BDC may finance dozens or even hundreds of businesses in different sectors.

This provides exposure to a broad portfolio through a single investment, although the actual level of concentration by company and sector should always be checked.

Disadvantages and risks

Credit risk

The businesses financed by BDCs generally carry greater credit risk than large, well-established companies.

There is therefore a higher probability that some of them will have difficulty paying interest or repaying their loans. This risk forms part of the business model and helps explain the higher interest rates BDCs can charge.

Sensitivity to the economic cycle

Small and medium-sized businesses can be more vulnerable during economic slowdowns.

A deterioration in their financial condition can increase defaults and reduce the BDC’s income, which may also affect its dividends.

Asset valuation

Many of the businesses and loans in a BDC’s portfolio are not traded on public markets. A market price is therefore not always available.

Their valuation requires periodic estimates of fair value, which introduces more uncertainty than for assets with observable market prices.

Possible dilution

BDCs may issue new shares to raise capital and finance new investments.

If the number of shares increases without proportional growth in the value created, each shareholder’s economic interest may decline. We must therefore assess whether management uses these issues with discipline.

Types of BDC investment and levels of risk

A BDC’s cash flow comes mainly from the investments made in the businesses it finances. These investments can take different forms, ranging from loans with high repayment priority to equity interests in the businesses.

Each has a different level of risk, repayment priority and potential return.

To understand this logic, we can imagine the order of repayment when a company encounters financial difficulties: the higher the priority for recovering the money and the stronger the collateral, the lower the risk generally is. As we move down this structure, the risk of loss increases, but the potential return may also rise.

These are the main categories that may appear in a BDC’s portfolio:

These loans are secured by the company’s assets, such as machinery, inventory, property or trade receivables.

They are among the investments with the highest repayment priority. This category includes first-lien and second-lien loans, according to their ranking over the collateral.

The BDC generates income from the interest paid by the borrowing company. In the event of default, the collateral may be used to try to recover part of the capital.

Because they have greater priority and protection, they generally form the most defensive part of a BDC’s portfolio.

Subordinated debt ranks behind senior debt in the order of repayment. If the company encounters difficulties, creditors with higher priority must therefore be repaid first.

To compensate for this additional risk, these loans generally pay higher interest.

Subordinated debt can increase the income generated by the portfolio, but also entails a greater risk of loss in the event of default.

Mezzanine financing occupies an intermediate position between traditional debt and company equity.

It generally combines relatively high interest with the possibility of participating in the company’s growth. In addition to the loan, the BDC may, for example, receive warrants, the rights we have already discussed that allow it to acquire shares under certain conditions.

The BDC can therefore receive interest and, in some cases, additional gains if the value of the company increases.

In exchange for this higher potential return, the risk is generally greater than for senior secured loans.

In addition to providing loans, some BDCs may hold small equity interests in the businesses they finance or receive warrants as part of a transaction.

Unlike loans, these investments do not generate income mainly through interest. Their return depends primarily on an increase in the company’s value and may be realised, for example, if the company grows, is acquired or goes public.

These positions rank below debt when the company encounters difficulties. They therefore carry a greater risk of loss.

However, they also offer greater capital-appreciation potential if the financed company performs well.

Why does portfolio composition matter?

Understanding which types of investment predominate in a BDC is fundamental to assessing its level of risk and the sustainability of its income correctly.

A portfolio concentrated mainly in senior secured loans generally has a more defensive profile. Conversely, greater exposure to subordinated debt, mezzanine financing or equity interests may increase potential returns, but also the risk of losses.

How do you analyse a BDC step by step?

As with dividend stocks and REITs, we will use the same fundamental-analysis structure: quantitative analysis, valuation and qualitative analysis.

The method remains the same, but the particular measures and risks change according to the asset class.

Quantitative analysis of a BDC

Quantitative analysis uses financial data to assess a BDC’s ability to generate income, maintain its dividends and control the risk in its loan portfolio.

For this purpose, we will use certain measures specific to BDCs.

NII (Net Investment Income)

Definition: NII is the income generated by the BDC’s investments after the expenses related to its activities have been deducted.

Most of this income comes from interest received on the loans in the portfolio.

Simplified formula

We can also analyse NII per share, which indicates how much of this income corresponds to each BDC share.

Interpretation: stable or growing NII per share indicates that the BDC maintains a good ability to generate income. Conversely, a prolonged decline may eventually reduce its ability to maintain or increase the dividend.

Portfolio Yield

Definition: Portfolio Yield indicates the average return generated by the loans in a BDC’s portfolio.

For example, a Portfolio Yield of 10% means, in simplified terms, that its loan portfolio generates an annual return close to 10%.

Interpretation: a high yield can help generate more income, but may also be associated with riskier loans.

A higher Portfolio Yield therefore does not necessarily mean that the portfolio is better. We need to analyse it alongside loan quality.

Dividend Coverage Ratio

Definition: this ratio checks whether the NII generated by the BDC is sufficient to cover the dividends distributed to shareholders.

Formula

Indicative range

1.10× → Good coverage

1.00× to 1.10× → Dividend covered, but with a smaller margin

Below 1.00× → NII does not fully cover the dividend

Example: a ratio of 1.10× means that the BDC generates approximately USD 1.10 of NII for every dollar distributed as dividends.

Interpretation: better coverage provides a greater margin for maintaining the dividend if income falls temporarily.

One quarter below 1× does not necessarily indicate a problem. The main point is to check whether the BDC covers its dividend sustainably over time.

NAV per share and NAV growth

Definition: NAV, or Net Asset Value, represents the value of the BDC’s assets after deducting its debt and other obligations.

In simple terms, we can understand it as the BDC’s net value. NAV per share indicates the portion of this value corresponding to each share.

Simplified formula

Indicative range

Sustained growth → Positive signal

Stability → Preservation of value

Prolonged decline → Requires deeper analysis

Interpretation: changes in NAV per share show whether the BDC is preserving or increasing the value of its portfolio over time.

A persistent decline may indicate losses on certain investments, deterioration in the portfolio or decisions that destroy value for shareholders.

We should therefore examine the long-term trend in NAV per share rather than a single quarter.

Non-Accrual Loans

Definition: Non-Accrual Loans are loans with significant collection problems on which the BDC has normally stopped recognising interest as income.

In simple terms, they identify the share of the portfolio experiencing credit problems.

Indicative range

Below 1% → Low level

1% to 3% → Level to monitor

3% → More significant portfolio deterioration

Interpretation: a low and stable level generally indicates a healthy portfolio.

Conversely, an increase in Non-Accrual Loans may signal that more financed businesses are having difficulty repaying their debt, increasing the BDC’s risk of losses.

In addition to the current level, we need to check whether these problem loans are increasing or decreasing over time.

Debt-to-Equity Ratio

Definition: the Debt-to-Equity Ratio measures the debt used by the BDC relative to its own capital.

Formula

For example, a ratio of 1.0× means that the BDC uses approximately USD 1 of debt for every dollar of shareholders’ equity.

BDCs use debt to increase the capital available for new investments. This mechanism is called leverage.

Indicative range

Below 1.0× → Moderate leverage

1.0× to 1.25× → Typical level for many BDCs

1.25× to 1.50× → Higher leverage

1.50× → Requires greater attention

Interpretation: leverage can increase profits when investments perform well, but also magnifies losses when problems arise.

We should therefore look for a controlled level of debt and also analyse how it changes over time.

What are we looking for overall?

No measure should be analysed in isolation. Each one answers a different question:

• Portfolio Yield → What return does the portfolio generate?
• NII → How much income does the BDC generate?
• Dividend coverage → Is that income sufficient to cover the dividend?
• Non-Accrual Loans → What share of the portfolio is experiencing problems?
• NAV per share → Is the BDC preserving its value?
• Debt-to-Equity → How much leverage does it use?

The objective is to find a BDC capable of generating enough income to maintain its dividends without progressively degrading its portfolio or assuming an excessive level of risk.

How do you value a BDC?

As we have seen, a good company is not always a good investment if we pay too high a price.

For a BDC, we can analyse valuation from three angles: the value of its portfolio, the income it generates and the dividends it distributes.

For this purpose, we will use several complementary ratios.

P/NAV (Price / Net Asset Value)

Definition: P/NAV compares the share price with NAV per share.

As we have seen, NAV is the net value of the BDC’s assets after deducting its obligations. This ratio therefore shows how much we are paying relative to the net value of its portfolio.

Formula

Indicative range

Below 1.0× → Trades at a discount to NAV

Around 1.0× → Trades close to NAV

Above 1.0× → Trades at a premium to NAV

Example: if a BDC trades at USD 18 and has NAV of USD 20 per share, its P/NAV is USD 18 / USD 20 = 0.90×. The share therefore trades approximately 10% below its NAV.

Interpretation: BDCs with a good track record, strong portfolio and respected management can often trade at a premium to NAV. Others may trade at a discount when the market has lower expectations for the quality or development of their portfolio.

In addition to the current level, it is therefore particularly useful to compare P/NAV with its own history and with similar BDCs.

NII Yield

Definition: NII Yield relates the NII generated per share to the BDC’s current share price.

In simple terms, it indicates how much income the BDC generates for each dollar paid for its share.

Formula

Example: if a BDC generates USD 2 of annual NII per share and trades at USD 20, its NII Yield is USD 2 / USD 20 × 100 = 10%. The BDC therefore generates NII equivalent to 10% of its current share price.

Indicative range

Higher NII Yield → Greater income generation relative to price

Lower NII Yield → More demanding valuation

Interpretation: NII Yield allows us to compare the valuation of different BDCs according to their ability to generate income.

It is also useful for observing how the valuation of the same BDC changes over time.

Relationship with P/NII

NII Yield is the mathematical inverse of P/NII:

Both express the same relationship from different perspectives. We therefore do not need to analyse them separately.

Dividend Yield

Definition: Dividend Yield indicates how much a BDC pays in dividends each year relative to its current share price.

Unlike NII Yield, here we are not measuring what the BDC generates, but what it actually distributes to the shareholder.

Formula

Example: if a BDC distributes USD 2 per share each year and trades at USD 20, its Dividend Yield is USD 2 / USD 20 × 100 = 10%. This represents a dividend yield of 10% at the current share price.

Interpretation: in a strategy focused on generating passive income, this measure directly shows the yield offered by the dividend at the current price.

However, we need to consider it alongside the Dividend Coverage Ratio discussed earlier. It is not enough to know how much a BDC pays; we also need to check that it generates sufficient income to maintain those payments.

How do you combine these ratios?

Each ratio answers a different question:

• P/NAV → How much are we paying relative to the portfolio’s net value?
• NII Yield → How much income does the BDC generate relative to the price paid?
• Dividend Yield → How much dividend do we receive relative to the price paid?

Using them together provides a more complete view than relying on a single measure.

We should also compare the current valuation with the BDC’s own history and other BDCs with comparable characteristics because they do not all deserve to trade at the same multiples.

A BDC may show a large discount, high NII Yield or attractive Dividend Yield because its share price has fallen. This may represent an opportunity, but may also reflect genuine problems within the company.

Valuation therefore shows the price we pay. Fundamental analysis helps us determine the quality we are buying at that price.

Qualitative analysis of a BDC

Qualitative analysis helps us understand how decisions are made within a BDC beyond the financial ratios.

Because its business consists mainly of lending money, Scale & Own will focus on four essential areas: who manages the capital, how the financed businesses are selected, how risk is distributed and what results have been achieved over time.

Management and management model

BDCs can be managed internally or externally.

In an internally managed BDC, the management team works directly for the company. In an externally managed BDC, a specialist company administers the investments in exchange for fees.

External management can provide the experience and network of large private-credit managers, while internal management avoids dependence on an outside manager and its fee structure.

What should we analyse?

Beyond the model alone, we need to examine the management team’s track record, its costs and its alignment with shareholders.

We can also check skin in the game, meaning the amount of personal capital that executives or managers keep invested in the BDC.

Origination and credit analysis

Origination is the process through which a BDC finds and selects the businesses it will finance.

A strong origination network gives the BDC access to more opportunities and allows it to be more selective. The team must then determine whether each business will be able to repay the funds and whether the proposed return compensates for the risk assumed.

What should we analyse?

We want to check the manager’s track record in selecting loans and its ability to avoid significant losses.

The logic is simple: lending money at 15% may appear attractive, but that return is of little use if the company cannot ultimately repay the capital.

Portfolio composition and diversification

The portfolio’s composition shows the level of risk assumed by the BDC and how it distributes that risk.

As we have seen, a greater proportion of senior secured loans generally provides a more defensive profile than high exposure to subordinated debt, mezzanine financing or equity interests.

What should we analyse?

We need to examine the weight of each type of investment, the distribution across sectors and the concentration among the largest borrowers.

Holding 100 loans does not necessarily mean that the portfolio is well diversified if a significant share depends on the same sector or a small number of companies.

Track record during difficult periods

Periods of crisis show how a BDC actually manages credit problems.

To evaluate this, we can examine changes during previous crises in measures we already know, including NAV, Non-Accrual Loans and the dividend.

What should we analyse?

We are not looking for a BDC that has never had problem loans. We need to check how the management team responded when they arose and whether it managed to limit losses and preserve value for shareholders.

In our Cashflow strategy, we seek to generate high income while keeping risk under control.

Analyse BDCs with HRStock.io

HRStock.io

Turn data into a clearer decision.

HRStock centralises the data that genuinely matters when analysing a BDC and making decisions with greater clarity and discernment.

• Financial history
• Essential indicators
• Company comparison

Explore HRStock

Designed to analyse companies from a long-term perspective.

Some well-known BDCs

Many BDCs are listed in the United States. Here are some of the best known that you can use as a starting point for putting the analysis we have just learned into practice:

BDC	Ticker
Ares Capital Corporation	ARCC
Main Street Capital Corporation	MAIN
Blue Owl Capital Corporation	OBDC
Hercules Capital	HTGC
Blackstone Secured Lending Fund	BXSL
Sixth Street Specialty Lending	TSLX

The next stage of the Cashflow journey

So far, we have explored different assets for diversifying our sources of passive income: dividend stocks, REITs and BDCs.

At the next stage, we will cover bonds, a generally more defensive category that can provide stability and diversification to a portfolio.

Although they do not necessarily need to occupy a central place in every Cashflow strategy, understanding how they work will allow us to decide when it may be appropriate to add them and what role they can play in a portfolio.

Continue to the next stage: Bonds

→

• Definition of BDCs
• How does a BDC work?
• Advantages and disadvantages
• Types of BDC investment
• How to analyse a BDC
• Quantitative analysis of a BDC
• How to value a BDC
• Qualitative analysis of a BDC
• Well-known BDCs
• Next stage of the Cashflow journey