Private Credit ETFs 101: Business Development Companies
Unlock the secrets of Business Development Companies (BDCs), the foundational private credit assets now in ETFs. Go under the hood of BDC equity vs. fixed income to better understand the trade-offs before you allocate.
Private credit ETFs are a mixed bag. Their strategies can be index-based or actively managed. They can have assets ranging from business development companies (BDCs) and closed-end funds (CEFS) to direct private loans, collateralized loan obligations (CLOs), and others. Determining how much of your overall portfolio to potentially allocate to private credit and what asset mix to target is a tough equation. Investors and advisors really need to understand the assets that underpin each style of offering.
In my last article, Your Private Credit ETF Crash Course, I gave a basic overview of the current products available in the segment. Over the next few articles, we’re going to continue our education by going underneath to take a deeper look at the asset types themselves.
I’ll take you through each of them and what potential benefits and risks they bring to the table. After we’ve gone through all the assets, we’ll finish up with an article showing some basic examples of how these different ETF assets could be used in a portfolio. We’ll start with Business Development Companies.
Under the Hood of Business Development Companies (BDCs)
The name Business Development Company is more of a nom de guerre than reality. It doesn’t really describe what BDCs do. These “companies” are more akin to an investment fund or hedge fund than they are a traditional company. They don’t make anything, and they don’t provide any services to customers. Instead, they provide financing to middle market companies and generate their returns based on two broad segments, private equity stakes and private credit debt instruments.
Figure 1 - OFS Capital
Two separate pieces of government policy, one an amendment to the Investment Act of 19401 and one a change to the IRS tax code, are responsible for the creation of this financing market. BDCs are an offshoot of closed-end funds (CEFs) which we will discuss in the next article. The equity shares of BDCs are sold via IPO and invested across a very specific sector of private credit.
The first piece of government policy, the Small Business Investment Incentive Act of 1980, amended the Investment Act of 40 and mandated that these new BDCs invest at least 70% of their assets in private business and debt, later amended to include a market cap under $250mm in 20082.
The second piece of government policy was two updates to the IRS tax code subchapter M in 1986 and 2010. The first was the Tax Reform Act which allows BDCs to elect to be taxed as a Regulated Investment Company (RIC). This RIC structure lets BDCs operate in a tax-efficient way, avoiding double taxation on distributions to their investors. In order to qualify they have to distribute at least 90% of their taxable income, similar to Real Estate Investment Trusts (REITs).
In 2010, the RIC Modernization Act3 streamlined and standardized a slew of operational disparities and further enabled the development of the asset class.
The Ups and Downs of BDCs
BDCs and CEFs have an inherent advantage over their CLO brethren; they’re actively managed. The investment managers running BDCs keep a close eye on their portfolio companies and can sell off positions that no longer meet their requirements or have signs of distress.
Nearly all of the portfolio loans in BDCs are floating-rate. This makes them very susceptible to interest rate risk. Over the last year or so, the Federal Reserve has begun to lower rates from their post-COVID heights. This drop in benchmark rates lowers the cashflow of the BDCs and their current prices reflect that drop. After a number of very strong years of returns, BDCs have given back a hefty chunk of gains.
I also have to mention the recent public failures of a number of portfolio companies across various sectors of credit lending recently, most notably First Brands Group, Renovo Home Partners, and Tricolor Holdings. While most of these loans were in the syndicated market, a cousin of private credit arranged by banks, a few have impacted BDCs and other parts of the private credit market. I don’t mention this to scare anyone off but the companies being lent to by BDCs are, by definition, risky. Advisors and investors must be kept aware that the premia part of risk premia isn’t the only component!
Business Development Companies (BDCs) – Equity
BDC equities were the first private credit assets put into the ETF wrapper. Though the public narrative recently would have you believe that private credit is only now coming to ETFs, they’ve been available for over a decade in this form and have weathered macro credit cycles across a broad range of conditions.
The biggest advantage of BDC equity is its liquidity. These are publicly traded securities listed on major exchanges and have much deeper liquidity profiles than other options for private credit exposure. Being so easy to get in and out of is both a blessing and curse though.
Because of the relative illiquidity of the underlying loan portfolio market participants incorporate the assumed default rate, the current default rate, potential recovery rate, and a number of other factors into their market price. If credit sentiment is low, the share price of these BDCs usually trade well below their net asset value (NAV), negating some of the magic associated with private credit. In reality, that “magic” is just illiquidity that masks potential hiccups. If those hiccups stack up high enough, the loans in the portfolio can be marked down quickly.
So is this discount an opportunity or a risk? I think it can be both. These discounts do represent a market skepticism about current portfolio valuations but if a manager is confident in the portfolio companies, they get access to those cashflows under NAV which juices returns.
One other major factor for BDC equity products versus BDC fixed income products is the fees. BDC equity products can come tagged with what look like incredibly high total expense ratios. However, these are a bit of an illusion as the SEC requires funds to disclose the fees of BDCs as if they were being paid by the ETF investor. These fees are baked into the distributions and come out of the income before passing through.
That’s not to say that these fees are low. They usually cost 1-2% of assets and have a 15-20% fee once a minimum income rate (called the hurdle rate) is met. Complicating things further is there are catch-up clauses in some of these BDCs that allow the manager to receive 100% of the income between a certain amount until they’ve recouped the “lost” fees of the initial hurdle rate. If this seems confusing, don’t worry. It is.
What does it all mean? It means that the returns for BDC equity tend to compress very quickly when rates drop because the fee structure favors the managers. We’ve seen this play out recently as the Federal Reserve has begun to lower rates following the post-COVID hikes.
Business Development Companies – Fixed Income
We talked above about the equity shares of BDCs but that’s not the only way that they can raise capital for investment. They can also issue debt via bonds. In a similar relationship to what you see in traditional public market equity versus public market debt fixed income, investors give up their equity return profile in exchange for a less volatile, more protected, and less leveraged exposure to the private credit markets.
BDC bonds are almost entirely fixed-rate instead of the floating-rate debt carried by the portfolio companies. While they do have a risk premia that pays well above comparable investment grade public credit (usually 100-200bps), they are a much steadier income stream compared to the equity side.
Figure 2 - Loomis Sayles
This area has exploded in popularity over the last few years. Issuance has grown past $50B as the industry boomed during the COVID pandemic. Prior to this growth, the segment probably wasn’t big enough to sustain the potential needs of an ETF. Due to the analytical requirements to track the portfolio company credits across such a large range of BDCs, these are research-intensive products that most advisors and retail investors are unlikely to have even heard of, let alone have the operational wherewithal to add to their portfolio. Compared to the equity side, PM/fund managers have the additional burden of keeping the covenants, potential callability, and asset coverage models straight.
What are the major risks for these bond products? There are a few. These issuances tend to have a shorter maturity than most corporate bonds. This means constant refinancing and higher interest rate exposure. If a huge swath of BDCs need to roll their debt in a tight window, as they will in 2026 and 2027, and benchmark rates have dropped it’ll lower the yield of the overall ETF portfolio quickly.
There is also a structural difference in credit exposure. The bonds are also dependent on the BDC’s ability to service its debt, not the underlying credit, which has a different default and risk profile.
Last but definitely not least is that BDC bonds are still a niche market. Total issuance in 2024 was over $20B4 which is a marked increase over prior years but still pales in comparison to other markets. REITs, which are also a fairly small market, raised ~$73B in 2024. This small total addressable market (TAM) means it can be tough to get in or out of positions, particularly in a stressed or volatile market. This leads to wider spreads and potential tie-ups in liquidity.
So Which One is Better?
Don’t worry, we’re not going to play that game.
Both of these product types give investors the ability to access private markets in ETF format. BDC equities offer a potentially higher yield upside but are far more volatile and sensitive to NAV dislocation. The higher potential yield compensates investors for taking a position lower on the seniority in the capital structure.
BDC fixed income ETFs offer up the top of the capital structure and gives up the higher potential upside. Investors still collect a premium versus investment grade products. Regardless of which you pick, it’s important to remember that you are still dependent on the same underlying middle-market credit and credit risk. This part of the market is very exposed to interest rate risk and also serves as a bellweather for the junkier parts of the credit market.
Rate cuts are being priced in by most market participants over the next 18 months which could substantially impact both varieties of BDC products. On the other hand, if inflation picks up and the Fed moves through to a cycle of hiking, the opposite could be true. These investments require consideration and understanding so don’t assume that past performance will ever be indicative of future returns.
In the next article, I’ll dive into CLOs and do a similar analysis and breakdown of how those products work. Please remember to assess your risk tolerances and if you’re unsure of how to proceed, contact an investment professional.
Footnotes
1 - https://www.congress.gov/bill/96th-congress/house-bill/8123
2 - This 250mm requirement was added by the SEC in 2008 (Rule 2a-46). https://www.sec.gov/info/smallbus/secg/rule2a-46-secg.htm
3 - https://www.congress.gov/bill/111th-congress/house-bill/4337
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