The stock market is dominated by ultra-large businesses.
The smallest company in the S&P 500 based on market cap is Under Armour (UA), which is currently valued at $3.8 billion and has generated $5.68 billion in annual sales over its last 4 fiscal quarters.
While a $3.8 billion company may be small by the S&P 500’s standards, it’s a truly gigantic company by real-world standards.
Gigantic businesses are typically followed by many analysts, have top-flight management teams, and tend to execute well on average.
Smaller, non-publicly traded businesses on the other hand often have more room for improvement. There’s much more room for improvement in smaller businesses because they don’t have access to the same resources as much larger businesses.
But non-publicly traded business are not easy to invest in. They are, by definition, not available on any stock market.
And that’s where ‘alternate asset classes’ like private equity and BDCs come into play.
Private equity funds are set up as partnerships. The fund’s general partner manages the investment funds of its limited partners in exchange for a management fee. These funds are invested (in most cases) into non-publicly traded businesses selected by the fund’s general partner.
This gives the fund’s limited partners access to investment opportunities that would otherwise be unavailable. Private equity funds tend to invest in private businesses that are smaller than the typical publicly traded company.
Investments can be equity (buying ownership in a business) or debt (lending money). The private equity firm’s management team will typically seek to improve the operations of the companies in which they invest. By improving the businesses in which they invest, private equity firms can generate sizeable returns.
Like private equity firms, BDCs – short for Business Development Companies – make debt and/or equity investments into small and mid-sized non-publicly traded companies.
One of the areas where BDCs differ from private equity is in their legal structure. Business development companies are closed-end investment firms that choose top operate as a BDC.
The BDC form was created in 1980. The primary requirements for being registered as a BDC are for a firm to invest 70%+ of its assets into non-public companies worth $250 million or less, and to distribute 90%+ of income to investors.
If these requirements are followed, the BDC avoids “double taxation” and is not taxed at the corporate level. This makes them efficient vehicles for passing income to investors. Publicly traded BDCs typically have high dividend yields, which makes them appealing to many income-oriented investors.
Both private equity firms and BDCs typically employ debt to leverage returns. Leverage ‘super charges’ returns, but increases risk.
Individual investors don’t have access to the same quality of debt that private equity firms and BDCs have. Individual investors typically only have access to brokerage margin. Margin carries with it the risk of being ‘called away’ when your investments are down.
When you are forced to exit your positions when they are underperforming, you are forced to lock in leverage-amplified losses at the worst time.
The type of debt that institutional-level investment firms like private equity companies and BDCs employ tends to not have as strict of requirements as margin debt.
Additionally, in many cases, interest rates may be more favorable.
By investing through a private equity firm or BDC individual investors can gain access to the benefits of leveraged returns without incurring debt themselves.
Another area where private equity firms and BDCs differ significantly is liquidity. BDCs tend to be publicly traded, just like common stocks. As a result, they can be bought and sold easily.
In contrast, investing in private equity means becoming a limited partnership in a fund. There are often no redemption rights when investing in private equity. Your investment cannot easily be liquidated until the private equity fund has exited its positions and returns money to investors. This means a very long investment horizon.
There are pros and cons to being ‘forced’ to hold a private equity investment. When markets are down, it can be more comforting to not see the day-to-day value of your investment. Seeing a long string of ‘red days’ in the stock market can prove psychologically difficult and cause investors to sell at inopportune times.
Ultimately though, it’s more preferable to have a more liquid investment versus a less liquid investment because it gives the investor the option of when to sell and reinvest into other opportunities.
It is worth noting that there are some publicly traded private equity firms.
When you buy the stock of a private equity firm, you are investing in the actual underlying private equity business, not the investments the business makes.
As an example, an investor in a publicly traded private equity firm benefits when the firm generates more management fees from the investors in its funds. Fund investors, on the other hand, are worse off the more management fees are charged, all other things being equal.
A list of three of the largest publicly traded private equity firms is below:
In contrast, BDCs tend to be smaller. Five of the largest BDCs are listed below:
There are many significantly smaller BDCs as well. It’s not uncommon to find truly small cap BDCs with market caps of under $300 million.
Whether to invest into a private equity fund of BDC (or both) depends on what an investor is looking for. These investment opportunities both give exposure to smaller, non-publicly traded companies. And both typically employ leverage.
BDCs are more liquid, and are required to return the bulk of their income to investors. In practice, many BDCs pay monthly dividends, which can be appealing for income investors. The downside is that BDCs tend to produce very little in the way of capital gains since they distribute almost everything they make.
Private equity has the advantage of being more flexible into what they invest. Additionally, private equity firms have access to long-term capital since they are less liquid. The private equity industry is significantly larger than the BDC industry, so top-flight management may be more incentivized to be onboard a private equity firm.
Private equity also has the advantage of an exemplary long-term track record. As an asset class, it has outperformed the market over long periods of time. There is less research into the long-term track record of BDCs.