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BDCs: An Untapped Tool for Local Investing?

Michael Sauvante | February 15, 2016

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Take a look at this Presidential signing statement“This new law will facilitate the financing of small businesses by providing needed reform of the Federal securities laws. Small businesses are essential to economic growth and to innovation. No effort is more difficult for small businesses or more crucial to their success than raising investment capital. This legislation will provide a new statutory framework to streamline legal structures and encourage venture capital to invest in small businesses.”

President Obama’s signing statement for the 2012 JOBS Act authorizing crowdfunding? Actually, no. It was President Jimmy Carter signing the little-known Small Business Investment Incentive Act of 1980, enabling a new kind of venture capital-like entity called a Business Development Company (BDC).

BDCs are publicly traded entities that invest in small and mid-sized businesses. They may not be well known, but BDCs are emerging as one of the most powerful tools available for Main Street investment.

Why Should Local Investors Care?

Because BDCs are probably the best vehicle for financially supporting local small businesses ever invented.

First, in contrast to traditional venture funds, BDCs are allowed to lend as well as invest, thereby greatly increasing the ways in which they can fund small businesses through capital, credit or a mix.

Second, BDCs democratize venture capital. They are typically public companies owned by the general public, rather than private companies owned by wealthy investors. Anyone can buy shares in the BDC (through an  IPO or other public offering). The BDC then invests that money in (or lends to) small businesses. That means BDC investors can subsequently buy and sell their shares anytime they want on the stock market. Investors in a traditional VC fund can have their money tied up for a decade or more—perhaps not a problem for the wealthy, but most of us can’t risk locking up our money that long.

Source: Commonwealth Group
Source: Commonwealth Group

Third, BDCs are similar to mutual funds in that they serve as a collective investment vehicle for diversifying investments over a large number of businesses.  However, while mutual funds invest their money in publicly traded companies, BDCs invest in small and mid-sized private businesses (or very small public ones). Investors can spread their risk over many small companies, even directing that money down to their local communities.

In contrast to venture capital firms, which are only interested in investing in high-growth companies (so they can sell them for a profit), BDCs can provide access to both capital and credit for a much wider spectrum of companies that includes startups, growth and even mature small and mid-size businesses. And no company ever has to be sold for investors to realize a profit. Companies may remain under the umbrella of the BDC forever, without being forced out or sold off to another company (the normal path for VC-funded companies).

Organizers of a BDC can elect to pursue a profit extraction model, a capital appreciation model or some mix of both. The profit extraction model would translate to maximizing dividends to shareholders and is the preferred approach of most Wall Street BDCs. That may be good for shareholders but is probably not the best model for a community-oriented BDC, as that model would pull money out of the local community, the opposite objective of most local investment movements. Instead, the capital appreciation model more closely aligns with such goals and results in maximizing the retention of resources and benefits to the whole community.

Better than Crowdfunding

BDCs represent a superior alternative for small business fundraising. Better in fact, than even the most idealized version of crowdfunding. Crowdfunding only solves one of two problems related to investing in small businesses: It helps to raise funds but doesn’t solve investors’ liquidity needs after the investment (i.e., get your money out when you need to). A BDC’s investors, on the other hand, can sell their shares at any time. Investors are also able to diversify their risk across a portfolio of investments.

These benefits make the BDC an ideal structure for community venture funds, allowing them to provide capital to a substantial number, and wide variety, of companies up and down Main Street. And BDCs align the interests of investors and the companies receiving investment better than any other way of investing in small companies, as this matrix shows.

Health and Quality of BDC Portfolio Companies

The laws governing BDCs require them to make available management support to their portfolio companies. As anyone familiar with the small business world knows, starting a standalone (not franchise) small business is usually a sink or swim proposition. And most sink—the five-year survival rate for small startup companies hovers around 20 percent.

Startups and other companies under a BDCs umbrella, however, have access to tools, resources and expertise that help them thrive. In addition to high quality handholding, BDCs can offer shared resources like accounting, payroll, tax and legal help, along with group insurance plans, and creative services like graphic design, marketing and more. Imagine the quality of a group of local businesses with access to that kind of support, as well as the money BDCs can provide!

If BDCs are So Great, Why Haven’t I Heard of Them?

BDCs were the brainchild of a venture capital industry initially struggling with lackluster fundraising, which in 1980 totaled $3 billion for all VC funds. But things were about to change. VC became hot, and by 1990 total venture capital assets under management had surged to around $31 billion, rendering BDCs unnecessary as a fundraising tool. And since a public company is much more complex to assemble than a private partnership, VCs saw little reason to reach for BDCs.

So BDCs almost disappeared before they even got started. Only a handful were established before 2000, at which time the big Wall Street financial firms discovered them and dusted them off. There are currently over 50 publicly listed on Wall Street exchanges. However, those Wall Street firms zeroed in on BDCs’ lending capabilities rather than their investment potential.

They found that they could borrow funds around 2% and re-lend them at 8-12%, without the hassles of bank regulation. Sweet! And most of those Wall Street BDCs focus on companies sized at the upper end of the market segment that Congress had in mind. They almost never address the needs of startups or smaller businesses at the community level, even though those are the companies BDCs were designed for.

Bringing Investment Home

Implemented as originally envisioned, BDCs are an ideal funding vehicle for local small businesses.

  • They offer communities a way to form a public company that aggregates local investors’ money and places it with their local small businesses.
  • Investors can get in and out of their investment at any time yet still support their local businesses with critically needed capital and credit.
  • Most importantly, they can be applied to a broad range of businesses from raw startups to mature companies.

In fact, BDCs may be the only solution for a growing problem that is starting to hit communities across the country—the increasing number of baby boomer small business owners who are ready to retire. They’re flooding the market with businesses for sale, resulting in many just being shut down for lack of a buyer. But through a BDC, the community can essentially become the buyer and keep those businesses up and running, retaining the jobs they generate. And with the business support the BDC can provide, those companies can grow and create even more jobs.

Clearly, a community-focused BDC can be one of the simplest, safest and most effective tools a community can use to move its money from Wall Street to Main Street.

Michael Sauvante is the Executive Director of Commonwealth Group LLC, the only U.S. consulting firm specializing in the use of BDCs for the local small business community. To learn how you might use BDCs in your community, go to  www.commonwealthgroup.net.

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Comments

  1. Michael – very interesting article. A similar community centered scheme in the UK is the Community Share Issues which are beginning to gain popularity for acquisition of community assets and building community held commercial organizations.

    One point I would respond to however is the issue of liquidity. I see it as less of an issue. Community Share Issues are withdrawable shares but IF the issue is constructed well and the individual investment costs are held down in a proper crowdfunding manner there shoudl be no need or desire to liquidate individual investments.

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