The ABCs of BDCsAuthor: Adam AloisiLast Updated: December 11, 2013 Last week we discussed the basics of the high-yield bond market and how risk-tolerant investors might consider the space as a source for elevated income. This week I’d like to draw your attention to the business development company, or BDC, a rather niche corner of the equity market where income investors can find high yield.What Is A BDC?Business development companies invest in typically small- to middle-market private enterprises, structuring a mix of fixed-income and equity deals. The BDC provides a mutual fund like avenue for “average Joe” investors like you and me to access private companies we might otherwise be unable to invest in. Similar to the requirements of a REIT (real estate investment trust), BDCs are required by law to distribute 90% of taxable income to shareholders, providing bond-like cash flow for investors.Indeed, many liken a BDC to the junk bond fund, in that it invests in a variety of typically less established, less credit worthy, but growing businesses. Payouts for companies in the BDC space vary, with some yielding in the mid single digits, while others may yield in the low double digits. Some enter into deals with a broad range of businesses while others maintain discipline in a focused industry, like finance or technology. Cash flows from business development companies are taxed as unqualified, ordinary income and usually paid quarterly, although some BDCs, like Prospect Capital (PSEC) pay their investors on a monthly basis.Not For The Faint Of HeartDue to the usually risky, potentially upstart nature of what it is investing in, the business development space is not a place for widows and orphans to be putting their money, despite the diversified nature of the portfolio. BDCs are generally considered both economically and interest rate sensitive, meaning that a sudden downturn in the economy could put tremendous pressure on the payback ability of the companies it has invested in. A rising rate environment could put pressure on the value of the fixed deals that the BDC has in place or on other BDCs possessing a higher business leverage profile.Similar to the way in which mutual funds are priced, equity analysts and investors track the net asset value (NAV) of a BDC’s portfolio, which is typically reported on a quarterly basis along with the company’s financial results. And similar to the closed-end fund, BDCs trading at a price higher than net asset value are said to be at a premium, while those beneath NAV are said to be at a discount. BDC Choices And Allocation MethodologyThere are several dozen individual business development companies that exist today with ample liquidity on the open market. But due to the rather limited scope and appeal of the space, there are only a couple of pooled products that invest exclusively in BDCs. One is BIZD, Van Eck’s BDC Income ETF and another is an exchange traded note, BDCS. There is one closed-end fund, FGB, First Trust Specialty Finance that invests in a portfolio of BDCs as well. Pooled product choice is certainly limited, thus investors need to determine first if this space is worthy of their investment and second, what is the most prudent way to allocate.I would opine that while the average income investor with some ability to withstand risk should certainly consider exposure to BDCs, the allocation should probably be very small. Between high-yield bonds, business development companies, and other riskier income assets, including mREITs, with a tilt toward non-investment grade situations and lofty leverage, I would think that the ceiling should be no more than 10 percent. Those with lower risk tolerances or discomfort with high-yield investments should simply avoid them.To summarize, business development companies are a convenient way for income oriented retail investors to access cash flows, and to a lesser extent, reap capital gains from investment in a portfolio of small and middle market emerging enterprises. Though the vehicle shares structural and compositional similarity with other higher-yielding entities, the BDC offers a unique proposition in today’s market.About the author:Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.