Business development companies: Why dual holders are a win-win

In the wake of the 2007–2008 financial crisis in the United States, which resulted in tightened regulation for traditional banks, private credit has grown as an alternative source of financing, particularly for small and mid-sized firms.

Within this landscape, “business development companies, or BDCs, have played a crucial role in this expansion, providing an alternative source of funding to banks that allows these firms to grow and stay private longer,” notes Johns Hopkins Carey Business School Assistant Professor Tetiana Davydiuk.

Her research has found that a large majority of business development companies, between 80% and 90%, act as “dual holders,” meaning they also hold equity as shareholders in the firms to which they have extended loans as creditors.

How does holding both debt and equity impact a business development company’s loan pricing, and what is the impact on borrowing firms? These are among the key questions Davydiuk and co-authors set out to explore in a recent working paper that examines private debt funds as dual holders.

Monitoring offers value

To inform their inquiry, the team performed a cross-sectional analysis on a database of investments that covers 69 business development companies and more than 9,000 portfolio firms.

They found that firms most likely to benefit from dual holders are intermediate growth firms. “These are firms that don’t yet have robust cash flows necessary to service debt or substantial physical assets needed to serve as collateral. They aren’t good candidates for traditional bank loans, but they have real potential for growth. Such companies are often concentrated in high-R&D industries and are in constant need of funding,” explains Davydiuk, whose collaborators include Isil Erel of Ohio State, Wei Jang of Emory University, and Tatyana Marchuk of Nova School of Business and Economics.

Crucially, these companies benefit from an element key to dual holder business development companies. Much like private equity firms, many BDCs offer both financial and operational support, providing governance oversight. Thus, “BDCs play a more significant role in hands-on monitoring of their portfolio firms, offering valuable guidance and expertise,” Davydiuk says.

As a result of this increased “effectiveness,” the researchers found, dual holder business development companies benefit by being able to charge higher interest rates on their loans. And it’s a win-win, since the firms receiving the enhanced monitoring and guidance secure more funding going forward and experience a lower cost of capital from other lenders.

Could the higher interest rate simply be compensation for a firm’s heightened risk profile? To control for that possibility, the team examined portfolio firms that received loans from two different business development companies in the same quarter. One BDC offered a standalone debt contract, while the other bundled debt with an equity investment.

“Even when controlled for the firm’s risk profile, there is still a large positive spread for the loan bundled with equity,” says Davydiuk.

A viable alternative to the public market

Compared to bank loans, bond markets, and private equity, the private direct lending market, in the form of business development companies, “has been relatively unexplored,” the researchers note.

“As the first study to examine dual holdings in this context, we shed light on a key mechanism through which BDCs effectively serve a market segment that is less attractive to traditional financiers, yet offers appealing returns relative to the associated risks,” they write.

Based on the findings of her team’s study, Davydiuk says there is evidence that business development companies have strengthened the private market “as a viable and increasingly attractive alternative” to the public market for both mid-sized portfolio firms and their investors.