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There’s something wonderfully absurd about a law that forces companies to hand over their profits. It’s like mandating generosity, which sounds about as effective as legislating happiness or requiring spontaneity. Yet this is precisely what happens with Business Development Companies, and the mechanism behind it reveals something fascinating about how we’ve tried to engineer prosperity through financial regulation.
The 90% rule is simple on paper. BDCs must distribute at least 90% of their taxable income to shareholders as dividends. Do this, and the company pays no federal income tax. Skip it, and the IRS comes knocking with the standard corporate tax bill. This creates a peculiar situation where a BDC’s legal structure essentially prohibits it from hoarding cash like a nervous squirrel preparing for winter.
Most companies can choose what to do with their earnings. They might reinvest in growth, buy back shares, build cash reserves, or yes, pay dividends. BDCs don’t get this menu of options. They’re stuck at the buffet table of mandatory distributions, plate in hand, legally required to pile on the payouts.
Why Congress Engineered This Arrangement
The question worth asking is why this arrangement exists at all. The answer takes us back to 1980, when Congress decided that small and medium businesses needed better access to capital. Banks were picky. Venture capital was scarce. Public markets didn’t care about companies too small to justify the IPO circus. So lawmakers created BDCs as a vehicle to channel investment dollars toward these overlooked businesses, sweetening the deal for investors with this forced distribution model.
The logic was straightforward enough. If you want people to fund risky middle market companies, you need to offer them something compelling. Regular dividends create that appeal. But here’s where it gets interesting: by making distributions mandatory rather than optional, the structure assumes that investors can’t trust management to voluntarily share the wealth. It’s a legislative admission that given the choice, companies would rather keep the money.
What This Means for Investors
For investors, this creates an unusual dynamic. You’re not betting that management will eventually decide to reward shareholders. That decision has already been made by Congress. You’re betting on the quality of the underlying loan portfolio and the skill of the people selecting investments. The payout itself is guaranteed by law, assuming the BDC generates taxable income. Whether that income represents real economic value or accounting fiction becomes the critical question.
This is where the fairy tale gets complicated. A 10% dividend yield sounds magnificent until you realize that dividends can be funded by returning your own capital. Imagine a company that pays you a dollar in dividends but loses two dollars in portfolio value. You’re getting poorer while receiving checks. It’s like celebrating the generosity of someone who borrows from you to buy you gifts.
The Strange World BDCs Inhabit
BDCs navigate a strange corner of the financial world. They make loans to companies that are too risky for banks but too established for venture capital. This middle market space is neither fish nor fowl. The companies might have revenues of $50 million or $500 million. They might be growing or struggling. They might be owned by private equity firms looking to squeeze out returns, or by founders trying to avoid selling their life’s work.
The loans themselves are fascinating instruments. Many are floating rate, meaning they adjust with interest rates. This sounds like protection against inflation, and in theory it is. But it also means the borrower’s interest costs rise when rates increase. A company comfortable paying 8% might suffocate at 12%. The BDC collects higher interest payments right until the moment the borrower defaults. It’s a bit like turning up the heat on a frog in a pot. The rising temperature feels profitable until it isn’t.
The Dual Role Problem
Some BDCs also take equity stakes alongside their debt positions. This creates an alignment that’s either brilliant or troubling depending on your perspective. As an equity holder, the BDC wants the company to take risks and swing for growth. As a lender, it wants stability and steady cash flow. These objectives don’t always harmonize. It’s like being simultaneously a company’s parent and its enabler, unsure whether to offer tough love or another loan.
The people who run BDCs occupy an odd professional space. They’re not quite bankers, not quite venture capitalists, not quite private equity managers. They’re dealmakers who traffic in companies that others have passed on. Sometimes these are diamonds in the rough. Sometimes they’re rough for very good reasons. Distinguishing between the two requires judgment that’s part financial analysis, part psychological assessment, part pattern recognition.
What Makes a Good BDC Manager
What makes someone good at this job? They need credit skills to analyze financial statements and covenant structures. They need industry knowledge to understand whether a niche manufacturing business or a healthcare services company has real competitive advantages. They need to read people, because a company’s management team matters enormously when you can’t easily exit your position. And they need to think probabilistically, understanding that some loans will fail and the portfolio as a whole needs to compensate for these inevitable losses.
The Growth Constraint Nobody Talks About
The mandatory distribution rule means BDCs can’t easily grow by retaining earnings. If they want to make more loans, they need to raise more capital. This happens through secondary stock offerings or by issuing debt. Both options have consequences. Issuing stock dilutes existing shareholders. Taking on debt adds leverage, amplifying both gains and losses. The structure creates a treadmill dynamic where BDCs must continuously access capital markets to expand.
This has an interesting side effect. BDCs can’t hide mistakes as easily as corporations that reinvest earnings internally. If a BDC’s portfolio deteriorates, it will struggle to raise new capital on attractive terms. The market provides immediate feedback through the stock price and the cost of capital. This is discipline of a sort, though whether it’s the useful kind depends on whether market participants correctly assess credit quality in real time. The track record here is mixed at best.
The Philosophy Behind Forced Distributions
There’s a philosophical question lurking beneath all this financial engineering. Should companies be forced to distribute profits? The free market fundamentalist would say no, that managers should allocate capital however they see fit and shareholders can vote with their feet if unhappy. The skeptical regulator would counter that without forced distributions, insiders would entrench themselves and extract value through salaries and perks rather than dividends.
The BDC structure sides with the skeptics, but in a limited domain. Congress didn’t mandate distributions for all companies, just for this specific vehicle designed to serve a public purpose. The tax benefits offset the loss of flexibility. It’s a bargain, not a commandment.
When Mandatory Becomes Meaningless
Yet something peculiar happens when you make distributions mandatory. The dividend itself becomes less meaningful as a signal. Usually, when a company raises its dividend, it’s saying something about confidence in future earnings. When dividends are legally required, they say less. A BDC paying out 90% of taxable income might be thriving or barely surviving. The payout happens either way.
This means investors need to look past the yield to the underlying economics. What’s the portfolio generating in interest income? How are those loans performing? What reserves are being set aside for losses? These questions require work. The high yield advertised by BDCs can seduce investors into skipping this homework. The result is predictable: some investors buy yield products without understanding what they’re buying, then feel betrayed when things go wrong.
Why BDCs Can Never Compound Like Tech Companies
Perhaps the strangest aspect of the 90% rule is that it creates companies that can never become truly large through organic growth. A BDC that performs well generates earnings, distributes 90% of them, and has little left to compound. Compare this to a successful technology company or industrial firm that can reinvest profits and grow exponentially over decades. BDCs are structurally prevented from this kind of compounding.
This matters for how you should think about them as investments. BDCs are income vehicles, not growth vehicles. You’re collecting the dividends, not betting on capital appreciation. Sure, the stock price might rise if the portfolio performs well, but the core value proposition is current income. Expecting a BDC to behave like a growth stock is like expecting a cow to fly. The animal wasn’t designed for it.
The Information Problem
BDCs operate in the shadows of finance. Most people know about stocks and bonds. Many understand mutual funds and ETFs. BDCs remain obscure despite being publicly traded. This obscurity creates information asymmetries. Sophisticated investors who understand credit analysis and illiquid securities can potentially find value. Unsophisticated investors chasing yields can find trouble.
The regulatory structure tries to protect investors through disclosure requirements and oversight. BDCs must register with the SEC and follow strict reporting rules. But disclosure isn’t the same as comprehension. You can hand someone a 200 page document explaining credit exposure, portfolio concentration, and fair value assumptions, and they’ll still struggle to assess whether the BDC is a good investment. The information is there. Making sense of it requires expertise most people don’t have.
The Uncomfortable Truth
This creates an uncomfortable situation. The 90% rule was designed to make BDCs attractive to ordinary investors by ensuring high dividends. But the complexity of evaluating BDCs means ordinary investors may be poorly equipped to distinguish good ones from bad ones. The structure intended to help might actually set people up for mistakes.
None of this means BDCs are scams or bad investments. Many are managed competently by skilled credit investors. They serve a real economic function by providing capital to businesses that need it. The returns can be attractive for investors who understand what they’re buying. But the legal obligation to distribute 90% of income doesn’t automatically make anyone rich. It just ensures that if profits exist, they flow to shareholders rather than accumulating inside the company.
What the Rule Really Represents
The title of this article is deliberately provocative. BDCs aren’t obligated to make you rich. They’re obligated to distribute most of their taxable income if they want favorable tax treatment. Whether that makes you rich depends entirely on the quality of their investments and how much you pay for shares. A BDC trading above book value while experiencing portfolio deterioration can make you poor despite regular dividends. Context always matters more than structure.
What the 90% rule really represents is an experiment in financial engineering. Congress tried to create an incentive structure that would channel capital to underserved businesses while appealing to income seeking investors. The mechanism relies on mandatory distributions to ensure participation. Whether this works better than alternatives is debatable. It certainly creates interesting dynamics and unintended consequences.
The Bottom Line for Investors
For investors, the lesson is simple. Don’t confuse high yields with high returns. Don’t assume mandatory distributions guarantee anything except distributions. Look at what’s being distributed and where it comes from. Understand that leverage amplifies both gains and losses. Recognize that middle market lending is inherently risky and that some loans will go bad.
The 90% rule is a tool, not a magic wand. Used wisely by skilled managers and understood properly by investors, BDCs can play a valuable role in portfolios. Misunderstood or mismanaged, they’re just another way to lose money while collecting dividends along the way. The legal structure guarantees distributions. The rest is up to human judgment, which remains as fallible as ever.
