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An internally managed BDC, or business-development company, is a closed-end investment company that hires its own internal management team to invest debt and equity into small and medium-sized businesses. The BDC directly pays management based on a compensation plan that's fully disclosed to investors. As a result, an internally managed BDC will have operating expenses on its income statement, in contrast with externally managed BDCs.
An internally managed BDC's operating expenses tend to be lower than an externally managed BDC's
The difference between internally and externally managed BDCs is that internally managed companies hire their own staff, analysts, managers, and executives to manage the company's assets. Externally managed BDCs outsource that task to a third party.
The compensation structure paid to external managers is based on fees from the fund's assets and its performance. An internally managed fund pays its own operating expenses, including salaries and bonuses to the investment professionals in charge of putting the company's assets to work.
In general, the internally managed structure results in lower expense ratios. An externally managed BDC will typically have expenses around 30% to 40% of revenue or 4% to 4.5% of total assets. The best internally managed BDCs can have expense ratios at half that level.
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One risk to review before investing in an internally managed BDC is the stock compensation provided to the company's management. Some BDCs can be a little too generous in the stock options it awards its executives, undercutting existing shareholders with dilution each bonus season. Some internally managed BDCs have allocated upwards of 20% of total shares for management, an astronomical figure and an immediate red flag for investors. This consideration won't be readily visible on the company's income statement, regardless of how low its expense ratio may be.
Fully disclosed compensation plans reduce the potential for conflicts of interest
A second reason investors may prefer an internally managed BDC over an externally managed one is a lower likelihood of conflicts of interest between management and shareholders.
The SEC requires internally managed BDCs to report the compensation structures of its executives in regular proxy filings. That means investors will know exactly what benchmarks and milestones management is being paid to pursue. This approach contrasts with external structures, where the exact fee structure is not disclosed.
One consequence of these disclosures is that executives at internally managed funds tend to pursue growth only when it benefits existing shareholders and profitability. Externally managed BDCs, where third-party managers are paid based on a percentage of total assets, tend to pursue growth at all costs, even if that means selling new shares at prices near or below the company's net asset value.
In other words, the compensation disclosures provide a check to ensure that management incentives are fully aligned with shareholder priorities. Without the disclosures, there's no way for investors to ensure that all parties are working toward the same goal.
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