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UBS has made another addition to its fast-growing ETN lineup, rolling out a product linked to an index consisting of U.S.-listed business development companies (“BDCs”). The E-Tracks Linked to the Wells Fargo Business Development Company Index (NYSEARCA:BDCS) is an exchange-traded note due in April 2041. The underlying index currently consists of about 26 BDCs, including Ares Capital Corp. (NASDAQ:ARCC), American Capital Ltd. (NASDAQ:ACAS) and Apollo Investment Corp. (NASDAQ:AINV).

BDCs are generally involved in lending money to small and mid-sized companies, often establishing equity stakes in the companies as well. The portfolio of Ares Capital, one of the largest components of the index linked to BDCS, consists of First Lien Senior Debt, Second Lien Senior Debt, Senior Subordinated Debt, Senior Secured Loan Program, Equity, and commercial real estate. The portfolio of a BDS may consist of various types of investments in dozens or even hundreds of privately-held companies.

Unique Exposure

BDCs are legal entities that may maintain certain tax advantages. In order to qualify as a BDC, an entity must be must be registered in compliance with Section 54 of the Investment Company Act of 1940. Some publicly-traded private equity firms are registered as BDCs under the Investment Company Act of 1940. BDCs may enjoy many of the same tax benefits that REITs encounter if they meet certain criteria; they pay almost no corporate taxes as long as they pay out at least 90% of their profit and capital gains as taxable dividends. BDCs can also earn exemption from the 4% non-deductible federal excise tax if they distribute at least 98% of ordinary income for each calendar year. BDCs are not considered REITs under the Internal Revenue Code.

Because they are required to make substantial distributions in order to maintain their favorable tax status, investments in BDCs can be appealing to investors seeking to enhance current returns. Many components of the Wells Fargo Business Development Company Index pay out distribution yields in excess of 8%, and the current annual index yield was approximately 7.7% at launch.

Another attractive element of BDCs relates to the opportunity to access an asset class that is not readily accessible to most investors. Although the underlying index consists of 26 publicly-traded stocks, BDCS effectively offers exposure to more than 1,000 privately held companies through the broad-based portfolios of the component companies. And since those portfolio companies are not publicly-traded, most investors have no way of achieving direct exposure.

ETN Nuances

Achieving exposure to this asset class through an ETN may have some unique tax consequences. Coupon payments from BDCS will be treated as ordinary income for tax purposes, even though some of the distributions will be attributable to dividend payments on the underlying BDCs that will constitute “qualified dividend income” or long-term capital gain dividends that are currently subject to tax at tax rates more favorable than ordinary income.

The tax consequences of various investment vehicles have been a hot topic recently, focused specifically around the merits of accessing MLPs. There has been some uncertainty over the tax treatment of ETNs, as the IRS has not made explicit rulings in many instances.

PSP Highlights Potential Risk, Return for BCDs

As the first pure play business development company ETP, BDCS is a unique offering with only one ETF on the market delivering remotely similar exposure. PowerShares currently offers a Global Listed Private Equity Portfolio (NYSEARCA:PSP), which seeks to replicate an index consisting of about 60 publicly listed private equity companies, including BDCs and other financial institutions or vehicles whose principal business is to invest in and lend capital to privately held companies.

Though there is some overlap between PSP and BDCS, these products are far from identical. First and foremost, they offer exposure to this asset class through different structures; PSP is an ETF while BDCS is structured as an exchange-traded note. In addition to the trade-off between credit risk and tracking error, that distinction may have an impact on the tax consequences for these investments. PSP splits exposure between the U.S. and internationally, with the U.K., Sweden, France and Belgium receiving the largest non-U.S. weightings. The new ETN from UBS focuses exclusively on U.S.-listed companies.

PSP sank during the recent financial crisis, as many private equity companies and BDCs wrote off investments or struggled to find liquidity. Between the beginning of July 2008 and the bear market lows in March of the following year, PSP lost more than 75% of its value. The fund then surged during the subsequent recovery, more than doubling in less than two months and adding close to 150% by the end of the year. PSP gained about 26% last year and has already added another 12% or so in 2011. Still, it remains far below its pre-recession peak:

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Disclosure: No positions at time of writing.

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Source: UBS Debuts ETN Tracking Business Development Companies