Business development companies, closed-end funds that invest in the debt and equity of private companies, took their lumps during the credit crisis, but they are suddenly hot commodities.
These specially regulated investment vehicles are thriving by picking up the slack in middle-market corporate lending from banks and CLO managers.
"What made 2004 to 2007 a tough time to be a mezzanine lender was the general froth" in the market as second-lien lenders and hedge funds created CLOs, said Jim Hunt, the chairman of THL Credit. "Both structures are now gone from the market."
Just as important as the exit of CLOs is the fact that "banks are exhibiting very rational behavior," Hunt said. "They're not over-advancing" funds to middle-market companies. For BDCs, "this backdrop creates very favorable supply/demand characteristics."
Yield-starved investors can't seem to get enough of them. At a time when private equity and mezzanine debt funds are still finding it tough to raise capital, eight BDCs have gone public since the start of last year and have raised $770 million.
Several of the new funds are sponsored by private-equity firms; THL Credit is managed by an affiliate of Thomas H. Lee Partners.
Three more BDCs have filed registration statements with the Securities and Exchange Commission so far this year, including Garrison Capital, which will be managed by an affiliate of hedge fund firm Garrison Investment Group, NeXT BDC Capital and Monroe Capital Corp.
Other BDCs, even those that struggled when the credit crisis hurt the valuations of their holdings, have been tapping the market with secondary offerings of public stock, often multiple times. On Tuesday, Main Street Capital raised $62 million through a follow-on stock offering; that came on the heels of a $46 million follow-on in August. PennantPark Investment raised $99 million early last month through its fourth follow-on offering since the beginning of 2009. Also last month, Fifth Street Finance raised $145 million through its fifth follow-on offering since the beginning of 2009.
Vincent Foster, chairman and chief executive of Main Street Capital, said the fund finished 2010 with enough cash, idle funds and marketable securities to fund its backlog of investments going into the second quarter of 2010. Its latest offering was intended to raise capital to fund investment for the balance of the year.
While the broader, more widely syndicated loan market has been "flooded with new capital" since December, Foster said there hasn't been a material amount of new competition or pricing pressure in Main Street's core market of companies with Ebitda of $2 million to $10 million, at least not in "cash flow-based enterprise lending."
There has been more competition in asset-based lending, but that's generally not what the firm does.
BDCs and other kinds of closed-end funds often trade at discounts to their net asset value per share. Yet despite all the new share issues, investors are bidding prices of outstanding securities above NAV. As of Tuesday, the 20 BDCs tracked by Freeman & Co. were trading at an average of 1.1 times NAV.
"Given today's anemic yield environment, we would expect the retail demand for BDCs to spur further IPOs in the space, as their dividend payout requirements should attract income-seeking investors," said Jim Murray, a managing director at Freeman.
Murray said managers of private funds see BDC as an alternative source of managed funds. Unlike private-equity funds, which typically wind down after seven to 10 years and return their money to investors, BDCs are a kind of "permanent capital," since investors who want out simply sell their shares.
Another attraction is what Hunt calls the "exchange of industry information" between private funds that invest in the equity of larger companies and a BDC that invests in the debt of small companies operating in the same sector. "We have a credit orientation," while Thomas H. Lee Partners "have an equity orientation, but having both philosophies and skill sets is very complimentary."
THL Credit raised $260 million through its April IPO. It lends both to nonsponsored companies and to companies backed by private-equity firms other than Thomas H. Lee. (BDCs need an exemption from the SEC to co-invest in a company backed by an affiliate fund.)
Hunt said there is "a level of froth in the market" that is driven by "demographic demand," or money flowing into mutual funds that invest in loans. But he also said the market is not as overheated as it was before the financial crisis.
Launching BDCs also can provide liquidity to investors in private funds. Monroe Capital plans to purchase its initial portfolio of 34 loans from a sister private fund, according to its registration statement.
Murray said it is not unusual for new BDCs to acquire a "legacy portfolio." Other firms have done this by "rolling" a number shares of private funds into a new BDC as part of their IPOs. In addition to allowing investors in the private fund to cash out their shares, this allows the new BDC to pay a dividend right away, "which is helpful in marketing the fund."
Cynthia Krus, a partner at the law firm Sutherland, Asbill & Brennan, said "pure ramp-up periods are always difficult for BDCs." Shareholders like to see these funds acquire existing portfolios, she said, because they get immediate yield, as opposed to waiting six months or more for managers to put funds to work. "As a result, most BDCs have not launched as 'blind pools'."
Traditionally, private-equity firms have avoided the kind of regulatory scrutiny that comes with offering funds to the general public. But Krus said the increased regulation of private funds has made BDCs a relatively more attractive investment vehicle. "If you're welcoming the government in, and are regulated anyway, why not do a public fund" and in the process get access to additional investors and the ability to provide more liquidity than a private fund.
Also, like private funds, BDCs can charge performance fees. On average, Krus said, they charge a management fee of 2% of assets and keep 20% of the returns they generate for investors.
In addition to raising more equity, BDCs are finding new ways to leverage returns. Most use bank debt or senior notes from insurance companies, but some of the larger ones have been able to tap the convertible bond market. Ares Capital Corp. issued $200 million of convertibles this week, two months after issuing $500 million. Earlier this month, Kohlberg Capital made a $55 million offering. Last month, Apollo Investment Corp. issued $200 million of convertibles and Prospect Capital Corp. issued $172 million.
"In the last three or four months, the most active BDCs have tapped the market, and the others all sat up and noticed," Krus said. Her firm has advised on more than $1.5 billion of debt and equity deals so far this year.