Bankers looking for the next hot IPO structure are trying out business development companies (BDCs), 60-year-old relics that have been excavated and modernized to entice 21st century investors.
The initial test for BDCs in the new millennium came April 6, when Apollo Management LP raised $930 million in a public offering for Apollo Investment Corp., a closed-end investment company whose shares were priced at $15 a piece. The stock (Nasdaq: AINV) traded as high as $15.44 during its first week, although it finished down at $14.63 as of market close last Thursday.
Wall Street’s reaction was imitation. Last week saw BDC offerings from Blackstone Group, Evercore Partners and Kohlberg, Kravis Roberts & Co. Blackstone filed the largest offering at $850 million, followed by KKR with $750 million and Evercore with $460 million.
Together, the four firms could raise nearly $3 billion with their public offerings.
But the aggressive fund-raising assault won’t stop there. Thomas H. Lee Partners and Kelso & Co. are rumored also to be preparing public filings, while The Carlyle Group is reportedly considering a similar move, according to The Financial Times. If so, the seven investment firms could raise more than $6 billion from the public markets.
Will the market have the appetite for $6 billion of this stuff?
“How could someone not replicate this?” asks an equity capital markets banker from a mid-size firm. “It’s such a good idea. It’s so great for Apollo, and it’s great for the market.”
Similar to mutual funds, BDCs are managed portfolios that buy what would traditionally be private equity and venture capital investments rather than publicly traded stocks and bonds. As regulated investment companies, BDCs trade like individual stocks, yet they are annually required to distribute at least 90% of their income to shareholders, gaining tax benefits for doing so. As corporations set up under the Investment Company Act of 1940 – the congressional act that created mutual funds – BDCs maintain their non-tax-paying status by passing on any taxes for capital gains, dividends or interest payments to their individual investors.
The Investment Company Act has been on the books for almost two-thirds of a century, but few seemed interested in trying to utilize all of its sections until recently.
Last week’s rush of public offering filings is being explained by bankers as a coincidence and by private equity sources as bank pressure to join the trendy club. Overall, however, interest in BDCs has likely been caused by an increase in yield appetite.
“The capital markets are coming up with various ways to take companies with good cash flows public and structure securities to get better valuations in a low-interest-rate environment,” says the head of equity capital markets for a bulge-bracket firm. “Basically, we’re creating more high-yield structures.”
Erin Callan, a managing director and head of product development at Lehman Bros., says that the BDC structure is an attractive option for investment companies focused on early-stage investments because, unlike traditional private equity funds with finite investment periods, BDCs run more like operating companies because they can continuously invest and reinvest the return on their assets.
“It’s an interesting byproduct of the phenomenon of the yield-driven investor that exists in today’s equity markets, and smart private equity fund investors are seeing this as an opportunity to use the public capital markets more efficiently,” Callan says.
As a straightforward corporation with annual returns, the BDC structure makes early-stage investments more attractive to retail investors, along with tax-exempt investors such as pension funds, which tend to steer clear of traditional partnership investment companies because of the negative tax consequences they carry.
Showtime at the Apollo
Although the BDC structure has been used before, bankers structured Apollo’s IPO in a unique way.
Unlike REITs and MLPs, which usually have tight parameters for where management can invest the funds, Apollo’s prospectus gives few specifics about the company’s plans for IPO proceeds.
“We intend to invest primarily in middle-market companies in the form of mezzanine and senior secured loans, each of which may include an equity component, and, to a lesser extent, by making direct equity investments in such companies,” according to the company.
“It’s basically a black box,” says Callan, commenting on the lack of guidance the company’s prospectus outlines for its plans for the proceeds. “They indicate that at some point they might put on a little leverage, but there doesn’t seem to be any game plan to put on significant leverage.”
That’s because the investment company act that created BDCs carries strict reporting obligations and institutes significant limitations on the leverage these companies can assume.
Because of these guidelines, bankers say the BDC structure is most attractive for such riskier investments as structured equity and mezzanine deals.
The question now, of course, is whether or not other private equity firms will follow suit. Part of the answer may lie in the pricing successes or failures of last week’s filers, as firms such as Thomas H. Lee, Texas Pacific Group, Bain Capital and Welsh, Carson, Anderson & Stowe all fit the general demographics of Apollo.
There also is the question of Carlyle, which has deflected rumors of such a public offering for at least the past year. A source familiar with Carlyle says that the firm is certainly keeping track of the recent developments, but that no BDC filing is in its near-term future.
Dan Primack contributed to the reporting of this story, part of which is republished from Investment Dealers’ Digest.