Will BDCs kill the mezzanine star?
That question is being taken seriously by “traditional” mezzanine investors, after seven brand-name buyout firms recently unveiled plans to form new business development companies (BDCs).
Large buyout firms never are completely satisfied with buyouts. In the late 1990’s, Thomas H. Lee Partners (TH Lee), Kohlberg Kravis Roberts & Co. (KKR) and others launched venture capital affiliates, which followed earlier creations of real estate funds, collateralized loan obligation funds and collateralized debt obligation funds.
Today, many of those same shops are looking to expand their brands into the mezzanine markets, via the formation of BDCs.
Rather than simply dismissing such experimentation as bandwagon hubris, many “traditional” mezzanine players are worried that new BDCs could flood their market with cheap capital. Not only would this mean increased competition, but also an almost-certain reduction in yields that already are under siege by a first-quarter boom in second lien structures.
Such concerns were voiced repeatedly last week, during a two-day mezzanine finance symposium organized by Atlantic Conferences Inc. The original event program did not mention BDCs, but revised copies were printed after Apollo Management raised $930 million on the public markets for its inaugural BDC (named Apollo Investment Corp.).
“I’ve never seen anything like it,” says Louise Vogel, president of Atlantic Conferences. “Eight weeks ago, everyone was worried about second liens. Now I’m on the phone all day long with people discussing BDCs.”
Most panelists acknowledged that a significant influx of BDC capital could damage their returns, but cautioned that it was too early to predict mezzanine market Armageddon.
Instead, they observed that the hubbub is speculative rather than responsive, as firms like TH Lee, KKR and Blackstone Group have only filed – not priced – BDC offerings.
The basic concept of a BDC is to raise capital via the public markets – anywhere from $207 million to $930 million – and then to invest in deals that either are too small for the firms’ multi-billion dollar buyout funds, or otherwise do not fit existing investment mandates.
Only Apollo has yet managed to succeed on the public markets, outside of niche investors like Allied Capital and American Capital, both of which have successfully employed the BDC structure for years. Moreover, Apollo is still searching for its first deal, and consistently has traded below its $15 offering price. Both institutional and retail investors are betting on strong dividend returns (institutional buyers grabbed around 60% of the IPO), but there is not yet any proof of concept that would encourage similar bets on other BDCs.
Three private equity firms have issued BDC filings so far in May, following up on six filings in April. Banking sources say that other potential issuers are on deck, but that many may stay out of the box until they are convinced that Apollo’s pricing isn’t an aberration.
Even if all the prospective BDCs do come to market, there is no guarantee that they will be regularly tapped as mezzanine lenders.
“Some of these new funds will be able to provide additional sources of funding for people who want the lowest cost of capital,” says Doug Newhouse, a co-founder and managing partner of Sterling Investment Partners. “But our standpoint is that we’ll accept some extra basis points in order to work with someone who we have worked with before and feel will be around for many years to come.”
If Newhouse is right about the importance of fund management, some BDCs could be stillborn. Many of the prospective pricers do not currently employ experienced debt professionals, and their filings neither identifies specific fund managers nor specifies whether or not outside advisors will be hired.
Such vagueness is best illustrated by KKR, which is looking to raise $750 million for KKR BDC Inc. The buyout firm’s N-2 filing states that “the Investment Advisor will be led by [blank], who has [blank] years of experience in the investment industry, together with a team of investment professionals that will be dedicated full-time to the operation of the Investment Advisor.”
The filing does note that existing KKR professionals will pitch in, although KKR buyout funds will not co-invest in companies in which KKR or its affiliates have an investment.
Apollo was a bit more specific in that it initially plans to use existing investment staff led by partners Michael Gross and Art Penn. The firm also features a distressed debt fund, which arguably makes it more capable of investing mezzanine capital than an equity-only group like KKR.
Apollo’s BDC formation replaced earlier plans to launch a dedicated mezzanine practice, but Blackstone Group still is investing out of a $1.4 billion mezzanine fund raised in 1999. The New York-based firm will ask that fund’s staff to pull double-duty on a proposed BDC, and it seems unlikely that Blackstone will raise a second “traditional” mezzanine fund.
No one from Apollo, Blackstone, KKR or TH Lee was willing to comment on their BDC offerings, citing SEC restrictions. Informally, however, the conversation continues among just about everyone tangentially connected to the mezzanine industry.
For now, however, it’s all just talk.