The buyout market is once again abuzz with IPO talk, but the hottest offerings aren’t coming from portfolio companies. Instead, they are being filed by the buyout firms themselves.
Since the beginning of April, at least seven private equity shops have formed business development companies (BDCs) in order to raise capital on the public markets. Apollo Management was the only firm to have priced an offering as of press time last Tuesday, but similar N-2 filings had been submitted to the SEC by Kohlberg Kravis Roberts & Co. (KKR), The Blackstone Group, Evercore Partners, Kelso & Co. and Prospect Street.
A source familiar with BDCs says to expect future offerings from such firms as Bain Capital, Thomas H. Lee Partners, Gleacher Partners, Trust Company of the West and McKay Shields Financial. Bain denied having such intentions, although none of the other firms would comment on prospective BDCs. Ditto for rumored player Carlyle Group, although a source familiar with the firm says that no such offering is currently in the works. Calls to Thomas H. Lee Partners, Gleacher Partners and Trust Company of the West were not returned as of press time.
“It’s not too different than five years ago when several buyout shops set up CLOs [collatorized loan obligations],” says a buyout pro whose firm is considering its own BDC. “Part of the rush has been caused by the capital markets’ search for yield and return. And from private equity’s point of view, BDCs are very liquid and more flexible. Plus there are no artificial constraints and the actual fund raising of a BDC might be done in 90 days versus the six months to a year needed to raise funds privately.”
The BDC Blueprint
BDCs were born out of the Investment Company Act of 1940, and have been compared to mutual funds and REITs in that they are traded as individual stocks.
According to the prospectuses filed so far, private equity firm BDCs will primarily invest in senior and mezzanine debt, as well as in other equity and equity-linked securities. BDCs are granted immunity from paying taxes on capital gains, dividends or interest payments to their individual investors. To gain such exemptions, however, BDCs are required to distribute a minimum of 90% of their income to shareholders. That figure rises to 98% in order for a BDC to be fully exempt. In addition, BDCs are subject to regulatory limits on the amount of non-qualifying assets than can be held, which partially restricts their investments in public companies with marginable securities.
While BDCs are not similar in structure to traditional private equity funds, the participating firms are not straying too far from their established management fee blueprints. KKR, for example, will collect a 2% management fee based on gross assets. It also could receive incentive fees broken up into two parts: 20% of the net income that exceeds a yet-to-be-determined hurdle rate, and 20% of KKR’s net realized capital gains.
The benefits of a BDC seem obvious. However, for an industry that normally operates in the shadows, it may take a while for firms like Blackstone and KKR to adjust to the public spotlight’s glare.
“There’s tremendous scrutiny on the public market,” says Malon Wilkus, chairman and chief executive of American Capital Strategies. “It’s extremely rigorous, but still very important, and the transparency should help to create a standard.”
Another potential pitfall that incumbent players like American Capital have been forced to fend off, are allegations that the structure is essentially a Ponzi scheme. Because of questions into the accounting of BDCs, the sector has been beset by short sellers. For their part, the shorts argue that BDC sponsors sell shares above book value in order to fund the dividends distributed to investors.
Matthew Park, an analyst at A.G. Edwards, acknowledges that at one time this presented a heated debate, but says that now, the Ponzi allegations have largely dissipated. “Another point being made,” he adds, “was whether these companies could pay out a 13% interest rate to the lenders in a bad economy. As it turned out, though, the BDC portfolios were more robust than the short sellers gave them credit for.”
What’s The Hurry?
Ever since Apollo priced its $930 million offering on April 5, bankers have been trying to get their feet into new private equity firm doors. In fact, some speculation has arisen that recent BDC activity is reminiscent of previous bank-driven IPO crazes like the Internet offerings in the late 1990s. Even some of the names seem the same, with Credit Suisse First Boston, UBS, Citigroup and J.P. Morgan Chase all taking an active role.
Most bankers, of course, deny their own complicity, and private equity pros brush off any such suggestion:
“If you think we do what the banks tell us, you’re crazy,” says Wilkus. “These private equity firms are trying to institutionalize their companies instead of being just a limited partnership with a finite life.”
One banker who declined to be named (because his bank is in a BDC-related quiet period) adds: “It’s being driven by a combination of both the private equity firms and the banks. Some bankers that may not understand the product will use it as a window to go out and get a quick fee, but most are looking to go after the long-term prospects here.”
Peter Freudenthal, managing partner at Darwin Ventures and formerly the original founder of BDC-based meVC Inc., is not surprised that so many firms are racing out at the same time. He says that closed-end funds like BDCs generally trade lower than their offering prices, so it’s essential to get out the door before shares hit the open institutional market at a discount. Apollo (Nasdaq:AINV), for example, closed trading last Tuesday down at $14.18 per share, after having priced its $930 million IPO at $15 per share.
“There are really only two ways to keep a closed-end fund trading well, and that’s to either pay out money on a regular basis or keep up a steady stream of positive news to maintain shareholder interest,” Freudenthal explains.
Is it Stuffy In Here?
In the short-term, the BDC trend means that firms like Apollo can raise new cash cheap. In the long-term, however, there are questions as to whether or not follow-on offerings from firms like KKR and Blackstone not to mention potential offerings from Tom Lee, Bain, etc. will glut the market.
“There’s going to be a huge amount of capital in that space, and it’s not entirely clear how it’s going to be deployed,” says one buyout investor. “The mezzanine market is not all that big (probably around $4 billion), so they’ll likely look to the second lien and large institutional term B loans to deploy all that capital… What’s interesting is how little detail you’re getting from these prospectuses. Investors are really just buying the [firms’] reputations at this point.”
A.G. Edwards’ Park, however, is not concerned: “The commercial banks that have sometimes participated in the space have not really been active during this recovery. As long as the demand [for financing] continues to pick up among middle-market companies, [the competition] should not be a problem. Investors won’t view these entrants as reckless or irrational money coming into the markets.”
And while one might expect the incumbent public players to be protective of their space, some view the new interest as a validation of their business plan. American Capital’s Wilkus says, “The involvement of the KKRs and Apollos in our industry is a good thing. It will bring a greater awareness to the BDC sector, and that will bring an increase in the number of underwriters that follow and do research on the space.”
However, one group that cannot be happy is the coterie of privately funded mezzanine players in the space; a group that has already been coping with more competition and shrinking IRRs. Erik Hirsch, chief investment officer at Hamilton Lane, notes, “If I’m a mezzanine fund, I’d have to be pretty concerned about this huge influx of capital targeting my space. With the cost of capital being so much cheaper [for the BDCs], it really doesn’t look good for that segment.”
Also, it will be interesting to see how the limited partner community reacts to being excluded from the BDC bonanza. Hirsch states, “From our end, this raises a lot of questions that need answering to truly understand the implications. We’re wondering exactly who at the general partner firms will spend time on [the BDC vehicles], and also, whether there will be any conflicts of interest. In the press releases they all say they have the ability to invest in equity, but what bright lines are in place differentiating what deals their separate funds can invest in.”
Also, the specter of being excluded from fund raising may spook some limiteds. Hirsch notes, “It’s very possible this becomes a new way for GPs to raise capital and that would significantly change the dynamics of the industry. You don’t want to overreact, but this could have some very serious ripple effects.”
Dan Primack contributed to this story.