BDCs and the bumps in the IPO road

US private equity firm Apollo Group struck gold back in April this year when it raised $930m on NASDAQ via the IPO of Apollo Management, a publicly-traded investment vehicle.

Unfortunately, investors in Apollo Management, which is structured as a so-called business development company (BDC), now appear to be holding little more than base metal.

What with the prospect of Apollo’s hefty fund management charges and the dent left in its net asset value (NAV) following the deduction of underwriting fees, (Apollo’s offer price was $15 per share but its NAV after fees is closer to $14), the company’s shares have fallen by some 15% since the float.

“Underwriting immediately eats into a BDC’s NAV,” says Philip Howard, a partner in the US law firm Covington & Burling. “A BDC which floats at $10 a share will see its value reduced to, say, $9.30 after costs. Going forward investors will seek to buy in the after market rather than at the IPO stage, making further BDC issues structured in this way difficult,” he says.

The Apollo example has spoiled the game for many in the IPO queue, which quickly formed behind Apollo earlier this year.

Names such as Blackstone, KKR and Thomas H Lee all threw their hats into the BDC ring hoping that they, too, would be able to repeat the Apollo trick. No less than 13 BDCs filed with the SEC during April and early May this year, see table.

If all these new vehicles were to launch successfully, collectively they would raise nearly $7bn of new money. This is more than enough to swamp the US investment arena and send a sizeable overspill in the direction of Europe.

Of the filings, however, only Apollo and Prospect Energy Corp (sponsored by Prospect Partners) have actually managed to launch on the public markets. With most of the other structures looking set to die before they are born, no one in the UK is yet running for the hills.

One London-based mezzanine player maintains that the BDC fund raising window slammed shut after Apollo’s lacklustre debut. “The others will not be doing their IPOs. It is impossible, the numbers don’t add up,” he said.

Prospect Partners did manage to float its BDC on NASDAQ at the end of July this year but raised only 60% of what it was hoping for. Having set out to raise $180m (down from $207m in its original filing) through the sale of 12 million shares at $15 each it finally sold seven million and raised $105m.

As to BDCs such as Apollo and Prospect posing a threat to European mezzanine players and promoting a more competitive environment, one commentator points that there are tight restrictions on what the BDCs can invest in, with only 30% of the funds raised available for investment outside the US. “And why would they bother?” he asks.

“Personally I can’t see this type of vehicle having much impact in Europe,” says John Daghlian, a partner in O’Melveney & Myers in London. “Some of the major names in the US PE industry have cleverly seized the opportunity to raise funds from the public markets in an accelerated fashion but I think it will be harder for the late-comers to raise cash,” he says.

“Given the limited appetite of the European public markets for quoted private equity vehicles, I also doubt if this phenomenon will be replicated on this side of the Atlantic. BDCs are an interesting development and it could be good to have a new way of making PE more accessible as an asset class, but it will not sweep all before it,” says Daghlian.

A European mezzanine player points out it is great from the BDCs’ point of view to be paid to manage the money raised through an IPO. The floats are also money-spinners for the underwriters and lawyers involved. “But as to the returns that will ultimately go to investors, sponsors have been rather short on specifics,” he says.

Ian Hazelton, chief executive of Duke Street Capital Debt Management in London, believes BDCs have a transparency problem and questions whether retail investors really appreciate the risks. “I’m surprised the regulators are comfortable with letting retail investors get involved with this sort of thing,” he says.

Although one could argue many public market investments are inherently more risky than anything on the private equity spectrum and that most private individuals are indirect investors in private equity through their pension funds anyway. Morgan Stanley and Goldman Sachs are reported to have decided not to underwrite any IPOs of BDCs, considering them ‘not suitable’ for retail investors.

Certainly the fact that Allied Capital, the biggest and oldest BDC in the US, has recently been the subject of an SEC investigation will do nothing to inspire confidence.

Although marketed as a ‘new thing’, BDCs have actually been allowed in the US for years. Allied Capital made its debut on the OTC market in 1960 before listing on the New York Stock Exchange in 2001. Other established BDCs include American Capital Strategies, MCG Capital Corp, Capital Southwest Corp and Gladstone Capital Corp.

A BDC is, in essence, an investment fund organised under special provisions of the Investment Company Act. This permits it to receive tax free status on its earnings so long as 90% of these earnings are distributed to shareholders as dividends.

Because BDCs are not intended to be passive investment vehicles, they must either control the firms they invest in or offer to make available significant managerial assistance.

BDCs are also restricted to investing in ‘qualifying assets’. At least 70% of assets are required to be securities in private or thinly-traded public US companies, cash or cash equivalents, US government securities and high quality debt instruments.

Until the BDC epidemic began to emerge most private equity firms, keen to avoid the regulatory, reporting and valuation requirements and general scrutiny which is the price of access to the public markets, raised their cash from private sources.

As firms have collected more money from public pension funds over the years, however, the pressure on them to reveal more about their businesses and performance has risen. This has made the prospect of launching a BDC, despite its rigorous disclosure requirements, not quite the major leap it might once have been.

BDCs are similar to the UK’s Venture Capital Trusts (VCTs) in as much as they address retail investors. Also, similarly, VCTs often trade at a discount to net assets. Even those which don’t, such as Candover, 3i and Intermediate Capital Group, still rely primarily on conventional closed-end funds structured as limited partnerships to cover the majority of their capital needs.

VCTs, quoted on the London Stock Exchange, are not subject to the affiliate investing restrictions placed on BDCs in the US. These prevent tight integration within a multi-fund private equity group. This makes it much more difficult for a BDC to, for example, provide a mezzanine tranche in an investment where a related buyout fund is providing equity.

US private equity firms have got hung-up on BDCs as a way of using their growing brand recognition to access a permanent source of capital and thus reduce their dependence on having to raise fixed-life funds.

BDCs also allow private equity firms to tap into the US retail investment market where private individuals are apparently keen to buy potentially high yielding stocks in what has been a relatively low yield environment.

“Even so, many in the institutional investment community had reservations about this new wave of vehicles and what they are designed to achieve,” notes Dale Meyer, a partner in the US alternative investment advisory firm, Probitas Partners. “And with firms such as Allied Capital and American Capital already listed, there has never been any shortage of opportunities to invest in BDCs if that is what people wanted to do,” he points out.

About 65% of the shares in the Apollo IPO were bought by institutional investors although bankers said they expected retail subscribers to take a bigger role in subsequent offerings.

The high dividend component promised by most BDCs has been enhanced by last year’s US tax law changes which dramatically cut taxes on dividend payments.

BDCs also enable private equity firms to broaden their investment profiles, with many planning to target smaller investment situations and to supply mezzanine. This typically pays a coupon and provides a regular income stream.

“Private equity firms see enormous numbers of investment opportunities, many of which they cannot invest in due to their fund parameters. It would be useful for them to have other vehicles through which they can make investments that don’t fit their standard criteria,” Philip Howard points out.

The bugbear of the BDC concept is the high front-end fees and management charges. BDC underwriting costs range from 6.25% to 7%. Further, as demonstrated by Apollo, these fees are usually treated as an expense of the fund rather than an expense to be borne by the manager.

Management fees, meanwhile, are usually charged not only on the equity capital raised through the BDC but also on any debt the BDC issues at the holding company level.

Apollo, for example, is collecting 2% of ‘gross assets’ of Apollo Management. That is, 2% not only of the $930m raised but also of any borrowed funds, even if this money just sits on deposit awaiting investment.

And because BDCs are evergreen funds with no termination date, sponsors can collect these fees into perpetuity. Apollo also retains the normal incentive fee (‘carry’) of a traditional buyout fund; usually 20% of net profits above a hurdle rate.

With prospective investors balking at the proposed terms of the BDCs which were set to follow in Apollo’s wake, Blackridge Investment Corp, Blackstone’s planned BDC and the one regarded as most likely to proceed, made changes designed to address some of these concerns.

In June, Blackridge revised its fund raising target to $650m from the $850m set in its initial registration statement in April. It also reduced the management fees from 2% to 0.75% for the first six months of the fund’s life. The fees would rise to 1.5% for the next six months and to 2% after the first year.

Blackstone also pledged to put the new vehicle’s capital to work faster than originally planned, over 18 months instead of the 24 months initially specified. It also agreed to stop investing from its $1.1bn private mezzanine fund, Blackstone Mezzanine Partners, which would have competed directly with Blackridge.

The Blackridge IPO was considered such a leader in the pack of pending offers that Blackstone is reported to have extracted agreements from the joint book runners Merrill Lynch & Co, Citigroup and UBS, not to participate in any similar offerings before this one was complete. The banks also agreed to slash their fees to 4.75% from the original 6.5%.

Blackstone was also set to front part of the underwriters’ fee with shareholders shouldering it only if/when the fund passed a profit threshold.

According to the filing, Blackstone agreed to pay 1.75 points, or about $8m, of the total underwriters’ fee. The Blackridge fund would then have repaid the money to Blackstone a year after the IPO but only if it achieved a return on the investment threshold of 10%. Blackstone would charge interest to Blackridge, however, at LIBOR plus 2%.

Despite these concessions, in July Blackstone was forced to postpone the Blackridge float. Blackstone said market conditions caused it to delay the Blackridge offering. It has also been reported that there was a dispute over who would foot the underwriting bill.

Porticoes, another US private equity firm, similarly stalled the listing of its BDC this summer. It was seeking $575m for Porticoes Capital. In a recent amendment it had lowered its management fees until the fund was fully invested and reduced its target to $200m. And KKR has also recently shelved plans to float its BDC, according to reports. That issue was expected to raise $750m.

Many observers argue the unseemly scramble among private equity firms to launch public funds has been fuelled, predominantly, by investment bankers thirsty for underwriting fees.

“Private equity firms jumped on the BDC bandwagon because underwriters told them it was a good idea. Apollo said ‘yes’ first and this unleashed the gold rush. Firms thought it was free money from which they could make more money. It was a tidal wave rather than a thoughtful wave,” observes Dale Meyer.

Continues Meyer: “If I had to apportion blame, I would put 75% down to the irresponsible enthusiasm of the underwriters, 24% to the greed of the PE firms and 1% to the ignorance of private investors.”

Meyer sees the BDC story turning out to be a one-hit wonder. “If a blue chip firm like Blackstone, which already had an experienced mezzanine team in place due to its private fund, can’t get its BDC listing away then no one can,” he says.

But Philip Howard believes the BDC concept is by no means dead. “It will not disappear. It is simply a case of slowing down, putting in a little more time and effort and coming up with a business and investment model that works,” he says.

“Firms might be able to restructure their BDC offerings but making them more attractive to investors will simply make them less attractive to the sponsors, to the extent that they might just as well raise a straightforward closed-end mezzanine fund. This is the decision made recently by Carlyle, which has been conspicuously absent from the BDC scene,” says Meyer.

In short, it looks as if the new range of BDCs, in their current form, are not going anywhere. If private equity firms really want to reduce their reliance on cyclical funding, add new business lines and access retail money then it’s back to the workshop for an overhaul before hitting the IPO road once again.