Debt-market volatility has choked off a flood of new entrants that had been vying to enter the leveraged loan market as business development companies, suggesting credit markets will remain tight for mid-market sponsors, market watchers report.
According to Stifel Nicolaus & Co., which tracks the market, at least 11 BDCs completed IPOs in 2010 and the first half of 2011. Since June: None. Factors behind the freeze include the downgrade of the United States’s credit rating in July and the sovereign debt crisis in Europe, said Al Laufenberg, a managing director at Stifel Nicolaus in Chicago. One result was to push the trading value of existing BDCs below their net asset value, where they now have been trading for several months, Laufenberg said. “There’s not a lot of incentive for investors to buy into a new IPO when existing BDCs are trading at a discount.”
Stifel Nicolaus tracks about 25 existing BDCs in the market, and Laufenberg estimated there are perhaps 18 more in registration. Roughly half of those are pursuing a conventional public offering, where they file documents with financial regulators, while the others are pursuing their offering through alternative channels, such as private placements through financial planners, which do not require the same regulatory review.
But the stall in the BDC market is prompting some concern about the availability of credit. The “mid-market financing market right now is dominated by hedge funds and credit opportunity funds,” said Ronald Kahn, a managing director at Chicago investment bank Lincoln International LLC and head of its credit advisory service.
Banks, never enamored of cash flow lending, have been under pressure to restrict themselves to better-secured asset backed loans, putting the spotlight on the lenders that provide junior financing, including mezzanine, unitranche and other forms of second-lien credit, which are often critical to close the gap between what the senior lenders are willing to provide and the leverage that sponsors seek.
Global credit turmoil has made the situation worse, as BDCs, hedge funds and credit opportunity funds weigh the risks to their returns, Kahn said. “They do know what is going on in Europe, and they adjust their rates and leverage multiples accordingly.”
With the closing of the IPO window, existing BDCs have pursued other tactics to maintain liquidity, said Nicholas Marshi, a co-founder and the chief investment officer of Southland Capital Management, a Santa Monica, Calif., hedge fund that invests exclusively in BDCs. Some have increased their lines of credit, and a couple have been able to raise follow-on equity, Marshi said. “A lot of them are sitting on dry powder because they never got all their money deployed before the slowdown.”
In addition, demand from dealmakers is down, Marshi said. “I don’t think there’s going to be any shortage of capital for people who have deals to fund,” he said.
The business model has changed in 2011 for BDCs, which historically have been mezzanine lenders, Marshi added. “Many of the BDCs that came to market this year, and many of the ones that were already in the market, have switched to a senior loan model alongside subordinated debt.”
He cited Medley Capital as a senior capital lender. Medley Capital raised $139 million in its January IPO, according to Stifel Nicolaus. Others that have raised capital include Full Circle Capital, which raised $18 million in August 2010, mostly for senior lending. An existing BDC, TICC Capital, raised a closed a $225 million collateralized loan obligation (CLO) transaction but can invest only in A-grade transactions, he said. Meanwhile, two existing mezzanine-lender BDCs set up new affiliates—PennantPark Floating Rate Capital, which raised $103 million in April, and Solar Senior Capital, which raised $160 million in February.
These floating rate senior loans yield only around 8 percent rather than the 12 percent to 14 percent that BDCs are accustomed to from mezz lending, but it’s a tradeoff, Marshi said. “They’re making a little less money, but they’re a lot more confident about the risks that they’re taking.”
And if market conditions improve, the six-month freeze on BDC IPOs may end. The backers of these vehicles, having invested the time and effort to bring them to this point, may hold out and wait for the IPO window to open again, Laufenberg said. “Not everybody gets through that window, but you want to be ready.”