Wither the Mezzanine Market? –

Will BDCs kill the mezzanine star?

This 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). 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 (i.e. mezzanine investing).

Atlantic Conferences Inc. recently added BDCs to the top of promotional materials for its 11th Annual Mezzanine Finance event in New York, and expanded a panel discussion to include the topic. “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.”

On the previous page, Ronald Kahn of Lincoln Partners provides a strong argument for why BDCs could change the face of the entire mezzanine market, and several limited partners have voiced concern that the relatively cheap capital of BDCs will lower yield expectations for traditional mezzanine funds.

Before everyone gets too worked up, however, it is important to note that much of the hype is anticipatory instead of reactionary. Eight firms may have filed to form BDCs in 2004, but only one – Apollo Investment Corp. from Apollo Management – had priced as of press time last Wednesday. Moreover, Apollo hasn’t even made its first investment yet, and has followed other closed-end funds in trading below its $15 offering price. Moreover, only one firm (Thomas H. Lee Partners) has issued a new BDC filing in the past two weeks, although there are banker assertions that a handful of major firms already have drafted the appropriate papers. In other words, it’s become a game of wait and see.

Even if all the prospective BDCs do come to market, there is no guarantee that they will be regularly tapped as mezzanine lenders. Doug Newhouse, a co-founder and managing partner of Sterling Investment Partners, says: “Some of these new funds will be able to provide additional sources of funding for people who want the lowest cost of capital, 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. Almost none of the filings cite the identities of specific fund managers, or even whether or not outside managers will be hired. Kohlberg Kravis Roberts & Co., for example, writes in its N-2 filing 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 also mentions that existing KKR investment professionals also will pitch in, although the general KKR buyout fund will not invest in any company in which KKR or its affiliates have an investment.

Apollo is a bit more specific, in that it initially plans to use existing investment staff led by partners Michael Gross and Art Penn. It eventually could hire additional personnel to work on the BDC, but sources say not to expect a repeat of the team-pilfering phenomenon that occurred in the early 1990s when buyout firms launched CDO and CLO vehicles.

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, although it is unclear if a second “traditional” mezzanine fund will be raised. No one from Blackstone was available for formal comment last week, due to both SEC restrictions and an annual limited partner meeting in Orlando.

Informally, however, just about everyone in the market continues to talk about the potential impact of BDCs. But for now, it’s all just talk.