More product, more challenges

BDCs looking to break into closed-end funds and credit fund managers eager to get into BDCs have at least one thing in common: a long to-do list.

One of the big themes in the credit world last year was that many business development companies were trading below book value, which precluded them from raising new equity capital. Publicly-traded BDCs lost 6.7 percent on average in 2014, according to the Wilshire BDC Index. As a consequence, some BDCs are trying to branch out into other parts of the US debt market to refill their coffers elsewhere.

Take Greenwich, CT-based Fifth Street Asset Management for example, which has most of its $6 billion under management in two BDCs. Fifth Street is branching out into institutional strategies, which founder Len Tannenbaum recently gave up his chief executive title at the BDCs to focus on. The firm recently closed its first CLO on $309 million and has ambitious plans for other vehicles such as closed-end funds, hedge funds, an aircraft leasing strategy and expansion into Japan.

Fifth Street’s expansion plan means the firm will have lots of work to do. Creating CLOs usually involves working with underwriters at the major investment banks, and setting them up via a warehouse process to speed up the securitization process. Fifth Street is working with Wells Fargo to raise institutional capital for its CLOs. In 2013, the bank provided the firm with a credit facility.

In addition, raising institutional money for closed-end funds requires the nurturing of investor relationships and courting investment staff, pension plan trustees, other types of decision-makers and also external consultants for years. It’s a long-winded process, and any BDC specialist seeking to develop an institutional product line should be clear that the effort is considerable.

Now, intriguingly, there is also a movement in the other direction – from debt fund managers seeking to enter the BDC space. Driving this is the near-certainty that BDC valuations will recover eventually (some already have), and also the fact that they are a great source of permanent capital. Indeed, several large, well-established credit fund firms are now starting BDCs.

A case in point is Benefit Street Partners, which has launched a non-traded BDC in partnership with Los Angeles-based Griffin Capital. “We thought the BDC would be a good way to diversify our investor base beyond large pension funds and endowments, without changing our strategy,” Rich Byrne, Benefit Street’s president told PDI. “Permanent capital is a very important thing to an asset manager.” It’s important because it overcomes the inherent flaw in closed-end funds: when the last one is finished investing and money for a new one hasn’t yet been raised, the managers can’t collect fresh fees.

But again, setting up a new BDC from scratch is no easy task. Throwing darts at the wall and hoping they stick won’t work. Novice managers often start with non-traded ones first, spend several years getting the product registered on financial advisor and broker-dealer platforms and then, provided the vehicle has raised enough capital, offer it on an exchange. Confirms Byrne: “We expect the BDC to raise capital over the next three years through the broker dealer and RIA networks.” He estimates that there are thousands of them in the country.

When all is said and done, raising money for either type of structure is not easy. Before embarking on such a project, firms must make sure they have the right infrastructure and relationships in place to start tapping a new investor base. For houses that have scale already, such as the large alternative investment firms with deep pockets and connections, this might not be such a daunting task. For smaller firms, and especially BDCs that have been underperforming in recent times, it could be a more arduous road to travel.