US Special: How the BDC business is a consolidation play

Things appear to be turning hostile. On 15 August, TPG Specialty Lending took the fight to fellow business development company TICC Capital, urging the latter's shareholders to choose the “gold” proxy ballot, electing a dissident director to their board and dismissing the company's existing investment advisor. 

The move prolongs a battle that has been going on for a year, since TSLX, the BDC affiliate of TPG Capital, objected to TICC's decision to turn its management contract over to Benefit Street Partners, the credit investment arm of Providence Equity Partners. Shareholders were scheduled to vote on the rival plans at the company's annual meeting on 2 September.

The battle over TICC underlines the turmoil in the BDC marketplace six years after Dodd-Frank reshaped the lending industry. “There hasn't been meaningful consolidation yet,” said Ryan Lynch, BDC analyst at Keefe, Bruyette & Woods, but there has been movement.

Ares Capital, the BDC operated by Los Angeles-based leveraged lender Ares Management, said in May that it would acquire its rival American Capital in a transaction valued at $3.4 billion. Ares, the largest public BDC as ranked by total assets and market capitalisation, previously acquired Allied Capital in 2010 in the wake of the financial crisis. The American Capital deal, a consensual transaction, is expected to close in the fourth quarter.

Several potential transactions are also understood to be brewing behind the scenes, involving the likes of Fifth Street, Credit Suisse, Full Circle Capital Corporation and the Business Development Corporation of America (BDCA). Many other small BDCs are said to be for sale as they struggle to build scale.

Today's market represents a reversal from just two years ago, when the BDC boom was still in full swing. BDCs have grown sharply since 2008, with 29 IPOs, six of them in 2014 alone, at least partly due to Dodd-Frank. Today more than 40 companies compete in the BDC space.

Since the summer of 2014, however, prices for BDC shares have fallen significantly, and the industry as a whole now trades at a discount to the net asset value of the loans in their portfolios, according to data from Closed-End Fund Advisors. And because BDCs typically are not allowed to raise additional equity while book values are underwater, the ongoing slump in share prices could inhibit the industry's ability to grow.

A number of factors figured into the 2014 tumble and the year that followed – the first an odd technical issue, according to Lynch of KBW. The Russell Index, a barometer of the small-company market, decided to exclude pass-through vehicles such as BDCs and REITs because they are not comparable to other small-caps. Being deprived of such comparators chilled investor interest in the sector.

Then things got serious. Oil and gas prices tumbled at the end of 2014, and NAVs of BDCs that lent to that market suffered accordingly in the quarterly fair-value marks. By the end of 2015, high-yield investments began to plummet in the face of persistently low interest rates and weak credit quality, ending in a meltdown that cratered in February and encouraging activist investors to lobby for changes in the industry. 

“Consolidation is being driven by poor performance and shareholder activism,” says Michael Arougheti, president at Ares Management.

Two-thirds of debt-focused BDCs are still trading below book value, but that represents an improvement from the sector's February trough, says John Cole Scott, chief investment officer of Closed-End Fund Advisors. “Six months ago only three were above book.”

After a rough 2014 and 2015, there are some indications that market conditions are now reviving. Total return year-to-date has rebounded to 12 percent, Scott says, “not bad” compared with a 7.4 percent total return over the previous 12 months and 5.6 percent for the past three years. 

BOOM TO BUST 

Still, the industry's difficulties remain apparent. Fifth Street Asset Management, a former high flyer that has been beset in recent times by activist investors, lawsuits, staff defections and falling stock prices, was understood to be working with Morgan Stanley on a sale in June, although the firm said on an earnings call last month that it was no longer looking at “strategic options”.

The Credit Suisse Park View BDC has been put on the block a little more than a year after going live, sources told PDI in July. The non-traded vehicle may have been at a disadvantage by launching after the BDC boom had already started to go bust.

In another instance involving a non-traded BDC, AR Global Investments has reached an agreement to sell its Business Development Corporation of America to Benefit Street, according to reports. Both BDCA and AR Capital, a predecessor to AR Global and primarily an operator of REITs, have been involved in financial scandals. This sale appears to be part of an effort by AR Global to wind down its operations.

Further afield, The Carlyle Group is shopping its majority stake in diversified money manager TCW, in a move characterised as a way to deliver investment returns to its limited partners, PDI reported in August. TCW, which operates in a variety of markets including mutual funds and institutional credit investment management, does count a BDC among its businesses, and people familiar with the companies say part of the rationale for a sale could be that the portfolio company competes in some areas with Carlyle GMS Finance BDC, part of the mid-market lending business within Carlyle's own Global Market Strategies unit.

In any case, the demonstrated fragility of the BDC market is likely to continue to pressure the industry to consolidate. “It's in markets like this where the scale of your operation becomes really important,” says Arougheti. 
Adds Kipp deVeer, chief executive officer of Ares Capital and co-head of Ares Credit Group: “The larger you are, the more flexible you can be with your capital.” ?


THE CHANGING FORTUNES OF FIFTH STREET 
The BDC boom turned Fifth Street Asset Management into an industry dynamo and brought Leonard Tannenbaum, its founder and chief executive, to the threshold of the billionaires' club.

But issues over the firm's plummeting stock prices and high fees brought a spate of activist investors, lawsuits and an investigation by the Securities & Exchange Commission. The company was understood to be working with Morgan Stanley on a potential sale, although the firm said on an earnings call in August that it was not looking at “strategic options”.

Fifth Street Finance (FSC) went public in 2008, the only BDC to IPO at the nadir of the financial crisis. A sister vehicle, Fifth Street Senior Floating Rate, went public in 2013. Fifth Street Asset Management (FSAM), the external manager of the BDCs' portfolios, hit the market in October 2014, just as the segment was tumbling due to slumping energy prices, stagnant interest rate spreads and growing credit risk.

The trio soon attracted the attention of activist investors, including RiverNorth Capital Management and Ironsides Partners, which complained that FSAM was reaping rich fees for mediocre performance.

In response, FSC agreed to buy out the investor's interest at a premium, prompting criticism that the firm was yielding to 'greenmail' to protect its franchise. 

Fifth Street could sell the FSAM management contracts, but that would be unattractive to the sellers, says Ryan Lynch, BDC analyst at Keefe, Bruyette & Woods. “Len Tannenbaum would lose all the fees that FSC is currently paying,” which are running at $56 million per year. 

Fifth Street declined to comment.