Annual Review: BDCs – buy or hold?

After the financial crisis – and the reforms that came with it – business development companies seemed to reap the benefits and business boomed. However, by the start of 2016 it was clear that this prosperity had begun to dwindle and with it the net asset value and stock prices of many BDCs. The mergers that followed were inevitable.

The most recent deal was Ares Capital Corporation’s $3.4 billion acquisition of American Capital which was announced last year and reached a close in January. Another notable transaction was CION Investment Corp’s purchase of BDC Credit Suisse Park View in October for about $277 million. More consolidation looked likely, but at the start of 2017, the BDC’s average NAV and stock prices started to make a gradual comeback, meaning the acquisitions may come to a halt – for now.

“Last year, we saw a robust market for corporate control in BDCs,” says Thomas Friedmann, co-chairman of global corporate finance and capital markets practice at Dechert, which has represented numerous BDCs. “I don’t have a crystal ball, but I would expect BDC consolidation activity to subside a bit this year.”

Friedmann notes that the BDC consolidation activity in 2016 was largely fuelled by BDC shares trading below, or on a par, with NAV of the loans in their portfolios.

Since the summer of 2014, the market prices for BDC shares have fallen significantly and, on average, BDCs have continued to trade at a discount, according to data from Closed-End Fund Advisors.

Key factors behind this include the drop in global oil and gas prices near the end of 2014 and the fact that BDCs are typically not allowed to raise additional equity while their books values are underwater. Towards of the end of 2015, and well into 2016, BDCs were becoming increasing attractive to acquisitive suitors. “Consolidation is being driven by poor performance and shareholder activism,” Michael Arougheti, president at Ares Management told PDI in September.

But the tide is beginning to turn. The average market price has spiked 39 percent in the year-to-14 February, while NAV has jumped by 6 percent during the same period. Over a three-year period prices increased 3.5 percent and NAV 12.6 percent.

The “nadir in BDC stock prices” was early last year, Friedmann says. “And with stronger market prices, there’s a limited upside for potential BDC acquirers, so interest in buying or merging with BDCs may subside. In this credit environment, we can expect more people to want to build a BDC than buy one.”

Last year was a good time to buy, not build. At least that is the conclusion Ares Capital Corporation came to when it agreed to pay $3.62 billion for American Capital, which was initially placed on the chopping block in January 2015. In addition to Cion’s October Credit Suisse purchase, several other BDCs were rumoured to be heading toward the chopping block in the same month.

However, a recent tax incentive for foreign investors to build BDCs, could put the brakes on any further mergers. Jeffrey Sion, partner at Dechert, says that a change in the US tax law has reduced the amount of tax on dividends to foreign investors, making BDCs more attractive to foreign capital than they were before the change was enacted in December 2015.

“We are seeing this make BDCs more attractive to foreign investors,” Sion notes. The change allows for a pass-through tax exemption for regulated investment companies, including BDCs, Sion says. As a result of the tax law change, any portion from a BDC’s dividends, derived from US-sourced interest income, distributed to foreign investors would be exempt from US withholding tax.

Such earnings are no longer taxed at 30 percent, which previously made foreign investors less interested in BDCs here, he adds. Foreign investors used to be reluctant to consider the BDC structure because this tax exemption used to be subject to an uncertain periodic renewal, but is now a permanent part of US tax law. More and more foreign investors may catch on to this relatively new tax perk, and some BDCs are already capitalising, Sion and Friedmann note.

“We’re hearing that people organising BDCs have a lot of interest in targeting non-US investors due to BDCs’ relatively high yields and tax-blocking advantages,” Friedmann says. “To people forming new BDCs, the tax blocking advantages of a BDC for non-US investors is a key focus. You can’t overstate that.”

Mergers, movers and markets

2016

JANUARY

  • Franklin Square Capital Partners sets up new BDC: FS Investment Corporation IV

FEBRUARY

  • GSO Capital co-founder Doug Ostrover and Marc Lipschultz, KKR’s head of energy and infrastructure, set up new BDC along with Owl Rock Capital

 MAY

  • Ares Capital reveals plans to acquire American Capital
  • Ratings agency Fitch reiterates negative outlook for BDCs

JUNE

  • Apollo Investment Corporation names Howard Widra as BDC head

JULY

  • Credit Suisse reveals BDC sale

OCTOBER

  • Credit Suisse’s BDC picked up by Cion
  • Bain Capital Credit BDC opens its doors, pulling in over $500 million

NOVEMBER

  • Former Credit Suisse BDC execs Jens Ernberg and Tom Hall plan new venture
  • Benefit Street Partners closes its purchase of Business Development Corporation of America

2017

JANUARY

  • Goldman Sachs set up new BDC with $600 million in capital
  • Ares Capital closes merger with American Capital
  • BlackRock BDC, BlackRock Capital Investment Corporation, picks new CEO: Michael Zugay