US debt: Which BDCs stand the best chance of going public?

The initial public offering of The Carlyle Group’s business development company in June was the first stock exchange debut by a BDC for more than two years, and the latest signal that these types of lending vehicles are becoming increasingly institutionalised.

TCG BDC, as Carlyle’s vehicle is known, raised $166.5 million in an offering of nine million shares priced at $18.50, and followed the IPO of the Goldman Sachs BDC in March 2015. Other large alternative asset managers including Bain Capital, Golub Capital and TCW Group have also launched private BDCs, which offer mid-market debt, but there has been a listings drought.

In all, 40 BDCs are included in the S&P BDC Index. But they have had a tough time. “For the last couple of years, BDCs have been trading below net asset values,” says Cynthia Krus, a partner with the law firm Eversheds Sutherland. “As long as they are doing that, you really can’t do an IPO because there isn’t suffi-cient interest. In the past year, BDC NAVs have been improving, so market accessibility has improved.”

She says BDC stocks have suffered alongside all other listed financial services businesses and may now turn a corner if markets strengthen.

STOKE DEMAND

By launching private BDCs, managers must report to the Securities and Exchange Commission but are able to raise money privately and build up a portfolio before tapping the public markets, which helped Carlyle stoke demand ahead of its IPO. On 27 July, its BDC shares were still trading at the offer price.

“The private structure allows you to ramp up a portfolio, so you’re not going public with a blind pool,” says Krus. “Years ago, you could IPO that way, but now the market wants to see what you have and how you are going to generate yield.”

Challenges in the BDC space have created a bifurcation: according to the S&P Index, the largest BDC has a market cap of $6.9 billion, while the smallest is at $58 million. 

Sean Coleman is chief credit officer at FS Investments, which manages, among other funds, FS Investment Corporation, a publicly-traded BDC focused on providing credit to US mid-market firms, and is the largest sponsor of BDC assets with approximately $18.3 billion in BDC assets under management.

“The market today is one where you have quite a number of smaller BDCs, and they are really competing for $50 million to $100 million loans. And then at the upper end of the market you’ve got the big players like FS Investments, Ares and Golub,” says Coleman. “It’s going to be hard for small-scale players to go public unless they are differentiated. I expect new entrants to the BDC space will be from existing, well-known credit platforms or large alternative asset managers with a strong brand.”

He says demand from investors continues to grow, but consolidation looks inevitable as BDCs seek greater scale in order to compete.

In January, Ares Capital closed a deal to buy rival BDC American Capital, adding $3 billion to the Ares credit unit’s assets under management and allowing it to do even bigger deals. The deal increased Ares’ total BDC assets to $12.3 billion; last year Ares led the origination of one of the largest loans arranged by a BDC, lend-ing $1 trillion for the August buyout of Qlik by private equity firm Thoma Bravo, and retaining about $200 million on its books.

And in July, Oaktree Capital signed a purchase agreement to assume the management of two BDCs run by Fifth Street Management, paying $320 million in the transaction. Jay Wintrob, chief executive at Oaktree, said at the time: “These BDCs are a clear strategic fit with Oaktree’s direct lending expertise, and the com-pletion of this transaction will create a BDC platform with scale that leverages our deep credit expertise, loan origination capabilities and underwriting skills.”

Coleman says there are signs BDCs are becoming more of an institutionalised asset class. “From an inves-tor perspective, BDCs remain very attractive, but you have got to pick the ones with scale and a large deal funnel that allows them to pick credits with attractive yields and minimal downside risk,” he adds. “With in-creased competition, there has been yield compression and a weakening of covenants, so investors really need to gravitate to established players capable of getting better terms and originating better assets.”

Carlyle may not be the only firm to take a BDC public this year, with TCW Group’s BDC, TCW Direct Lend-ing, also considering a listing of its private BDC. But few are predicting a swathe of IPOs any time soon.

Michael Littenberg, a partner with the law firm Ropes & Gray, says: “It’s been hard for many BDCs to find attractive investment opportunities in the current environment due to the availability of lower cost bank fi-nancing in many cases. So, it hasn’t been a particularly robust environment for BDCs to go public. Some industry observers feel the market is improving for BDC IPOs, but whether it’s a harbinger of things to come remains to be seen.

“BDCs are a niche product. There has never been more than maybe six or seven BDC IPOs in any one year. Even if we see more BDC IPOs, it will remain a small part of the market.”

Krus has been working with BDCs for about 20 years. She says: “It would be my expectation that there would be more IPOs in the future, as long as they trade well. There are obviously investors out there looking for yield, and as long as interest rates stay low, these products offer them access to a part of the mid-market that is not otherwise easy for them to tap. So I think we will see more IPO transactions, but also some more consolidation as people migrate to larger platforms.”

TOUGH CHOICE

Efforts continue to be made by the BDC community to modernise regulation, pushing for more capacity to lend to, and invest in, small to mid-sized US companies. In 2015, the US House Financial Services Commit-tee passed a bill to update the rules, allowing for the use of more leverage. At the moment, BDCs are limited to a 1:1 debt-to-equity ratio; the legislation would increase that to 2:1, thereby expanding lending opportunities while keeping leverage much lower than is seen in banks and other lenders.

However, the legislation stalled, and the changes are now wrapped up in the Financial CHOICE Act, which also includes plans to repeal or replace key provisions of the Dodd-Frank Act. The House of Representa-tives passed the CHOICE Act in June, but it is yet to gain Senate approval, pushing changes for BDCs back for some time.

“Increasing the amount of leverage permissible is something a number of BDCs would find attractive,” says Krus. “When Congress will get around to it is uncertain, but it looks likely that it could happen. That would be a real boost to the market.”

Littenberg says the BDC market looks set to stay small, but activity levels could well start to increase. “BDCs will remain a niche product,” he says, “and we are not going to suddenly see 50 BDC IPOs. With that said, there are managers that BDCs may make sense for. For a couple of years, the market wasn’t support-ive of BDC IPOs, but we are again now seeing some asset management clients looking at whether it might make sense for them to add a BDC to their platform.”

BDCs PUSH FOR REGULATORY CHANGE
It is not just the rules on permissible leverage that BDCs are lobbying to change through the CHOICE Act. It has also been a challenge for BDCs to raise capital because they don’t necessarily have all the benefits of accessing the capital markets that are available to other operating companies.

The CHOICE Act directs the SEC to revise rules to allow BDCs to file offering materials and proxy state-ments under the rules that apply to other non-investment company issuers. This would offer big advantages, like automatic shelf registration not subject to the SEC review process, and much lower registration fees for shares.

Anna Pinedo, a partner in the securities practice at the law firm Morrison & Foerster, says: “A number of the big indices stopped including BDCs, which created an exit for big institutional holders of BDCs, and they be-came very retail-oriented. It would be very helpful if the SEC took some of these concerns to heart and simplified some of the disclosures so that BDCs could once again be included in some of the indices.”

Other rule changes will remove limits on investments made by BDCs that were central to the definition of a BDC under the Investment Company Act of 1940. BDCs have always been limited in the type of companies they are allowed to invest in, but the CHOICE Act removes limits on them investing in investment advisors and certain other financial companies.

Pinedo says: “The particular provisions in the act related to BDCs have generally wide support, so I could see them being reformulated back into a stand-alone Bill that might get passed without the CHOICE Act. What’s more, a lot of the provisions in the CHOICE Act related to BDCs don’t actually require legislation – the SEC on its own has the authority to make many of the changes, so it would be certainly within the realm of reason to contemplate a situation where the SEC would just go ahead and adopt some of these changes.

“That has the potential to really change the market. Right now, the process we are going through for any securities offering of a BDC is antiquated in comparison to the process for a securities offering for an operating company.”