The arrival of the big guns

As Christmas looms, 2017 will be remembered as a year when two BDCs went public and several others contemplated doing the same. The recent IPOs serve as encouragement to other private debt managers and their investors who view the public business development company market as a way to expand and gain liquidity.

“A lot of private BDCs want to grow AUM,” says Ryan Lynch, an analyst and BDC specialist at financial services firm Keefe, Bruyette & Woods. “They may not want to stay as a private company. They may want to try an IPO.”

The recent BDC IPOs were both backed by large, well-established asset managers – pedigrees have been helpful in attracting investors to the public issues while also bolstering the standing of the public BDC market.

“BDCs are still a small group,” Lynch says. “If you can bring a large alternative asset management platform to the BDC space, that is good, because it brings more credibility.”

The Carlyle Group, one of the world’s largest alternative investment firms with more than $160 billion under management, took its TCG BDC public in June. TCG’s stock has traded in the low-to-high $18 range since. It started out as a closed-end investment fund in 2012, then morphed into a private BDC that registered with the Securities and Exchange Commission in 2013. At about $1 billion in market capitalisation, it immediately joined an elite club.

The Carlyle IPO was followed by one from KKR in November. Its Corporate Capital Trust has traded in the low $17 range since the IPO. It has a considerably larger market cap of $5 billion.

KKR, with more than $150 billion under management, and Carlyle each manage more assets than the size of the entire public BDC market, which has a market cap estimated at less than $40 billion. A market of that size can face difficulty attracting large institutional investors.

“The rap on the public BDC market is that it is too retail focused,” says Stephen Nesbitt, CEO of Cliffwater, a Los Angeles-based investment advisor to institutions. “What needs to happen for the public market to grow is that you need more private BDCs to go public, and get more market cap so you can then attract more institutional investors.”

“On the margins, you are seeing direct lending funds forced to do more unitranche or stretch senior loans. It is important for investors to recognise that there could be some migration in the fund they have invested into”
Christopher Acito

Nesbitt says his firm has provided backing to four private BDCs that are candidates for going public in the future. The quartet are among a number of private BDCs registered with the SEC and could be candidates for IPOs.

Nesbitt says there are currently around 30 private BDCs now, with about a dozen having the track record and management capability to consider going public.

An open window

Christopher Acito, CEO of Gapstow Capital Partners in New York, an alternative investment firm that allocates to credit strategies, says one of the key catalysts for BDCs to go public is their trading value. They have been trading at a premium to book value recently, but below book value in the recent past.

“The window isn’t always open to get BDC IPOs done,” Acito says. “Good BDCs are trading above book value now, so it is a good time for them. It is tough to issue when they are below book value.”

Underlying the IPO trend for BDCs is broader interest in private debt and mid-market lending, which has provided attractive yields and returns to investors. Responding to demand, asset managers have been raising private debt funds at a rapid clip. According to data from Keefe, Bruyette & Woods, mid-market loan funds raised more money in 2016 than all of 2014 and 2015 combined. Lynch says 2017 appears on track to hit $70 billion in new funds raised – about double the 2016 total.

Only about 2 percent of the total being raised is in public BDCs, Lynch says. But all the extra capital flowing into private funds, including private BDCs, creates a growing pool of candidates that could go public. But even with the growth of private debt funds, Lynch doesn’t foresee a rush. He anticipates just one or two BDC IPOs in 2018.

What Lynch and others see is an increasingly crowded mid-market lending space, where BDCs and other fund managers compete for small business loans. The result has been downward pressure on loan interest rates and a drop in yields for loan funds. KBW reports that institutional mid-market loan yields have fallen from an average of 7.9 percent in the first quarter of 2013 to 6.2 percent in the second quarter of 2017. Not surprisingly, BDC portfolio yields have also declined, falling from 13.3 percent in the first quarter of 2011 to 11 percent in the second quarter of 2017.

Adding to the pressure on BDCs and their competitors is the move away from riskier parts of the capital structure, increasing crowding at the top. First lien loans are in high demand now, so borrowers have more power in obtaining favourable interest rates and other loan conditions. In 2011, first lien loans comprised 51 percent of BDC portfolios, according to KBW. By mid-2017, the total had reached 57 percent. While first lien loans carry a lower risk profile, they also tend to carry lower interest rates than second-lien or mezzanine loans.

“Everybody is talking about moving up in the capital structure,” Lynch says.

Pushed back

But, at the same time, some BDCs and other direct lenders are encountering push-back from small business borrowers with good track records that are being heavily courted. Some fund managers trying to land first-lien loans are finding themselves pressured to offer lower-level financing as part of the deal.

“Borrowers are being more aggressive on terms,” says Acito. “On the margins, you are seeing direct lending funds forced to do more unitranche or stretch senior loans. It is important for investors to recognise that there could be some migration in the fund they have invested into.”

The combination of increasing competition and crowding at the top of the capital structure are expected to continue into 2018, which could continue to put pressure on yields and returns for BDCs and other direct lending funds.

But, despite the challenges, investors remain keen on placing money with well-managed BDCs and other private debt funds. While part of the attraction is that returns can still be favourable, the other element is the potential for a profitable exit strategy after a few years.

The IPO market remains an attractive option for private BDC investors, as long as BDCs trade at a premium to book value. But there are other options besides going public. One is simply to liquidate a private fund when it reaches a point where its investors want to cash out. Another is to sell all or part of a fund or merge with another company. There have been a number of those deals in recent years where BDCs merged or sold assets. That trend is expected to continue.

The health of BDCs is, of course, tied to the health of the overall economy and to credit cycles. At the moment, most analysts see no immediate setbacks that could derail mid-market businesses or the funds that lend to them.

However, “if you have a downturn in the credit cycle, BDC stocks won’t perform well”, Lynch says. “Ultimately it could shake out some of the excess competition. It won’t be a good experience for BDC investors.”