Prospect Raises Bid for Allied Capital: This Is Far from Over

Includes: AFC, ARCC, PSEC
by: Nicholas Marshi

One of our self imposed rules for 2010 is that we want to provide useful commentary on every material news item related to the BDC industry and its constituent companies which we track on Seeking Alpha and our own website. However, in the last 48 hours the news has been coming fast and furious on the triangle of Allied Capital (NYSEARCA:ALD), Ares Capital (NASDAQ:ARCC) and Prospect Capital (NASDAQ:PSEC), and we’ve not been able to keep up. Events are overtaking our one finger typing abilities.

Anyway, we woke yesterday to Round Two of Prospect Capital seeking to wrest away Allied from Ares Capital. PSEC raised its stock offer to ALD shareholders: 1 share of your troubled company for 0.40 of ours (up from 0.32 a few days ago, and without benefit of being able to see the books). PSEC says this is worth $5.02 a share and is 20% higher than ARCC’s offer.

Going down the same path as before, PSEC points out that the result will be a higher dividend post merger to look forward to, if the distribution remains unchanged. PSEC also points out that ALD shareholders will end up owning 53% of PSEC versus only 31% of ARCC, but that’s mostly because Ares is a much bigger BDC. PSEC makes a subtle dig by reminding ALD shareholders of yesterday’s new equity raise at Ares, which is dilutive to everyone including prospective ALD shareholders. The heading for that argument in the press release is “Superior Upside Potential”, but could as easily be “bigger fish in smaller pond”.

PSEC seeks to address the “bird in the hand” issue straight on by promising to close a deal essentially similar to what ARCC has negotiated with ALD:

We have reviewed the merger agreement signed between Allied and Ares and are comfortable, subject to due diligence, executing an agreement with Allied substantially similar to Allied’s agreement with Ares. We believe we can complete our due diligence within 15 business days once full access to due diligence materials has been granted.

Neither prospective buyer is intending to pay-off all existing ALD debt (just its Revolver and certain private Notes, if we’ve read correctly). PSEC, though, is confident that it can receive the approval of “Allied’s institutional debt” holders, and presumably in short order.

PSEC also makes a promise to retain “a significant portion” of Allied’s professional staff. ARCC has been vague on the subject, but one suspects that there would be less need for the ALD people in the long run at a big firm such as Ares Capital. Prospect’s argument is that retaining existing staff will enhance management continuity on the portfolio (the “knowing where the bodies are buried” argument).

Finally, PSEC takes a shot at the ALD Board for not responding to PSEC’s offers, and threatens to take the proposal right to the shareholders.

We can’t help feeling a little sorry for the Allied Capital Board. While PSEC is knocking at the door, ARCC and ALD announced yesterday a record date for the transaction and set the Special Shareholders meeting to consider the offer for March 26, 2010. ARCC still indicates a closing by first quarter end is possible. Would PSEC be able to duplicate all the authorizations that ARCC has been working on since late October in a few weeks ? Doubtful but not impossible.

Anyway, that’s our parsing of the revised PSEC offer. We remain agnostic on who should buy ALD. Certainly the ALD shareholders should benefit from all this attention. We do, though, have a few random comments which may be useful from our reading of the Ares N-2 filed Monday and the various press releases that have been flying around.

1. Ares is already ahead of the game whatever happens with the ALD acquisition. In the past few months, ARCC bought two of Allied’s investment management businesses. This helped ALD de-leverage in a hurry, and greatly expanded ARCC’s own asset management ambit. Here’s are two extracts from the ARCC N-2 which speaks volumes. We can’t calculate exactly how much in additional income these two transactions will generate for ARCC but it’s certainly a step forward.:

…On October 30, 2009, we completed our acquisition of Allied Capital’s interests in the SL Fund for $165 million in cash. The SL Fund was formed in December 2007 to invest in “unitranche” loans of middle-market companies and has approximately $3.6 billion of committed capital, approximately $900 million in aggregate principal amount of which is currently funded. Of the $2.7 billion of unfunded committed capital, approximately $350 million would be funded by us. Since our acquisition of the SL Fund we have made one investment of $11.6 million. Our investment entitles us to a coupon of LIBOR plus 8.0% and certain other sourcing and management fees. In addition, since we invest in the substantial majority of the subordinated certificates in the SL Fund, our underlying investment also entitles us to a substantial portion of the excess cash flows from the loan portfolio…

On December 29, 2009, we made an incremental investment in IHAM to facilitate its acquisition of Allied Capital’s management rights in respect of, and interests in, the Allied Capital Senior Debt Fund (now referred to as “Ivy Hill SDF”), for approximately $33 million in cash. Ivy Hill SDF currently has approximately $294 million of committed capital invested primarily in first lien loans and to a lesser extent, second lien loans of middle-market companies. IHAM manages Ivy Hill SDF and receives fee income and potential equity distributions in respect of interests that it acquired in Ivy Hill SDF.

2. Should ALD’s Board end up taking the PSEC or some other offer and leave ARCC at the altar, the spurned suitor does get $30mn in a break-up fee. Admittedly ARCC has absorbed numerous and unstated costs to buy ALD, but $30mn is equal to one quarter’s of Net Investment Income, a tidy sum. (If the shareholders of ALD reject the ARCC offer the payment drops to $15mn).

3. ARCC faces a risk of its own should it not be able to close its side of the deal with ALD by June 30, 2010: a $30mn termination fee going the other way !

As they say, this is far from over and we’ll be back on this subject shortly.

Disclosure: Author has a long position in ARCC, no positions in ALD and PSEC