BDC Mergers: Past, Present And Future

by: Philip Mause

In 2009-2010, there were two important mergers of Business Development Companies (BDCs): the Prospect Capital (NASDAQ:PSEC) takeover of Patriot Capital and the Ares Capital (NASDAQ:ARCC) takeover of Allied Capital. In each case, the takeover was a stock-for-stock deal. BDC veterans remember Allied Capital; it was, for a long time, a kind of flagship of the BDC industry and ran into problems with lenders, with its ratio and with short sellers. When a takeover is planned, there is always a risk that the assets of the company being acquired may not be worth the amounts set forth on the books, and that losses will have to be recorded on those assets after the acquisition.

Both PSEC and ARCC seem to have fared well since the takeovers. ARCC's website provides quarterly reports, which allow the reader to track the performance of the legacy Allied Capital assets. I haven't found a way to do this with respect to the Patriot Capital assets, but PSEC's overall performance suggests that they have worked out reasonably well.

This raises the question of whether any more acquisitions or mergers are likely in this sector. A number of BDC's have been engaged in secondary equity offerings - ARCC, Fifth Street Finance (NYSE:FSC) and PennantPark Investment (NASDAQ:PNNT) all in the last couple of months. Some BDCs could probably even contemplate a cash for stock takeover depending on scale and pre-existing leverage.

A takeover of another BDC can be attractive for a number of reasons. If the takeover price is less than the book value of the target, then the acquiring firm may be able to increase its own book value per share by virtue of the takeover. There are advantages to acquiring a book of loans rather than having to go out and negotiate them one by one. Most BDCs also have deal pipelines and acquiring a good deal pipeline and a team capable of continuing to fill that pipeline can also be attractive.

A good place to start looking for takeover prospects is among BDCs priced well below book value. A takeover proposal can be structured to give the shareholders a price well above market and still provide the acquiring firm with a portfolio of assets at a price well below book. With the recent upsurge in the stock market, it is getting to be more and more difficult to find BDCs pricing substantially below book value.

Two BDCs trading well below book or net asset value are Saratoga Investment (NYSE:SAR) trading at about 62% of book and MCG Capital (NASDAQ:MCGC) trading at about 73% of book. MCGC has considerable debt and would be digestible only by some of the largest BDCs. SAR is quite a bit smaller and has very little debt. It does seem to stick out as the most plausible acquisition target in the BDC world right now. Now that financial and credit markets have moved away from the "risk off" mode we saw in the second half of 2011, it probably makes sense to monitor this situation and to continue to identify situations in which BDCs trading substantially below book value offer attractive takeover prospects.

Disclosure: I am long SAR, PNNT, ARCC, FSC, MCGC.