What The Wave Of New Private Mezzanine Funds Means For The BDC Sector

Jun. 10, 2013 10:56 AM ETARCC, AINV, BKCC, SLRC, FCRD, OCSL3 Comments
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Value, non-investment grade debt

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Nicholas Marshi is the Editor of the BDC Reporter (www.bdcreporter.com), the leading online publication dedicated to the Business Development Company ("BDC") sector. The BDC Reporter is read by thousands of individual and institutional investors for its broad and incisive coverage of this $60bn segment of the financial sector. Since 2008, Mr Marshi has also been a frequent contributor to Seeking Alpha, penning hundreds of articles and blog posts. Mr Marshi is also the Chief Investment Officer of BDC Investment Advisors (BDCIA), a Registered Investment Adviser based in Los Angeles, California. BCIA manages investment portfolios, both for its own account and those of third parties, solely in the publicly traded securities of BDCs. Since 2009 SCM has also managed a "friends and family" investment fund focused on the BDC sector, which has recently opened up to third party accredited investors. Prior to forming BCIA, Mr. Marshi managed two private equity firms. Both firms were active in acquiring lower middle market private companies, principally in Southern California. Before getting into Private Equity, Mr Marshi was the head of the Los Angeles office of Kleinwort Benson Limited, a British merchant bank, from 1987-1990. Mr Marshi was involved in investment banking, lending and principal investing activities. At the outset of his career, Mr Marshi held various positions with Citibank at locations worldwide including Athens, Dubai, Puerto Rico and London. Mr Marshi is a graduate of Tufts University (B.A.) and Harvard University (M.A.).

BDC REPORTER: Here's a link to story about the number of private mezzanine funds being raised to invest in the U.S. market, based on data supplied by Private Equity industry data gatherer Prequin. The BDC Reporter goes on to speculate about what all this new dosh coming to town will mean for the existing Leveraged Finance players, and more specifically for the Business Development Company industry.


" Of these [mezzanine] funds, 43 primarily focus on North America, collectively targeting $15bn and representing 71% of the total capital targeted."

The article provides color about a couple of the top contenders:

"The largest mezzanine private equity fund currently in market, Crescent Mezzanine Partners VI, is targeting $2.5bn. The fund is the first private equity to be managed by US-based Crescent Mezzanine Partners since spinning out from TWC Group early in 2011. So far it has held one interim close, collecting just over $1bn in capital commitments.

The second largest fund in market, Sankaty Middle Market Opportunities Fund II, is aiming to raise $1bn. The fund is managed by Sankaty Advisors and its fundamentals include purchasing subordinated debt, senior and second lien loans, preferred and common stock and other instruments of middle market companies. ABRY Senior Equity IV is the third largest, targeting $950mn and seeking investment opportunities across North America in business services, communications, information services, media, and technology and telecoms sectors"

WHO CARES ?: The wave of additional mezzanine capital coming to market is additional competition for the established middle market players: both public and private. The BDC Reporter's focus is principally on the former. In this category, the Business Development Company sector is the Leveraged Debt segment most likely to compete with the private mezzanine funds. How much competition is $15 billion ? The answer: Plenty ! Roughly, the entire public Business Development Company sector has loan assets outstanding of $35 billion-$40 billion. Throw in the private BDCs and we'll guess total BDC balance sheet assets must top $50 billion.

NOT EVERY BDC WILL BE EQUALLY AFFECTED: We need to drill down some more, though, to delineate where competition might be the fiercest. As most investors know, the BDC industry has made a major push into two lending segments in recent years where the private mezzanine funds are unlikely to follow. We assume the new private mezzanine funds will not be competing directly for $2mn-$10mn senior secured loans made by Full Circle Financial (FULL) or by Solar Senior Capital (SUNS) or PennantPark Floating Rate Capital (PFLT). Similarly, we doubt most the mezzanine funds will want to compete head to head for the smaller SBIC funded mezzanine and uni-tranche deals that BDCs like Fidus Investment (FDUS), Main Street Capital (MAIN) and Triangle Capital (TCAP) specialize in.

WHY NOT ?: It comes down to the economics of the lending business. Mezzanine funds need to generate superior returns to attract investors willing to commit capital for 5-10 year periods. We would guess (which we have to do not having access to the 43 private prospectuses running round America right now) that the 7%-8% yields on new senior secured deals being booked by many BDCs will not achieve the returns required for the new players. Moreover, smaller mezzanine deals can be also be very time and manpower intensive, both in the origination and ongoing maintenance phases. Most of the new and existing private mezzanine groups do not have the infrastructure to find and book and monitor $3-$10mn mezzanine loans. Furthermore, two dozen BDCs benefit from very inexpensive debt capital raised from the SBIC in recent years, which provides them with a competitive advantage.

NEW MONEY'S TARGET MARKET: Our educated guess is that the BDCs in the middle and upper middle of the middle market who provide straight mezzanine and uni-tranche capital will be the most affected. Here's a hint at what the new players will be looking for from a February 7, 2013 article about the existing Sankaty Fund, whose successor entity is in the market for new money, as mentioned above:

" [Sankaty] typically invests $20 million to $75 million in companies with more than $10 million in earnings before interest, taxes, depreciation and amortization, or Ebitda. The group's money can be used to finance leveraged buyouts, complete recapitalizations or restructurings, provide liquidity or emerge from bankruptcy".

Of course, that's just one of 43 would-be players, so take what follows with a grain of salt till we get more information.

WHO WILL BE IMPACTED: We are most concerned about a half dozen major BDC players who operate in the higher reaches of the middle market, and at higher "attachment points" (another way of saying they take more risk on the balance sheet of their borrowers), in order to achieve yields north of 10.0%. This list is not all-inclusive, and many of the companies mentioned have a mixture of different loan assets, many of which may not see much competition from the new funds. Moreover, it's worth pointing out that the BDCs mentioned often have long standing relationships with certain equity groups which can partly offset the pressure of new competitors. Also, some BDCs have already begun to think outside the box and are developing new sources of income which some of the new players may find hard to duplicate, either because of the length of the loans involved or the industry expertise required.

Nonetheless, we are worried (in the long run) about Apollo Investment (AINV), Ares Capital (ARCC), BlackRock Kelso (BKCC), Solar Capital (SUNS), Fifth Street Finance (FSC) and THL Credit (TCRD).

HOW THE COMPETITION WILL PLAY OUT: The great hope is that the abundance of capital in the Leveraged Finance industry will create a boom in buy-outs. The theory is that much of the new capital coming to market will be absorbed by the expansion of the buy-out industry.

More likely, in the short run anyway, is that everyone will compete on price. That's a boon for the Private Equity groups and larger companies seeking to refinance existing debt or make acquisitions, but bad for the BDC lenders who will find more competitors bidding on every new deal, see leverage multiples rise (to please the sponsor groups), and loan yields will drop. It's part and parcel of the business cycle, but could significantly hurt profits. Even a 1% erosion of gross yields might mean a 10-15% drop in earnings per share.

WHAT IS AN INVESTOR TO DO: We would suggest doing what we'l be doing: watching yields on new loans like a hawk in order to determine if they are dropping materially. Also, there will be many rueful comments in the BDC Conference Calls if new players begin to have an unusually large impact on pricing and portfolio growth. This is a risk to BDC profits that, if it occurs at all, will take several quarters to play out.

Disclosure: I am long ARCC, AINV, SLRC, FSC, TCRD.

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