All of a sudden, it seems, every big US private equity firm wants a BDC.
Loosely defined, a business development company is a publicly traded firm that makes debt and equity investments, mostly in small and middle-market private companies. BDCs typically send the bulk of profits back to shareholders in the form of quarterly dividends.
These companies represent a rather obscure niche on the public market. The largest BDC, Washington DC-based Allied Capital, has a market capitalisation of $3.32 billion (€2.77 billion). The next largest is American Capital Strategies, also based near Washington, which has a market cap of $1.9 billion. Other BDCs include MCG Capital, Technology Investment Capital and the miniscule MVC Capital.
The BDC niche, however, is about to get a lot more crowded. Last month, several major private equity firms unveiled affiliated business development companies of their own. On April 6, New York private investment firm Apollo Advisors raised $930 million in an IPO for Apollo Investment, which will provide growth capital to small and middlemarket private companies.
Several days later, the mighty Kohlberg Kravis Roberts registered to raise $750 million for KKR BDC, a similar debt-and-equity investment company. Days later, The Blackstone Group's mezzanine debt team registered to seek $850 million for a company called Blackridge Investment. Evercore Partners also registered to raise $460 million for Evercore Investment, which will buy – you guessed it – “debt and equity securities of privately-held middle-market companies,” according to the registration statement. Since then Kelso & Co, Partecoes Investment Management, Marathon Capital Finance, Prospect Street and Ares Management have all registered similar structures.
Press reports indicate that many more US private equity firms are preparing to create public funds. Interestingly, MVC Capital used to be a venture-oriented holding company called MeVC that was recently purchased by former KKR partner Michael Tokarz, who is transforming the company into more of an income-producing vehicle.
You'd think that William Walton, the chairman, president and chief executive officer of Allied Capital, would be getting nervous about all the new players entering a game that he dominates. Not the case – Walton is tickled that so many private equity firms are finally establishing what he has long believed is the better way to invest in private equity.
“I'm delighted they're doing this,” Walton says. “It will help people understand the BDC model. The more people understand us, the more that helps us.”
Founded in 1958, Allied Capital has been traded on the OTC market since 1960 and listed on the New York Stock Exchange since 2001. Walton has led the company since 1997, when several Allied Capital entities were merged into one. The company proudly notes that it has been paying a quarterly dividend without fail for 40 years.
Although about a third of the firm's investment activity is in equity securities, including buyouts, Allied Capital is best-known in the US private equity market for its mezzanine investing, and the firm frequently joins equity sponsors in deals. The bias towards debt investments means a greater flow of current income for the shareholders.
CARRY GOES PUBLIC
This mix of debt and equity investing is being roughly mimicked by all of the private equity newcomers to the model. But Walton notes some significant differences. For KKR, Blackstone, Apollo and Evercore, the public entities will be managed by investment advisors that are affiliated with the private firms. For example, a KKR-‘supported’ investment advisor will manage KKR BDC and, in addition to receiving a 2 percent management fee for its work, will charge carry – 20 percent of realised capital gains and 20 percent of pre-incentive fee net investment income, according to the registration statement.
“We're internally managed, which means all the people that operate the investment activity are employees of the company,” says Walton. “We either own stock in the company and have an option plan. All of our compensation is based on the performance of the stock.”
Recent fears about increasing interest rates have hammered the shares of Allied Capital and American Capital, but this is a recent setback from what has otherwise been an impressive run. As public investors have clamoured for returns, they have increasingly rewarded stocks that pay dividends. And it doesn't take much to impress – private equity firms are well aware that the public is as receptive as ever to securities backed in part by loans to, and investments in solid, middle-sized companies that will never be the next Cisco.
Who better to manage this private investment process than firms well established in the practice? This may be an historic opportunity to apply private equity brand names – KKR, Blackstone – to public entities.
The KKR registration papers, for example, relate the impressive history of the buyout firm and its principals, and notes the many deals the firm sees but passes over for its giant buyout funds. The best of these deals, the statement suggests, will be the fruit ripe for KKR BDC's picking.
If this is such a great strategy, why not raise a dedicated fund as a private limited partnership, a process well known to private equity firms? The answer may be that GPs know the process all too well. Private funds need to be reinvented once the money runs dry, imperiling the franchise with each new fundraising. Walton notes the regenerative nature of publicly traded BDCs. “This is permanent capital which we recycle in the new deals as the old ones pay off,” he says, noting that both borrowers and managers like the flexibility this affords.
He adds: “If you manage perpetual capital with a 2 percent fee, you have a steady fee income stream that can be monetised. This may be an effort to create franchise value for the investment managers.”
And while the expectation of rising interest rates has lately dropped the share prices of Allied Capital and other BDCs, this trend bodes well for companies in the business of making loans.
MEET THE PUBLIC
The amount of transparency required of a publicly traded investment company can be overwhelming. In going public, the affiliated investment managers of these private equity firms will be required to publicly disclose financial details of their holdings every quarter, and see their valuation methods publicly debated.
Allied Capital spends millions every year on valuation, auditing and investor and public relations services. Both Allied Capital and American Capital have been hounded by short-selling hedge funds who claimed their portfolio company valuations were inflated. Allied recently hired additional consultants to assure its investors that the portfolio was being properly valued.
Every success, failure and money shuffle must be broadcast in a public announcement. Last month, for example, American Capital issued a press release explaining $60 million in losses on debt and equity assets, with soothing quotes from CEO Malon Wilkus. Recently, a Wachovia equity analyst dropped his coverage of Allied Capital because the company failed to disclose a loan transfer valued at $9 million.
One wonders if Henry Kravis will agree to issue public explanations for each earnings fluctuation and financial transaction, let alone spend time complying with the demands of analysts and answering the manipulative claims of short-sellers.
“Private equity is an extremely complicated business and when you're conducting it in public, it's even more complicated,” says Walton. “You're taking companies through bankruptcy, scraping off equity partners, renegotiating deals with lenders – all the things you do to protect and create value. It is easily mischaracterised by people who can benefit from doing that.”
He adds: “But even with transparency challenges, I think the business development company model is a superior business model for private equity. Our cost of capital as a public company is somewhat lower than private partnerships.”
Walton notes that the Real Estate Investment Trust scene began a decade ago with only a handful of stocks. Now, there are hundreds of REITs which, like BDCs, invest in a diversified collection of assets and must pay a large share of their income to shareholders. Whether the market can support as many private equity-affiliated BDCs remains to be seen.