Private-equity firms increasingly turn to BDCs

Sep 25, 2011 @ 12:01 am

By Arleen Jacobius

Having little luck raising capital from institutional investors the old-fashioned way, private-equity firms are turning to the public markets, forming business development companies and other publicly traded vehicles to invest alongside shrinking private funds.

“The attraction stems from the fact that private-equity funds are no longer in a target-rich environment of investors,” said Steven E. Siesser, chairman of the specialty finance group at law firm Lowenstein Sandler LLP. “Institutional investors are not eagerly running back to this asset class, leading private-equity firms to look to alternative sources of capital, and BDCs are a good example.”

The trend offers good news and bad news for institutional investors. BDCs provide a more liquid way of investing in debt strategies but also could dilute the focus of their managers.

A number of private-equity and money management firms already have launched BDCs to make debt investments.

They include Apollo Global Management LLC, Ares Management LLC, BlackRock Inc., Crescent Capital Partners LLC, Prospect Capital Management LLC, Tennenbaum Capital Partners LLC and THL Credit Advisors LLC, a subsidiary of Thomas H. Lee Partners LP.

More are expected in the near future, Mr. Siesser said.

BDCs are attractive to private-equity fund managers that are having a tough time raising money. Even marquee firms have resorted to lowering fees, easing terms and reducing fund sizes.

Of the 1,676 funds worldwide that attempted to raise $680 billion among them in the second quarter, just 120 funds closed with a combined $66 billion, according to Preqin, an alternative-investments research firm.

BDCs also provide investors with another more liquid way of investing in debt strategies. The downside for institutional in-vestors is that adding a public fund with retail investors who might have different goals could cause private-equity managers to lose their focus, negatively affecting their private-equity-fund investors, industry insiders said.

WAY TO INVEST OUTSIDE P-E

“The trend has been for private-equity firms that have an established private mezzanine or debt practice to eventually launch a BDC,” said Thomas K. Lynch, managing director of alternative-investments consulting firm Cliffwater LLC. “We view it as a way for the sponsor to increase revenues, diversify their business, obtain permanent capital and leverage off their credit resources.”

Managers of private-equity funds generally will explain that it is a way for them to invest in companies that they know and like but that don't fit their private funds' strategies, Mr. Lynch said.

A private-equity “sidecar” fund — a separate fund that invests alongside the business development company — is a big plus for BDC sponsors.

“Since BDCs are required to maintain investment diversity or the amount of capital they can invest per deal, a traditional private mezzanine fund can cost-effectively provide the remainder of the money that is needed,” said James K. Hunt, chief executive of THL Credit.

Not only are they launching their own BDCs, private-equity firms also are co-investing with and finding deals with others, Mr. Siesser said.

Overall, the number of BDCs has grown to 29 as of last month from just six in 2000, according to a recent report by ratings agency Standard & Poor's. S&P executives expect the pace of BDC launches to pick up because of new capital regulations for banks and a sharp decline in structured financing of middle-market loans.

New business development companies are finding a receptive audience among stock investors looking for investments with higher dividends while interest rates remain low, according to the report.

“It is clear that the BDC is becoming the dominant model for issuing junior capital and mezzanine [debt] in the marketplace,” Mr. Hunt said.

The addition of a private-fund vehicle gives investors another way to access the same investment opportunities, he said.

THL Credit has a BDC, as well as a sidecar private-equity fund that co-invests alongside the public vehicle.

“Private funds potentially offer institutional investors a "wholesale' investment choice [usually lower fees and costs] but without the liquidity benefit of the publicly traded stock,” Mr. Hunt said.

FEES

Typically, BDCs charge 1.5% to 2% in management fees plus a performance fee; sidecar funds charge 1% to 2% but without the overhead of a public company and perhaps a lower performance fee. Another difference is that typically, the debt investments are monetized sooner than equity investments.

The business development company usually recycles or reinvests the capital; the private-fund partner doesn't, Mr. Hunt said.

“A lot of private-equity firms have been exploring alternative financing vehicles,” Mr. Siesser said.

But Cliffwater executives are wary of the increase of BDC launches by private-equity firms, Mr. Lynch said.

“We prefer the private-equity sponsor that remains focused on their strategy and has a limited universe of like-minded investors. The trend of having public shareholders and a supermarketlike array of products runs contrary to our preference,” he said.

Still, there are a number of advantages to launching a BDC, Mr. Hunt said.

A BDC is a permanent source of capital for debt investments. Credit strategies require more capital than equity investments. On the other side, they typically are realized sooner than equity investments.

With a BDC, private-equity firms can get capital in a number of weeks, rather than six to 18 months.

Indeed, the average fund that closed last year took 20.4 months to complete.

The rocky stock market hasn't quashed private-equity firms' plans for BDCs, said Mr. Siesser, who heads his law firm's team that helps private-equity firms launch them.

“I don't think what happened in the global markets has caused [private-equity] funds to abandon capital raising altogether,” he said.

But Mr. Hunt said he thinks the stock market's recent volatility could be good for existing BDCs.

“The current equity market will constrain creation of new BDCs. This will occasion more opportunities and demand by BDCs for private vehicles to co-invest or partner in investments,” he said.

Arleen Jacobius is a reporter at sister publication Pensions & Investments.

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