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.
PE firms turn to BDCs as limited partners become scarce
“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, specialty finance group, at law firm Lowenstein Sandler LLP in New York. “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 business development companies to make debt investments. They include Ares Management LLC, Tennenbaum Capital Partners LLC, Apollo Global Management LLC, BlackRock Inc., Prospect Capital Management LLC, Crescent 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 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 attempting to raise $680 billion in the second quarter, only 120 funds closed with a combined $66 billion, according to Preqin, a London-based alternative investment research firm.
While attractive to managers, BDCs also provide investors with another, more liquid way of investing in debt strategies. The downside for investors 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 say.
“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 investment consulting firm Cliffwater LLC, Marina del Rey, Calif. “We view it as a way for the sponsor to increase revenues, diversify their business, obtain permanent capital and leverage off their credit resources.”
Private equity fund managers generally will explain that it is a way for them to invest in companies they know and like but that do not fit their private funds' strategies, Mr. Lynch said.
A private equity “sidecar” fund — a separate fund that invests alongside the BDC — 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,” explained James K. Hunt, CEO of Boston-based THL Credit.
Not only are they launching their own BDCs but private equity firms also are co-investing with and finding deals for existing BDCs, 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 New York-based rating 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 BDCs are finding a receptive audience among stock investors looking for investments with higher dividends while interest rates remain low, the report states.
“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.
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 BDC would usually recycle or reinvest the capital; the private fund partner would not, 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 gradual increase of BDC launches by private equity firms, Mr. Lynch said.
“While some very good private equity firms have launched BDCs and have remained very good private equity firms, we are always concerned about the impact on the institutional investor in the private funds,” 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 supermarket-like array of products runs contrary to our preference.”
Still, there are a number of advantages to launching a BDC, said Mr. Hunt of THL Credit.
A BDC is a permanent source of capital for debt investments. Credit strategies require more capital than equity investments, however, typically are realized sooner than equity investments. The BDC would typically recycle the capital and the private fund partner would not.
With a BDC, private equity firms can get capital in a number of weeks rather than six to 18 months. According to Preqin, the average time it takes to close a fund has not dipped below 15 months since 2009. Indeed, the average fund that closed in 2010 took 20.4 months to complete.
The rocky stock market has not quashed private equity firms' plans to go forward with BDCs, said Mr. Siesser, who heads his law firm's team that helps private equity firms launch these vehicles.
“I don't think what happened in the global markets has caused (private equity) funds to abandon capital-raising altogether,” Mr. Siesser said. “If anything, the markets have prompted funds to find something else to do, and this is one of the somethings.”
But Mr. Hunt said he thinks the stock market 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.