More managers put BDCs in crosshairs

Alternative investment firms are taking advantage of a dislocation in the market to target business development companies as acquisitions, thereby gaining access to a source of retail capital, a possible route to defined contribution plans and a sizable arbitrage.

Mergers and acquisitions of BDCs have just started to crop up in the past 18 months, including PennantPark Floating Rate Capital Ltd.'s acquisition of MCG Capital Corp. in August and private equity firm Oak Hill Advisors LP's November 2014 takeover of NGP Capital Resources Co.

And more BDCs are being urged to sell assets or put the companies up for sale.

“Much of the BDC sector is trading below book value, which makes additional capital raises more difficult,” noted Will Tuttle, partner in the corporate and securities group in the Washington office of law firm Dechert LLP.

That has led business development companies to expand their capital base by acquiring other BDCs, he said, but also has “caused those not in the BDC space to think of ways to gain entry.”

Within the past six months, activist hedge funds also have tried to acquire BDCs, seeking the arbitrage between the stock price and the value of the company's underlying assets.

Private equity firms began launching BDCs five years ago as a way of getting a permanent source of capital. Business development companies are mostly publicly traded closed-end funds that provide debt to small- and middle-market companies and private equity level fees to their owner. Money managers including Ares Management LLC, Tennenbaum Capital Partners LLC, Apollo Global Management LLC, KKR & Co. and BlackRock Inc. all launched BDCs around that time.

BDCs have been “a growing trend and a changing trend ever since the big guys like Apollo” got into the business, said Elliott Wislar, CEO of New York-based Clearbrook Global Advisors LLC, an adviser and consultant for multimanager strategies.

Recent M&A activity around the companies is “part of the move by large asset managers to cover the more alternative asset classes from equity to debt,” said Ken Young, partner in Dechert's Philadelphia office.

“Private equity is an elephant hunting business,” Mr. Young said.

Alternative investment managers are looking to increase their assets under management in part by adding new asset classes.

If an equity investment in a business is too pricey, why not make a debt investment in the company instead, he said.

BDCs might also be a way for private equity investment firms to get their investment options into defined contribution plans, Mr. Young said.

“Defined contribution is where the asset management business is going. Liquid, traded BDCs and other closed-end funds are good ERISA investments,” he said.

Money managers with big defined contribution businesses also are looking at BDCs, Mr. Young added.

At the same time, Congress is considering legislation that could make BDCs a more attractive asset class.

“If the BDC legislation passes, I think it makes the BDC a more attractive asset class for managers and investors (in BDCs), and that could increase the interest in BDC consolidation transactions,” Mr. Young said.

Under the bill, BDCs would be allowed to raise their leverage limits (to 2-to-1 from the current 1-to-1), increase the sums they can invest in financial firms and be allowed to own registered investment advisers without filing for an exemption, he explained.

So far the bill, which is opposed by Securities and Exchange Commission Chairwoman Mary Jo White, passed the House Financial Services Committee in November. It is expected to reach the House floor as early as the first quarter of next year, said Brett Palmer, president of the Washington-based Small Business Investor Alliance, an industry trade group that backs the legislation.

Alternative investment managers have been involved in BDC mergers and acquisitions before.

In 2010, Ares Management LLC's BDC, Ares Capital, acquired Allied Capital Corp. in a mutually agreed upon transaction.

But it's not always so friendly, as an ongoing battle over TICC Capital Corp. shows.

TICC Capital management entered into a tentative deal with hedge fund Benefit Street Partners LLC, with a shareholder's vote planned for Dec. 22.

But TPG Specialty Lending Inc., the business development company of alternative investment firm TPG, and NexPoint Advisors LP, an affiliate of credit manager Highland Capital Management LP, are challenging the deal. They are appealing to shareholders to vote against the Benefit Street Partners proposal, arguing TICC board members will be personally enriched by the deal and that TICC management has misled shareholders.

NexPoint has taken TICC to court to force the BDC's shareholders to entertain its bid at the upcoming Dec. 22 shareholders meeting.

“It is clear the board effectively made the decision that new management is in the best interest of the company because the board approved and recommended to stockholders that BSP assume control of management,” said Thomas Surgent, NexPoint partner and deputy general counsel, in an interview. “Having recommended managerial change, it is incumbent on the board to ensure that the ultimate advisory agreement recommended is in the best interest of stockholders.”

Since NexPoint and TPG began doing battle for TICC in August, it piqued alternative investment manager interest in BDCs.

Earlier this month, hedge fund RiverNorth Capital Management LLC challenged the management of BDC Fifth Street Finance Corp.

Hedge funds are interested in the arbitrage, said Stephen Nesbitt, CEO of alternative investment consulting firm Cliffwater LLC, Marina del Rey, Calif., which has a BDC index.

The TICC battle put a spotlight on poor performing BDCs, he said.

“The BDC market is ... one of the few markets where there are large discounts” to net asset value, Mr. Nesbitt said.

“The bottom half of the (BDC) market is trading at a 20% discount to net asset value because of a bad portfolio manager or the fees are too high or they are investing incorrectly,” he said.

Alternative investment firms can acquire BDCs cheaply and then build them up, he said.

“The problem from a hedge fund activist point of view is to make a change that would close the discount,” Mr. Nesbitt said.

But if the turnaround is successful, the activist hedge funds stand to make as much as a 33% return, Mr. Nesbitt said. “That's a great potential arbitrage,” he added.

Alternative investment firms also are attracted to the permanent capital aspect of BDCs, said Timothy C. Ng, chief investment officer of Clearbrook Global Advisors.

Firms no longer have to subject themselves “to the vagaries of clients making investments,” he said. Managers “can attain the assets and take over the management of the vehicle.”

But BDCs do have limits.

“Not all deals that qualify as a private equity deal will qualify for a BDC,” due to the current leverage limits, Mr. Ng said.

“Private equity firms can do six times leverage for a buyout, which you can't do in a BDC,” he added. n