Access To Permanent Capital Makes Entering In BDC Space Attractive For Private Equity Firms, Says Senior Vice President Of Keefe, Bruyette And Woods

Wall Street Transcript

67 WALL STREET, New York - November 30, 2011 - The Wall Street Transcript has just published its Business Development Companies Report offering a timely review of the sector to serious investors and industry executives. This Business Development Companies Report contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

Topics covered: BDC Risk/Reward Profile - Higher Dividend Yields - Private Middle Market Funding - Business Development Companies Historical Overview

Companies include: Allied Capital (AFC); American Capital (ACAS); Apollo Investment Corp. (AINV) and many more.

In the following brief excerpt from the Business Development Companies Report, interviewees discuss the outlook for the sector and for investors.

Sanjay Sakhrani is a Senior Vice President and Analyst covering the specialty finance sector in the equity research department at Keefe, Bruyette & Woods, Inc., with specific focus on credit card issuing and payments companies, as well as business development companies. Before KBW, Mr. Sakhrani was at Calyon Securities, a subsidiary of Credit Agricole S.A., where he followed the specialty and mortgage finance sectors. He also spent five years in Citigroup Inc.'s U.S. equity research department's specialty and mortgage finance team. Mr. Sakhrani has a B.S. in finance from St. John's University and an MBA from Cornell University.

TWST: Are we seeing more entrants into the BDC area right now?

Mr. Sakhrani: Definitely over the past several years, we've seen a lot more new entrants into the space. I think what is attractive about the model is that for private equity firms, it gives them access to permanent capital versus having to go out and keep raising money every two or three years. With the BDC model, capital raised is permanent, and they can raise more and grow over time, but that's a little bit different than having to replace or re-up on existing capital.

More recently, there were a couple of BDCs looking to go public, but I would think that the volatility in the equity markets probably has put those deals on the side burner. I think the challenge for new entrants is most of them are trying to go public as a blind pool. So you don't really have an existing dividend distribution upfront. It's a lot more favorable for those types of companies to go public when dividend yields for the industry are pretty low. Specifically, you may sacrifice a little bit of time without a significant dividend over the short term, but you end up with a really high dividend yield at some point in time in the future if you get in at the beginning. But at these levels, the risk/reward tradeoff favors the existing players that have the scale, and have an existing distribution that can be paid to investors.

TWST: Why is it that the sector has evolved from a few players to now, where there are several major companies in the BDC space?

Mr. Sakhrani: It's basically that dynamic where you have permanent capital. Apollo, when it went public, was innovative in that they started what's known as the externally managed model. Apollo Investment Corp. is basically a fund, a publicly traded fund that's managed by Apollo Management, the private equity firm, whereas American Capital Strategies (ACAS) is actually its own asset management and private equity firm. So I think that was the turning point in terms of the industry where it got a lot more external private-equity-type players involved in this space because they created their own management companies and basically started public funds. A lot of the BDCs out there right now are basically public, externally managed funds, so I think that's driven the growth in the industry, and I think that will continue.

But I want to also make sure to point out that while there has been a huge amount of growth in terms of the number of the BDCs, if you just look at the size of the smaller BDCs, they're not that big, and I think that's been the problem with getting this space to be larger. If you don't have scale, it's very hard. And it seems if you are not large enough at the outset, it's very hard to become large. Part of that is driven by the fact that previously you had a lot of retail money flowing into the space like retail investor money, then you had problems with some BDCs doing poorly. Some of these retail investors were burned, and it's been very hard to get them back into the space. That's constrained growth of the industry.

TWST: How has the BDC industry changed since the recession?

Mr. Sakhrani: The two major companies that faced issues during the recession were American Capital Strategies and Allied Capital (AFC). Those were obviously two of the three larger players ahead of the recession and probably the longest-standing BDCs. I think what's different about the space today versus how it was before is those two players obviously had a disproportionate amount of market share in the industry and then, two, they were like private equity companies, so they did a lot of buyout yields where they bought out companies and owned them. When you have deals like that within your portfolio, you're exposed to a significantly larger percentage of equity in your portfolio. And I think that was part of the reason they faced problems when things got really bad - is the downturn was so severe that a lot of those equity valuations on their investments basically were washed out.

As we talked about before, these companies can only lever one to one, and some of these companies, like American Capital Strategies, levered pretty substantially close to the maximum allowable levels. So what happened is that when they experienced negative marks that caused them to break through their maximum allowable levels, and that led them into technical default on their debt. They were basically at the mercy of their debt investors in terms of restructuring the terms of the debt, and that's what created the problems. This was the primary story for American Capital Strategies.

With Allied Capital, they prudently sold a lot of their winning deals. So they monetized on a lot of gains that they had ahead of the cycle. The problem was when you monetize on those investments, you lose a lot of income. And what subsequently followed that period of time was a very low interest rate environment, so they couldn't reinvest and recapture the amount of income that they lost from the sales, and they never ended up rationalizing their dividends. That created a problem for them in addition to the fact that they had marks that they had to take on their equity investments. So that was what was different about the industry. Today these companies really are mainly debt focused, so a majority of their portfolio is invested in debt, and that matches up pretty well with the most significant liability that these companies have, which is paying off that dividend to investors.

The Wall Street Transcript is a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs and research analysts. This Business Development Companies Report is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

The Wall Street Transcript does not endorse the views of any interviewees nor does it make stock recommendations.

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