Banks to Benefit from Wave of Business Development Co. IPOs

Several business development companies have gone public in recent months, and the trend appears likely to continue into next year — giving these investment vehicles more money to put to work in leveraged loans.

That could present more opportunities to lenders searching for higher yields. Already banks and institutional investors have provided loans with attractive rates to private and public BDCs.

A $100.5 million IPO for WhiteHorse Finance was launched last month. OFS Capital Corp., Stellus Capital Investment Corp. and Monroe Capital Corp. completed offerings in the last week of October and first week of November, following a deal in April by TCP Capital. Those offerings ranged between $75 million to $140 million in size.

Theodore Koenig, CEO of Monroe Capital, said the 10-year-old firm's business has grown significantly, requiring it to generate more liquidity and capital. Much of that capital has come from institutional investors, "but we thought we should introduce a public vehicle as well, so public shareholders can generate the same type of returns as we provide to our private fund institutional investors."

IPOs also provide BDCs with a permanent source of capital. Over the last decade, the number of BDC offerings annually has ranged between zero and half a dozen, making 2012 a relatively active year. The number of IPOs by BDCs in the pipeline is unclear, since April's federal Jumpstart Our Business Start (JOBS) Act enables prospective issuers to publicly announce their intentions late in the registration process. Nevertheless, signs point to another active year as long as the current factors remain mostly in place.

Koenig noted that "our investors continue to be a variety of institutional investors, endowments, foundations, and pension funds."

BDCs compete with banks, too, though they generally provide funding that is unsecured and lower down the capital structure than bank loans.

If anything, the financial crisis and ensuing regulation may prompt further BDC industry growth into a void left by banks and others.

Specialty finance companies often competed against BDCs for assets, but following the crisis those firms have either curtailed their lending or disappeared. The Dodd-Frank Act and especially Basel III have made it less attractive for commercial banks to lend to riskier midsize and smaller companies, offering more openings for BDCs to provide especially subordinated- and mezzanine-type debt. And provisions of the statute, such as its pending 5% risk-retention requirement, may dampen issuance of collateralized loan obligations.

A Nov. 14 report by Wells Fargo Securities, titled "Regulatory Reforms — A Catalyst for BDCs, says the teeth of this regulation will hit just as many existing CLOs begin to wind down. "Note that effectively one out of every two loans originated today is purchased by a CLO, thus any curtailment in CLO issuance is likely to leave a financing void in levered finance markets," the report says.

In late August, a month after its $31 million secondary stock offering, Horizon Technology Finance Corp. closed a $75 million term loan provided by Fortress Credit Co., an affiliate of Fortress Investment Group, that priced at Libor plus 6%, with a Libor floor of 1%. The three-year deal carries two one-year extensions with a draw period of up to four years, and it complements existing credit facilities provided by Wells Fargo Capital Finance and WestLB.

Another way for investors to get exposure to BDCs is by purchasing equity shares from IPOs or secondary offerings. Most BDCs currently pay dividends of 9% or more. Wesley Grace, managing director at Memphis' Wunderlich Securities, said the past 12 to 18 months have been "very unique in that most of the capital provided through [BDC] IPOs — 90% or more — has been from retail investors, rather than institutional."

That split can vary widely from deal to deal. However, an $80 million IPO in September for Garrison Capital, led by JPMorgan Chase, Deutsche Bank and Barclays, was reportedly aimed mostly at institutional investors, and it failed.

In fact, firms such as Wunderlich and Stifel Nicolaus Weisel, with their extensive financial advisory networks, have played key roles in the offerings — they are among six co-managers and four joint managers on the WhiteHorse IPO.

Selling shares to retail investors can be attractive to issuers, since institutions tend to drive a harder bargain. An additional benefit to going public is that seasoned BDCs can issue shares through "overnight" offerings, in which underwriters use their financial advisors and investment bankers to drum up share sales from shortly after market close one day until the market reopens the next.

Prospect Capital Corp., for example, has raised $784 million in three, successively larger secondary offerings this year alone, according to data provided by St. Louis-headquartered Stifel Nicolaus

Institutional investors can also capture exposure to BDCs by purchasing their bonds, which are sold both to retail and institutional investors and which BDCs have issued increasingly over the last year. Allen Laufenberg, managing director at Stifel Nicolaus, noted that Hercules Technology Growth Capital, for example, has issued upwards of $170 million of public debt this year, with a majority sold to retail investors. It has a maturity of seven years, a 7% coupon, and is unrated.

"Debt issuance is evolving," said Laufenberg, noting that prior to 2012 BDCs issued only a handful of debt offerings away from their bank revolving credits. "There have been about 13 debt issuances in 2012, and we expect a number of folks to continue to issue over time," Laufenberg said.

Seven of those transactions were unrated and paid coupons of 7% or more.

Many BDCs essentially are vehicles to provide public market access to private-equity firms, which typically will contribute an existing portfolio of assets that is used to value the IPO. The largest BDC, for example, is $6.3 billion Ares Capital Corp., a private-equity firm that manages more than $54 billion overall. WhiteHorse is an affiliate of H.I.G. Capital, a private-equity firm managing more than $10 billion in assets.

Demand for BDC debt and stock is likely to remain as long as interest rates remain historically low and investors search for higher yields. BDCs also have components that make them attractive to investors seeking to minimize risk. For example, they are limited by statute to incur only as much debt as they have in equity — so a BDC with $100 million in equity cannot exceed that amount in debt capital.

Thomas Friedmann, a partner at Dechert, said statute also requires BDCs to invest in companies based in the U.S. that either have no publicly outstanding securities or that have market capitalizations of no more than $250 million. Dechert is Whitehorse's counsel on the IPO.

"They have to invest at least 70% of their assets in companies with no outstanding publicly registered securities or in micro-cap companies," Friedman said.

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