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LPC: BDC space ripe for consolidation

| NEW YORK, Sept 16

NEW YORK, Sept 16 Business development companies (BDCs), which extended share price gains this summer after a prolonged slump, still face hurdles that prime the specialized closed end investment funds for consolidation, according to sources.

While BDC share prices are trading closer to book value, a majority are still at a discount, limiting their ability to raise fresh capital. Also, smaller platforms are at a disadvantage compared to larger ones in a marketplace where lenders are competing aggressively for assets and new money deal flow.

"While the rising tide has provided lift to the sector, the average BDC still trades below book value," said Marc Yaklofsky, senior vice president at FS Investments, formerly known as Franklin Square Capital Partners, which manages five BDCs. "If anything, the rally has heightened the demarcation between the stronger BDCs and the ones that face challenges."

Since 2014 the sector had been trading at a steep discount to Net Asset Value (NAV), a measure of a mutual fund's price per share, but in the last six months shares have rallied with equities. BDC prices now trade at a discount to NAV of about 4%, on average, after hitting an average discount of as much as 27% in February.

BDCs are also dependent on the equity markets to raise growth capital and though that window has reopened for select BDCs, those trading above NAV, many are still capital constrained.

BDCs lend to small and mid-sized U.S. private companies. The universe includes publicly traded funds whose shares are listed on an exchange, as well as unlisted, or non-traded vehicles.

The funds, which raise capital from retail and institutional investors, saw rapid growth in the aftermath of the financial crisis as BDCs led the charge of alternative debt capital providers stepping in to fill the void where traditional bank lenders pulled back from leveraged lending under heightened regulatory scrutiny.

BDC total assets were roughly $84 billion in the second quarter of 2016 compared to $30 billion in the second quarter of 2012, Wells Fargo data show.

"There is definitely over capacity. Consolidation is part of the maturation of the industry," said Yaklofsky. "Manager track record, strategy, and scale are key differentiators and will continue to bifurcate the market," Yaklofsky said.

Not only did the number of BDCs multiply, but the field of alternative lenders has deepened, as more and more institutional investors allocate capital to the middle market via a range of credit strategies, senior loan funds and direct lending platforms.

The competitive nature of the current middle market lending landscape favors the larger BDCs that can syndicate transactions, dictate terms, provide borrowers with certainty of close, and source deals through longstanding relationships with financial sponsors.

"There are still a lot of BDCs trading at a discount to NAV and some could be there for awhile," said Meghan Neenan, senior director and BDC analyst at Fitch Ratings. "But there are also benefits of scale. Teaming up with a bigger guy may be a better bet." CHANGE

While market participants see opportunities for consolidation, with some actively agitating for it in certain instances, change may take time.

"The sector is ripe for consolidation but there are also a lot of challenges given how management contracts are structured and because portfolios are marked to fair value every quarter," said Neenan.

TPG Specialty Lending Inc (TSLX), a BDC and the US direct originations investment platform of TPG's credit arm, continues its push for a change of control at TICC Capital Corp, also a BDC. TSLX, a shareholder in TICC, had in September 2015 made an unsuccessful bid to acquire TICC in a stock-for-stock transaction.

Business Development Corporation of America (BDCA), a non-traded BDC, is slated to change hands. In July, alternative asset manager AR Global Investments agreed to sell BDCA, to Benefit Street Partners, the credit investment arm of Providence Equity Partners, according to regulatory filings. Under the agreement Benefit Street agreed to purchase 100% of the interests in BDCA's investment advisor BDCA Adviser.

Late last month, however, regulatory filings show that NexPoint Advisors submitted a competing management proposal for BDCA, which among others things offers a permanent reduction in management and incentive fees. NexPoint is affiliated with credit manager Highland Capital Management.

In May, Ares Capital Corp (ARCC) said it would acquire American Capital Ltd in a transaction valued at US$3.4bn that is expected to further solidify Ares Capital's already dominate position in the market. ARCC is the largest BDC by market capitalization and total assets. The combined company would have on a pro forma basis more than $13 billion of investments at fair value as of March 31, 2016, according a joint statement announcing the deal. (Reporting By Leela Parker Deo; Editing by Lynn Adler)

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