September 17, 2019 / 3:45 PM / a month ago

Race to scale triggers BDC consolidation

NEW YORK, Sept 16 (LPC) - Business development companies (BDC) are consolidating in the highly competitive middle market as more firms look to scale up their operations ahead of a potential recession in the US.

Recent acquisitions including Crescent Capital’s purchase of Alcentra’s BDC for US$142.6m in cash and stock and the sale of OHA to BC Partners-backed Portman Ridge, illustrate just how important size has become in the lending space.

As non-bank lenders continue to increase their share and firms face more pressure to differentiate themselves among borrowers, an affiliation with a larger investment platform enables lender access to a wider network, longer-term institutional support and the capability of speaking for larger hold sizes.

“The BDC market has been very competitive for a while, so it’s important to have scale to compete for dealflow and take on larger hold sizes,” said Chelsea Richardson, an analyst at Fitch.

Crescent BDC CEO Jason Breaux said that the deal, which will make the new entity the fifteenth largest externally managed BDC, “will significantly increase its market presence, improve economies of scale and enhance asset diversification,” in a call with shareholders after the deal was announced.

Ted Goldthorpe, head of BC Partners Credit, cited the “lower financing costs and increased trading liquidity in the equity” as the benefits of the merger in a press statement released last month.

Golub Capital completed the merger of its BDC platforms on September 16, establishing a unit that would make it fifth largest publicly-traded externally managed BDC in the market. Medley Capital’s 60-day go-shop for the merger of the BDCs it manages is set to end on September 27.

For newer players, building scale is difficult in a crowded market and consolidation is not always the silver bullet.

BlackRock acquired a book of assets in 2015 that today it continues to restructure and is rotating its portfolio more heavily in favor of senior loans, but the difficulties in managing its book recently resulted in a cut in its dividend in the second quarter.

The firm acquired Tennenbaum in 2018 and its BDC vehicle has enabled the firm to offset the difficulties.

While Tennenbaum’s BDC continues to operate separately, the ability to invest side-by-side has resulted in an uptick in dealflow and originations.

“BlackRock Capital has started to realize benefits from its affiliation with BlackRock, resulting in more dealflow and originations, which should improve the diversification of the portfolio,” Richardson said.

“There are established larger players and it's harder to gain scale as a newer entrant. Owl Rock has done it pretty successfully, but for newer players to gain scale and market share an affiliation with a larger platform is often the best way,” she added.

ZOMBIE BREAKS

Even in the decade-long benign credit environment since the global financial crisis, BDCs have recorded losses above expectations.

BDCs reported 168bp and 187bp in annual credit losses on a trailing five-year and four-year basis, respectively, for the period ending December 31, 2018, according to a report from research firm Janney.

Janney added that this is higher than the 100bp of normalized losses expected by the market, attributing this to poor underwriting standards and exposure to the troubled energy sector in its report.

BDC Collateral data shows the share of non-accruals for the second quarter was 3.1%, totaling US$3bn across the market, up from US$2.9bn and US$2.8bn in the previous two quarters, respectively.

“Right now, it seems like the mergers occur when a BDC gets into trouble,” said Mitchel Penn, managing director at Janney.

“The firms that purchase BDCs or assume the advisory role are likely making an economic decision. They are estimating the future income they will receive from the base management fee and the incentive fee and present valuing those expected cashflow streams – it’s a good annuity and those revenue streams can be very valuable to the adviser,” Penn added.

Even the prevalence of inactive BDC market players, or what some describe as ‘zombie BDCs’ provides a valuable stepping stone for others investment firms or alternative lenders wanting to get into the lucrative market of middle market loans.

“There are several BDCs that are available at a significant discount which could make them an ideal acquisition target for private credit managers that are trying to get into the public middle market lending space,” said Ryan Lynch, an analyst at KBW.

For externally managed public BDCs management plus incentive fees were 2.28% of assets, compared with 1.62% for private BDCs. Yet the upside that bigger is better is key to overcoming any bout of volatility.

“It’s the old investment principle – a diversified portfolio and smaller position sizes leaves you less vulnerable in a downturn,” said Lynch. (Reporting by David Brooke. Editing by Michelle Sierra and Leela Parker Deo.)

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