|
|
 |
|
| Risk & Reward |
Private Equity's Wide Embrace
Eileen Gunn
12/01/2004
|
Medium Rare
Perhaps the biggest challenge to investing in these new funds
is that there still are not many on offer. Apollo’s came to market in April.
Technology Investment Capital (TICC) debuted in fall 2003; it makes loans to
small-to-midsize technology companies. American Capital is longer in the tooth,
having debuted in 1997; it focuses its mezzanine and senior lending on
management and employee-led company buyouts. Both TICC and Apollo have seen
their share prices fall from the $15 at which each launched, and both are
trading at discounts to their net asset values, which is discouraging to those
BDCs still waiting in the wings.
More than a dozen BDCs have filed with the
SEC to go public since the start of the year, but at least four, including one
backed by the Blackstone Group, changed their minds and withdrew their filings.
Others have cut the size of their planned offerings.
Apollo’s front-end load
contributed to the fall in its price because it eroded the asset base right
away. “Unless they can figure out how to structure the offerings to prevent that
from happening, the retail and institutional appetite isn’t going to be there
for these IPOs,” says Brian Conn, an equity analyst at RBC Capital Markets in
San Francisco. Their stock prices are also likely to remain low until they
invest most of their funds, which could take Apollo two to three years, Conn
adds. “They’ll put the cash in bank loans so they can get a decent yield, and
then transition the money as they find mezzanine deals,” he says. “I don’t think
either company has missed the investment targets they talked about, but I think
investors had expectations that they’d get their income levels up more quickly
than they’re going to.”
Herzfeld agrees that the initial investors in these
funds will lose money. However, the BDC issues may be attractive once their
price falls. “Wait for December when people who bought at the IPO sell to take a
tax loss,” he advises.
Longer term, these funds may have potential. The
market for mezzanine lending is strong. “There’s been a comeback in merger and
acquisition activity by smaller and medium-size companies,” says Matthew Vetto,
a research analyst with Merrill Lynch who covers the specialty financial sector.
With the regional and smaller investment banks that used to lend to these
companies swallowed up in consolidation, there is room for these new funds to
move in. “American Capital’s net loans outstanding have grown by more than 30
percent, year over year, for the last several quarters,” Vetto notes.
In
addition, American Capital, which has a slightly different fund structure but a
similar investment strategy to these new entrants, has performed respectably. It
has seen its quarterly dividend climb steadily from 21 cents a share in the
first quarter it traded to 72 cents in the third quarter of this year.
Rate Rationale
Fries observes that the interest rate environment was more
friendly to business development companies when they started making noises about
raising public funds earlier this year. As is often the case with complex income
plays, these funds are desirable when interest rates are low, but demand for
them wanes as rates rise. “If the yield on one of these funds is 10 percent and
interest rates are 1 or 2 percent, you’re being paid for the risk of investing
in an illiquid market,” Conn explains. “But if interest rates go up, and people
can find good yields elsewhere, they’re less inclined to take those
risks.”
Moreover, Vetto points out, as rates rise, the risk level for these
funds budges upward as well. The funds usually borrow money to increase the
amount they can lend and boost their returns to investors. They hedge and use
other strategies to avoid being paid lower interest rates than they pay out,
but, Vetto says, “As rates go up, you do have to worry about their lending
margins getting squeezed.” This is why some observers believe that the BDCs
waiting to go public will hold off until interest rates recede again.
In the
meantime, Boone, the investment advisor, plans to keep a careful eye on these
instruments. “Having a track record is an important part of the picture for us,”
he says, as are a history of trading and a basket of similar public firms to
benchmark against. Since these new funds do not have either, investors are
still, to an extent, committing their money to the unknown.
Illustration by Hugh Kretschmer.
|
|
|
|
|
|
|
