Mixed Prognosis
Those of us who invest in private equity limited partnerships may find some characteristics of BDCs appealing. Perhaps their largest advantage is the liquidity they provide. “The problem with most private investment deals is that you’re like a pig in a poke: If it doesn’t work out, you can’t just get out when you want to,” notes Norman Boone, president of Boone Financial, an investment advisory firm in San Francisco.

Also, because BDCs are public companies, they are required to disclose more information than private equity funds normally do. “You have a net asset value from day one,” Fries says, as well as quarterly income statements and balance sheets, and real-time share prices. (Click image to enlarge)

Additionally, typical private investment funds distribute their returns to investors near to, or at the end of, their lives, while BDCs strive to provide a steady stream of income. Their mezzanine investments generate cash via the interest paid by borrowers, and the tax code requires BDCs to pay out at least 90 percent of that income to shareholders, which they typically do in the form of quarterly dividends.

However, we should weigh these advantages against some significant drawbacks. First, when they debut, the funds must pay fees to the underwriter of their initial public offering. If the investment bank that takes one public charges a 5 percent fee, it reduces the investable assets of the BDC by that amount.

TOP VIEW Private equity returns combined with stock market liquidity and ease of access sounds like an unbeatable mix. Over a dozen leading private equity firms announced plans in the last year to offer this attractive amalgam through a vehicle called a business development corporation (BDC), which raises capital on the stock market. However, these investments suffer from high fees, often-inefficient use of capital and poor aftermarket performance. Investors have stayed away in droves, causing many of the sponsors to shelve their offerings. Even so, some BDCs could emerge as attractive investments if the right set of market circumstances prevail.

A second drawback is a result of the BDC policy of raising money far in advance of investing it. With a typical private equity fund, we commit to providing our capital in stages, as the fund is able to put it to work, and we may invest it in productive ways until that time. However, if we invest in a BDC at its initial public offering, we pay all our money up front, meaning it may sit in low-yielding assets for as long as a few years, until the fund finds enough attractive investments. In the meantime, we sacrifice the additional yield we might have obtained on the money, had it been left in our hands; meanwhile, our investment in the BDC will most likely underperform until the firm has invested its capital.

Ongoing fees are another concern. BDCs start charging fees from the get-go, despite the fact that they have not yet invested their capital. There is often a front-end load taken directly out of the IPO proceeds—Apollo’s was 6.25 percent. BDCs also charge a 2 percent annual management fee. While this is typical of private equity funds, it is aggressive for funds aimed at retail investors. Like traditional private equity funds, the BDCs charge 20 percent of returns as an incentive fee.

Also, while a highly liquid security providing access to a diversified portfolio sounds attractive, it is not the whole story. Thomas Herzfeld, a Miami-based investment advisor who specializes in closed-end funds, warns, “Returns for BDCs tend to be less predictable than for closed-end funds with more actively traded portfolios.” As a result, he says, “Their behavior is more erratic than the stock market in general,” so timing our sale of these funds to get out with a gain can be difficult.

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.