BDCs Bulk Up to Serve Middle-Market Companies Snubbed by Banks

Taking advantage of a strengthening stock market and a lending market where many borrowers struggle to find financing, several business development companies (BDCs) are taking steps to fortify their financial positions.

BDCs are closed-end investment funds that are publicly traded on stock exchanges. Designed to provide capital to privately owned businesses, they can provide both equity and debt financing.

Healthier BDCs, led by Ares Capital Corp., are issuing stock and reducing their debt, while other such lenders, including American Capital Ltd., are taking other steps to shore up their capital positions. At least five BDCs have taken these steps since November, a review of their regulatory filings and press statements shows.

The series of moves could augur well for mid-market companies seeking financing in 2011, said Troy Ward, an analyst at Stifel Nicolaus & Co. “Banks are still lending, and they’re very competitive on the pieces where they are lending,” Ward said. But, he added, “that’s only at the very top of the capital structure. They’re not willing to take any risk.”

By contrast, the BDCs are often more willing to take greater risks, on subordinated debt and mezzanine financing, Ward said. “The opportunity is good in the middle market, and the price is attractive enough that they believe they can issue new capital and make new loans,” he noted.

The $2.3 billion-asset Ares Capital — one of the larger players in the segment since its $648 million acquisition of its struggling rival Allied Capital Corp. in April – issued stock in November to raise $180.5 million in new capital. The New York company, primarily a provider of first-lien and second-lien loans and mezzanine debt, said it planned to pay down its senior secured revolving credit facility and other debt, and to fund new investments.

A smaller rival, the $509 million-asset Hercules Technology Growth Capital Inc., raised $71.9 million in a stock offering last month. The Palo Alto, Calif.-based BDC, which focuses on private equity, venture capital, and venture debt, said it planned to use the money to fund additional portfolio growth. A third BDC, $225.3 million-asset TICC Capital Corp., issued $41 million of new stock at the end of November. The Greenwich, Conn.-based firm, which invests primarily in debt and equity of technology companies, said it would use the money for investing in debt or equity and for other purposes, including working capital.

Two other BDCs took steps in November to strengthen their own balance sheets without raising net new funds.

American Capital prepaid $107 million to holders of its secured debt due in 2013. The prepayment took the total debt under that facility to below $1 billion, taking the interest rate to the lowest level allowed under its debt agreements. The $6.7 billion-asset Bethesda, Md.-based firm said it will face no scheduled amortization of the remaining secured debt until June 30, 2013. Before American Capital restructured $2.4 billion of debt in June, it had been out of compliance with its debt covenants for some 18 months.

New York-based Solar Capital Ltd., which went public in February, sold 1.8 million shares of common stock to institutional investors in a private placement, raising $44 million. Although the $885.4 million-asset firm raised no net additional capital, it did reduce its leverage by paying down a portion of its outstanding 8.75 percent senior unsecured notes.

The timing of the parade of BDC stock offerings is more than coincidental, said David J. Chiaverini, a senior research analyst at BMO Capital Markets Corp. “The market had rebounded from the summer. Valuations had improved. Investor sentiment was stronger.”

Given the turmoil in the economy since the end of 2007, it was not surprising that a number of BDCs would respond in the same way to improving market conditions. “When times are good, it might be more evenly spread out,” Chiaverini said. “When things are choppy, as they have been the last several years, the window of opportunity might close at any moment.” As a point of comparison, the Dow Jones industrial average began December at 11,255.78, up 16 percent from a recent low in July.