Cracking the Code (Part Two)

Last week’s column got more reaction than any since our On The Left newsletter began publication two and half years ago. Who knew everyone has a meatloaf story?

The best was from a friend of the firm who told us he couldn’t believe any mother would foist a faux loaf on her children. “My mother would never have done that!” He was so upset that he called his own mother in Miami to relate his outrage.

“You’re right, dear,” she told him, “my meatloaf was always the real thing.” Brief pause. “But you never asked about my tuna casserole.”

As tricky as divining yesterday’s mystery meat has been getting the right ingredients for today’s loan structures, particularly in the middle market. Vehicles that worked five years ago – CLOs, bank balance sheets, and finance companies – all had their challenges.

CLOs are showing real stirrings of activity, but it’s still premature to call a comeback. Banks? As attractive as their cost of capital (i.e. consumer deposits) is, the regulatory pressure to shrink assets has made them less than ideal parking lots for leveraged loans. Finance companies? Mismatches between short-term liabilities and long-term assets made some of them untenable, and few are active cash flow lenders today.

But as markets continue to look for ways to crack the liquidity code, some of yesterday’s recipes for capital are getting second looks.

One example is the business development company, or BDC. Stock prices of these publicly traded entities got whacked two years ago (along with the entire financial sector), but have rebounded as investors saw BDC assets hold their value, and defaults retreat to low single-digits. Now these companies can issue stock at reasonable multiples, giving them an excellent tool to raise permanent capital.

That’s great for equity issuance, but how do you leverage that equity? Many BDCs use CLOs to buy loans, but the arbitrage today isn’t as attractive as they once were.

Which is why BDCs (and other lenders) have been applying in growing numbers to start small business investment companies. Like BDCs, SBICs aren’t a recent invention. And like BDCs, SBICs come with requirements and restrictions making them tricky to manage. But without many options, lenders are looking at the incremental liquidity (maximum $225 million per SBIC) as a real boon.

Another “what was old is new again” option is the good old-fashioned medium-term note. Last Wednesday, Apollo Investment, one of the biggest BDCs, raised $225 million in five-year paper at 6.25%. While that’s not an exactly IBM-cheap rate (especially compared to the roughly 3.5% Apollo pays to use its revolving credit facility), it’s another example of smart money locking in longer maturity capital when it can get it.

To meet shareholder return requirements, most BDCs invest in higher yielding debt instruments, such as second lien and mezzanine. Since that also involves pushing up the risk spectrum, one might ask, can you make the economics work for first lien loans?

Stay tuned.

Randy Schwimmer is senior managing director and head of capital markets at Churchill Financial, as well as columnist for its weekly “On the Left” newsletter. Reach him at