Consolidation among BDCs seems poised to continue to be a hot topic in 2016. Mirroring the larger M&A market, merger and other strategic alternative activity levels in the BDC space (and associated conversations) have increased since late 2014: Oak Hill Advisors, L.P. assumed the external advisory role for NGP Capital Resources Company (now OHA Investment Corporation), PennantPark Floating Rate Capital Ltd. acquired MCG Capital Corporation, and, more recently, American Capital, Ltd. publicly announced that its board of directors was evaluating strategic alternatives and TICC Capital Corporation received advances from a number of suitors before announcing a proposed sale of its investment adviser to Benefit Street Partners LLC, a deal that was abandoned because TICC failed to secure enough shareholder votes.
What’s driving this uptick in BDC consolidation activity and will this trend continue? Importantly, what are key deal structuring and diligence issues that BDC market participants ought to know?
Here are the key takeaways:
The panel began by discussing views on why there is increased interest in BDC consolidation:
- Shares of many listed BDCs continue to trade at or below NAV, creating a challenging environment for new capital raising and organic growth.
- BDCs aspire to grow so as to increase scale to better compete, improve liquidity and public float and spread their fixed, non-advisory costs over more assets.
- As the BDC industry has grown and matured, BDCs have become an attractive vehicle for asset managers, making M&A transactions an appealing way to secure a footprint in the BDC market and otherwise fill a gap in the type of assets under management.
- Activists continue to pressure BDCs to evaluate alternatives designed to improve shareholder value.
The panel also covered certain significant considerations when evaluating and negotiating a BDC transaction:
Pricing Tensions and Negotiating NAV – Parties can find it challenging to agree on pricing mechanics, especially when acquirers use stock as consideration for an acquisition.
- To accurately assess a target’s value, potential acquirers generally conduct asset-by-asset diligence on the target BDC’s portfolio, often seeking input from independent valuation firms to estimate the fair value of illiquid assets. If a target BDC is levered, diligence will also be needed to assess debt repayment requirements and whether any debt can be rolled and assumed by the acquirer at closing.
- The quarterly fair value review process undertaken by BDCs may make target boards reluctant to agree to a transaction priced below NAV.
- Current market volatility has the potential to make what is already a challenging price negotiation dynamic even more difficult.
- Structure – Potential acquirers must consider tax matters, change of control and severance issues and adviser and employee arrangements in designing a transaction structure.
- 1940 Act – Numerous 1940 Act considerations must also be taken into account early and thoughtfully, especially concerning required board and shareholder consents.
- Shareholder Approvals – Because retail investors comprise a large percentage of the shareholder base of many BDCs, the proxy solicitation process can be expensive and drawn out, and BDCs may find it challenging to secure enough shareholder votes to satisfy applicable approval thresholds.
- The complexities surrounding BDC shareholder votes, combined with increasing activism in the BDC space, mean that strategic transactions may face the risk of lengthy delays between signing and closing, heightening the risk for other offers and post-signing challenges to announced deals.
- Because strategic opportunities can arise unexpectedly, often with a limited response window, potential BDC acquirers and targets should regularly consider corporate governance housekeeping and remain informed about their shareholder base.
Will we continue to see high levels of consolidation activity in the BDC space?
- The consensus view was that interest in BDC M&A activity will remain high in the near term as BDCs seek to enhance shareholder value and more asset managers look to enter the BDC space.
- Whether that strong interest will translate into a continued trend of strong BDC consolidation activity is unclear – some deals are likely to get done but, as evidenced by the abandoned TICC deal, the complexity of strategic transactions in the BDC space, heightened activist and shareholder scrutiny and volatile market conditions may limit the number of deals that actually close.