For a short while after the credit crunch hit, business development companies -- publicly traded, closed-end funds serving the middle market -- looked as if they were thriving. Unlike the rest of the financing markets, their balance sheets showed relatively low leverage risk, given the BDCs' prescribed debt to equity ratio at 1-to-1, plus they had capital to invest, at least for a time. But markets, or more precisely mark-to-market, eventually wreaked havoc on legacy portfolios of mezzanine debt and equity investments, and BDC stocks have been pummeled.
Some private equity wannabes might be heaving a sigh of relief that their BDCs never took off, now that they have the benefit of distance. BDCs work exceedingly well when markets are up, but the reverse is true when they tumble.
To fund operations, a BDC must issue new stock, because it pays out most of its earnings in dividends.
A BDC is usually precluded from selling new shares of its common
stock at less than net asset value without shareholder approval or
unless such shares are issued through a rights offering.
Continue reading below
The sector as a whole has taken it on the chin, but Allied Capital Corp.
of Washington appears to have absorbed more than its fair share of
collateral damage. The firm blames the broader financial crisis, but
analysts say it's difficult to disassociate Allied's troubles from its
long-running battle with short sellers led by New York hedge fund Greenlight Capital Inc. and founder David Einhorn.
Einhorn has had Allied in his cross hairs for several years now,
alleging fraudulent dealings over Allied portfolio company Business
Loan Express LLC, now known as Ciena Capital LLC.
Allied has denied allegations, but a federal investigation is still
pending. Einhorn devoted an entire book to the subject, "Fooling Some
of the People All of the Time," published in May.
Ciena, a small-business lender, filed for bankruptcy protection on
Sept. 30. Allied says Ciena, which it acquired in 2000 and was one of
its largest investments, continues to experience "significant
deterioration" in the value of its assets due to the uncertainty in the
financial markets, falling bid prices and a reduction in the number of
loan buyers.
Allied's $327 million outlay in Ciena has been written down to zero
over the past several quarters as of mid-2008. But some analysts warned
that Allied was exposed to $320 million in unconditional guarantees of
Ciena's outstanding obligations, which could eat into its spillover
income for the coming quarters and slash the dividend.
To fund the payment, the BDC says it used cash resources of $149
million and borrowings of $170 million. Allied says it has been
harvesting capital gains from the sale of debt and equity. As of the
end of June, it retained about $200 million in cash and had borrowings
on its $632.5 million line of credit of $170 million, along with
standby letters of credit of roughly $124 million.
American Capital Ltd. of Bethesda, Md., perhaps the most aggressive BDC, was recently downgraded by J.P. Morgan Securities Inc.
on concerns that the firm may not be able to maintain its dividend rate
in the coming quarters "without a significant improvement in the
current environment" of lower valuations and slowed deal activity.
Kohlberg Capital Corp., which has a relationship with Mount Kisco, N.Y., private equity firm Kohlberg & Co. LLC,
was faring better than average until recently, when it decided to go
for a rights offering, then withdrew it amid the Wall Street crisis
while cutting its dividend.
Worse is yet to come, though. As David Chiaverini, a vice president at BMO Capital Markets Corp., puts it, very simply, "Credit quality is weakening."
-- John E. Morris contributed to this article.
| BDCs take a beating |
| Shares of some business development corporations have held up fairly well as other financial stocks have been pummelled this year, but Allied Capital and Kohlberg Capital have lost much of their value since Labor Day |
Business development company |
Market cap ($mill.) |
Change in NAV per share: 12/31/07 to 6/30/08 |
Stock performance* |
Since Jan. 2 |
Since Sept. 2 |
| Allied Capital Corp. |
$1,160 |
-9% |
-69% |
-57% |
| American Capital Ltd. |
3,950 |
-18 |
-41 |
-12 |
| Apollo Investment Corp. |
2,040 |
-10 |
-14 |
-16 |
| Ares Capital Corp. |
855 |
-12 |
-39 |
-28 |
| BlackRock Kelso Capital Corp. |
570 |
-11 |
-31 |
-7 |
| Hercules Technology Growth Capital Inc. |
296 |
-1 |
-24 |
-12 |
| Kohlberg Capital Corp. |
132 |
-9 |
-45 |
-43 |
*Does not include dividends
Market capitalization and stock performance to midday Oct. 6
Source: The Deal |
