Wednesday, December 16, 2009

Why no BDCs?

One thing that is odd in the rush to file S-11's for new REITs, is the lack of filings of N-2's for new business development companies. So far just three have filed during this landrush to the SEC. The public markets have lost two BDC's (ALD and PCAP) to mergers, along with relatively little capital raising from secondary offerings. This doesn't make sense since the credit conditions in the middle market C&I lending are constrained and profitable.
  1. Trian Capital Corp
  2. THL Credit
  3. Golub Capital BDC

The Trian and THL offerings are boring 2/20-catch up jobs. The Golub offering is interesting, because Golub Capital had previously filed to create Golub Capital Partners LLC. This would have a been an LLC type vehicle similar to Compass Diversified Trust (CODI) in that it was structured as an LLC instead of as an investment company. Golub capital gets credit in my book for having funny advertising. Not often do we get to see the world through the gold colored glasses of a mezzanine lender.

The N-2 for Golub Capital BDC gets an award for the most byzantine management fee arrangement I've ever seen. I'm honestly not sure I even understand it, but it appears to be a traditional 20%+catch incentive fee over an 8% hurdle combined with a moving cumulative total return high water mark based on the relative differences of two different calculations of net investment income and total return. It's honestly not worth figuring out. Hopefully they simplify this fee structure in an N-2/A. Make it a straight 1.25% assets + 20% excess of an 8% hurdle on a four quarter rolling average, and they should be all set.

Financial LLC's (like the original Golub Capital Partners) have been an unpopular form of investment because they are flow through entities which issue K-1 forms instead of 1099-DIVs. An investor in such a entity gets to report his/her allocable share of taxable income which may not be matched by actual cash distributions.

The investor base is limited because tax exempt investors (including mutual funds) cannot jeopardize their status with the Unrealted Business Taxable Income (UBTI) that publicly traded LLC's/LP give off. Unlike traditional natural resource/hard asset MLP's, financial MLPs tend to generate almost no deductions which have the effect of shielding cash dividends from taxation.

This attained ultimate silliness in the S-11's for Michael Vranos's Ellington financial, which was planning to invest in subprime mortgages and related assets. The offering memorandum disclosed that Ellington intended to distribute only 50% of its taxable income each year; resulting in an absurdly high effective tax rate since the IRS would asking shareholders to pay 35% on 100% of the companies taxable income. The effective tax rate on cash distributions would be 70%. So you had a proposed IPO in which institutional investors were both unable to, and too smart to invest in.

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