Apollo Investment Corp.: Industry Contender or Frazzled Diversifier?

Apollo Investment Corporation (NASDAQ: AINV  ) is a somewhat diversified company, meaning that it competes not only with other BDCs, but with banks and other funds that supply financing or invest in "junk loans" and structured products. This is a large and fragmented industry with a lot of players. So, where does AINV fit in? 

AINV has to be better at its various investing activities than competitors in order to have a sustainable advantage, and considering the range of its activities -- and the way they've changed over time -- I'd argue that it doesn't have a clear leg up on the competition.

Let's investigate. 

Middle market financing 
There are a lot of sources of financing to middle market companies, which in AINV's case means companies with $50 million to $2 billion in revenue. The biggest players in the space are banks, which have been reducing their exposure to the market because of capital requirements and regulatory pressure, which leaves the field open to other players.

Other BDCs and private equity funds are direct sources of competition to AINV when it comes to the lending business. For example, Ares Capital Corporation (NASDAQ: ARCC  ) is one of the biggest, with $8.2 billion in assets as of March 31, 2014, and like AINV, it has increasingly turned its attention to secured debt.

As more BDCs turn toward senior secured loans in light of the somewhat frothy lending environment of late, competition for the best deals will heighten. While collateral is always a good thing, there might be competitive pressures that reduce the level of covenants in these loans and that provide financing to companies that may not be as strong as they appear. 

The lack of visibility into a BDC's lending arrangements makes this difficult to assess, so trust in management is a major requirement for the BDC investor. 

It does look like AINV is cognizant of its past mistakes and is earnestly looking to reduce risk in its portfolio. It also diversified into new business lines after the crisis, including energy. However, I don't see either activity as part of a larger, coherent strategic plan -- the company's moves look reactionary, rather than deliberate. This doesn't signal long-run competitiveness.

Other investment activities
AINV not only provides financing; it also invests in debt, equity, and structured products. This means market changes in these areas could also have a significant effect on AINV's performance and long-term competitiveness. 

The main risk with investing in these assets is that prices could go down or liquidity could dry up. Structured products introduce additional risks due to a lack of visibility into the underlying portfolio.

In all of these areas, AINV competes with other BDCs that share the strategy, and with banks and other funds. Large banks are, unsurprisingly, the biggest players, both in terms of size and market reach. They might have access to information that AINV can't get its hands on, or access to deals that are more advantageous than those AINV participates in. In both cases, AINV could be at a disadvantage. 

What's special about AINV? 
What AINV does have, however, is the support of Apollo Global Management (NYSE: APO  ) , its "parent" private equity fund. Apollo has been around for 24 years and has assets under management of close to $50 billion. In addition to traditional private equity, the firm invests in credit (meaning lending) and real estate.

In other words, AINV has access to expertise and deal flow that could be a source of advantage to the firm and place it on more equal footing relative to its competitors. This could help mitigate some of the potential risks involved in AINV's investing and lending activities. 

The verdict: Diversification is not always a winning bet 
AINV is a somewhat diversified player operating in a market with a lot of other diversified players. Its source of advantage has to come from being better at those activities than its competitors. Those competitors are numerous, and AINV doesn't appear to have a clearly delineated competitive strategy that sets it apart. 

You might look at AINV again and think that flexibility begets advantage, but I tend to disagree. I like companies that know where their talents lie, and while it's always possible to gain expertise in a new undertaking, I don't see a clear direction in AINV's activities. I see diversification for its own sake, and that, to me, is not the root of competitive advantage -- particularly since that diversification was borne of the pressure of the financial crisis.

So, despite the considerable clout of Apollo and its deep resources, it's not clear to me that AINV can outperform over the long run. 


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