Building the Biggest High-Yield BDC

After a nine-year run, Blackstone (BX +0.00%) will step aside as the investment manager of business development company FS Investment Corp. FS is going down a different path, drawing up a joint venture with private equity and credit fund manager KKR & Co. (KKR 3.15%) to combine their business development companies into one massive super BDC.

Here's what the change will mean for shareholders of FS Investment Corp. and KKR's Corporate Capital Trust.

1. What's going on?

In effect, FS and KKR & Co. are joining forces, putting their BDCs together (four from FS, two from KKR) to ultimately create the single-largest BDC in existence today, bypassing industry leader Ares Capital Corp. (ARCC +0.08%).

The BDCs involved in the deal range from minnows to some of the biggest funds in the industry. Two of the BDCs are publicly traded, four are not.

Data source: Company filings as of Sept. 30, 2017.

This combination wasn't in the plan when the BDCs were formed (FS' first BDC dates back to 2008, KKR's to 2010), so there are a lot of kinks to work out.

In what I'm calling "step 1," which is happening right now, all of the BDCs have to agree to new, standardized terms with their new manager (KKR and FS). They'll start soliciting votes in January 2018 and hold shareholder meetings to vote on the matter in March 2018.

If the agreements are approved, it will be easier to enact step 2, which is combining all six BDCs into one large publicly traded BDC. FS executive Michael Forman told InvestmentNews that it could be a process that will take as long as 12 to 18 months from start to finish. 

Image source: Getty Images.

2. Making much-needed improvements

Shareholders have a big reason to say "yes" to the FS and KKR tie-up. One of the biggest advantages of the proposal is that it offers a much better fee structure than the one under which the BDCs currently operate.

Most BDCs are externally managed, meaning that they pay a fund management company a fee for the service of finding good investments and managing their investment portfolios. The fees are similar to the prototypical hedge fund fee structure, whereby managers collect a base fee on assets plus an incentive fee to reward them for good performance.

The publicly traded FS Investment Corp. and Corporate Capital Trust BDCs currently pay a base management fee of 1.5% on assets, plus incentive fees equal to 20% of returns when returns exceed a hurdle rate of return. Annualized hurdle rates are 7% and 7.5% for CCT and FSIC, respectively.

Note that hurdle rates come with an asterisk. FS Investment and Corporate Capital Trust currently have controversial provisions that allow them to add back base management fees when calculating their shareholders' investment returns. Adding back these expenses has the effect of lowering the incentive fee hurdle to a rate much lower than the stated one, roughly 4.8% for FSIC and 4.3% for CCT, assuming each BDC is levered at approximately 0.8 times its equity. 

Data sources: FS Investment Corp., Corporate Capital Trust, SEC filings, calculations by author. Effective incentive fee hurdle assumes debt-to-equity of 0.8 times and does not add back base management fees. *FS Investment's base fee is 1.5% due to a temporary 0.25-percentage-point fee waiver.

If shareholders approve the proposed fee agreements, both BDCs will enjoy much better fee structures. Base fees will be set to 1.5% of assets permanently. Incentive fees will only be paid if pre-incentive fee returns truly exceed 7% on shareholder's equity, as the so-called "base management fee add-back" will be eliminated.

As yet another perk, the proposal calls for tabulating incentive fees based on a three-year performance period. FS Investment already employs this method, but Corporate Capital Trust uses a much lower bar, as incentive fees are based on returns over one year.

For all the good, it's my view that the change in fees is best described as the FS Investment and Corporate Capital Trust BDCs catching up with their peers rather than setting a new standard for fee agreements. There are many BDCs that already have hurdle rates of 7% to 8% that do not add back management fees when calculating returns.

3. A happier marriage?

Though they kept up public appearances, it was always understood that FS and Blackstone's GSO unit were never a good match. Behind the scenes, I'm told they frequently butted heads on how to run the business or how the fee haul should be divided.

It became very clear that the FS BDCs were really just a side project for GSO/Blackstone, since the BDCs were only allowed to participate in a portion of its deal flow. One could argue that GSO/Blackstone kept its best deals for its own funds, and sent the scraps to the FS Investment BDCs. (GSO/Blackstone didn't have much incentive to send the best deals to the FS BDCs because it only received half the fee haul.)

In their pitch and presentation, FS and KKR made a point to focus on the fact that the joint venture will enable the BDCs to pick off investment opportunities from KKR's credit platform on a pro rata basis. If KKR finds a particularly good investment opportunity, the BDCs will get a shot at putting some of it in their portfolios for the benefit of the BDCs' shareholders. 

4. Scale is a tangible benefit to investors

There is a case to be made that combining six BDCs into one company makes sense from an operational standpoint. Assuming that the BDCs leverage their portfolios at about 0.8 times equity, they would have a combined $19 billion to $20 billion of firepower based on total equity capital of roughly $11 billion. That will enable them to compete for larger investments and commit to doing deals sized at several hundred million dollars. 

There are many BDCs and private credit funds that can compete for $10 million loans, but there are substantially fewer players who can take down a $500 million investment in one go. Being able to do a big deal is a real advantage when credit markets turn south. Last year, three BDCs worked together to provide a massive $1.075 billion loan to a company known as Qlik Technologies. The BDCs scored an attractive return, thanks to a high interest rate, up-front fees, and prepayment penalties when the loan was refinanced in a traditional bank-led process earlier this year. 

Of course, scale begets a perennial advantage when it comes to a BDC's ability to borrow at attractive interest rates. Ares Capital Corporation frequently borrows at rates far lower than peers, thanks in part to its size and underwriting performance. Given that the industry earns income by borrowing low and lending high, being able to borrow at a lower rate results in better returns for shareholders, all else equal. 

More details will come as plans are cemented and the issue is put up for shareholder vote, but as it stands today, it's a pretty compelling proposal. Shareholders of the BDCs get a capable manager, a better fee agreement, and likely some extra oomph to returns thanks to improved economies of scale.