Business development companies make money by borrowing low and lending high. But the constant problem is finding new ways to invest -- new deals, new loans, and new partners to make it all happen.
On a recent conference call with RBC Capital Markets, four executives of the largest business development companies all agreed that conditions were improving for heavier lending volumes and new growth avenues.
I've compiled a list of quotes from BDC execs on their view of mergers and acquisitions (M&A) in driving bottom-line profits.
BDC execs are bullish on M&A
"M&A... begets M&A, and once you start to get all those ingredients and you see transaction volume increasing, particularly against the backdrop of strong earnings fundamentals and healthy credit markets, it moves pretty quickly.
Over the last two quarters we've actually seen the percentage of new deal flow or new lending opportunities coming from new M&A versus refinancing and recapitalization of existing companies increase dramatically. So I think some of that pent-up demand, if you will, is starting to play out."
Mike Arougheti, CEO at Ares Capital Corp. (NASDAQ:ARCC)
"They claim they have a lot of discipline, that they can't put this money to work. But that money has a time clock on it. So, we think that they're going to eventually have to go up to higher level multiples, and they're going to have to pay for it, which creates some great financing opportunities."
Len Tannenbaum, CEO at Fifth Street Finance (NASDAQ:FSC)
"The M&A market is finally picking up and we're very happy with what we're seeing. Cisco, Microsoft, and Googles of the world are trying to find new technological solutions because they've realized innovation is not necessarily their forte -- it's a lot cheaper to use their balance sheet to buy...technology -- so we're seeing a very robust market there. We needed M&A in the technology world for quite some time and it's finally happening after literally waiting 36 months."
Manuel Henriquez, CEO at Hercules Technology Growth Capital (NYSE:HTGC)
"There was a huge wave of repricing to the end of last year in all markets. And obviously in the first quarter of the year, in the syndicated market, close to 90% of all deals that were done...were just repricing. We underestimated...from a mathematical perspective, is that it made sense to do M&A over the last two years. But the one thing we probably underestimated is there's just, you know, post-crisis there's a lot of scar tissue built up in the system, and a lot of risk aversion on the behalf of corporates...and, quite frankly, that seems to be abating."
Ted Goldthorpe, President of Apollo Investment Corp. (NASDAQ:AINV)
Consensus can be scary. When everyone reaches the same conclusion, the opposite tends to happen. But the data supports the view that private equity funds need to start making new buyouts.
In July, Reuters reported that private equity funds were sitting on a record $145 billion of funds that had to be used in 2013. If the cash goes unused, it will be returned to investors, and buyout shops will forgo potential fee revenue.
Why M&A matters
Mergers and acquisitions are critical for the business development company industry. First, mergers and acquisitions are generally debt-financed, which gives BDCs the chance to find new deals to make high-interest loans.
Secondly, mergers and acquisitions allow for companies to generate fee income. BDCs don't hold every slice of every debt investment they make. Much of it is carved up and sold on the syndicated market to investors ranging from hedge funds to other private equity companies. Those sales create origination fees and gain-on-sale revenue. You can think of the fees like the money banks make by selling mortgages to Fannie Mae and Freddie Mac.
Lastly, M&A helps a BDC grow and make use of scale to drive profits. Many BDCs report that their transaction volume has been from the repricing -- or refinancing -- of existing loans, which doesn't grow the industry as a whole.
Will mergers and acquisitions play out? It's really anyone's best guess. But with rates on the rise, companies will have to act quickly to lock in low financing costs. That could be the catalyst for the next BDC boom.
Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and Google. The Motley Fool owns shares of Google and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.