Imagine you're the CEO of a middle-market cleaning service. This year, you expect your company to earn $10 million, and you'd like to expand to buy a competitor. So, you call up your banker, but since this is a big transaction, and regulators are circling, the bank doesn't want to give you the loan.
Where do you turn next? A non-bank financier, maybe a business development company like Prospect Capital (NASDAQ:PSEC) or Main Street Capital (NYSE:MAIN), or private equity or debt firms that can underwrite your expansion plans and give you the financing you need now.
From the borrower's view
Banks won't underwrite commercial loans based solely on the bottom line. As profitable as your company may be, without an asset for collateral -- an office building, receivables, or a fleet of cars, for example -- banks won't give you much more than a month-to-month credit line.
So, that's where private equity and BDCs can step in. Main Street Capital and Prospect Capital lend largely against a business's future profits. In fact, that's the majority of their business. They take the non-asset stuff; banks take the asset-based lending.
But because of the differences in how BDCs and private equity companies raise money, it's likely BDCs or private equity funds may have cash constraints of their own.
The BDC advantage
In general, private equity funds are raised for only short periods of time. The fund is opened, it accepts new investments, then it closes. At a predetermined time in the future -- say, seven years -- the fund will be liquidated, and the money returned to investors.
BDCs don't have this restraint. So, while they compete for the same deals as private equity firms, they don't have to worry about returning investors' money. Business development companies are designed to exist forever.
Let's go back to the credit crunch to see why this matters. In 2009, private mezzanine funds -- funds that invest in riskier debt, usually in private companies -- raised 92% less money than in the year before. Private equity firms as a whole raised 68% fewer dollars in 2009 than in 2008.
What about BDCs? A handful traded below book value and raised very little. The stars, however, did quite well. Main Street Capital issued more than a million new shares in 2009, and by the end of 2010, it had nearly quadrupled in size from the end of 2008. Fifth Street Finance (NASDAQ:FSC) tripled in size from 2008 to the end of 2010, too. At a time that Prospect Capital was trading at a roughly 20% discount to book value, it was able to use cash on hand and issue new shares to acquire a rival, Patriot Capital, at 54% of its book value.
BDCs have money when few others do
The point is this: Because BDCs raise permanent equity capital, and long-term debt capital, they have money when other bidders (private equity and debt funds) simply do not. And when the competition doesn't have money, you can set your own price.
Looking back, 2009 and 2010 were the best times to invest in nonpublic deals. It was also during this time that private equity firms raised very little cash to make new investments. BDCs, having a perpetual life, always have funds to invest, since by and large they distribute only their earnings, and rarely return capital to shareholders. It's a big advantage, one you can't see in a strong credit environment like today's. But when the tide goes out, this advantage gives BDCs the upper hand.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.