For private equity firms, the challenge of investing in commercial finance companies has generally resulted from questions of size and scale. Private equity investors generally want to deploy meaningful capital (oftentimes $25 million and up) at the onset of their investment or quickly over time, which means they need to buy into a company’s ability to scale. For high-yield generating asset-based lenders and factoring companies in particular, it can be difficult to retain customers, let alone have those customers grow with you while you attract new borrowers. Therefore, selling the ability to scale can be difficult.

This is an area in which BDCs have been able to forge an impact. The BDC model is generally focused on deriving consistent return on investment in the form of interest income or dividend income off of investments in portfolio or platform companies. While portfolio growth is certainly sought, the generation of consistent quarterly earnings is of critical import for the BDCs whose stock trades publicly off of a dividend yield. A BDC is generally seeking a low- to mid-teens return on its investment capital, which enables the BDC to pay a comparable dividend yield to its public company shareholders. A 10–15% return hurdle is far lower than the typical private equity firm’s hurdle of 20% or more, which means a BDC, if it is so inclined, can be more competitive on investment price and structure than many private equity firms.

In addition, BDCs offer an interesting prospect for the independent finance company’s management team. They are, in essence, publicly traded private equity firms that oftentimes incentivize their portfolio company management teams with incentive compensation, such as stock options, restricted stock, or long-term retention bonus pools.

In 2013, two BDCs in particular made a splash in the commercial finance sector. Solar Capital acquired both Crystal Financial and Gemino Healthcare Finance, two unique commercial finance companies that Solar is using to generate solid returns for its equity holders, while also diversifying their senior loan product offering and client base. Likewise, Fifth Street Finance acquired Healthcare Finance Group, which, like Gemino, is a commercial finance company focused on the healthcare sector. Fifth Street, as noted in the press release announcing the transaction, saw an opportunity to scale Healthcare Finance Group with a meaningful capital infusion in an attractive sector in which they have experience. The selling shareholders of Gemino, Crystal, and HFG all found the right mix of managerial fit and purchase price with these BDCs, not with a bank.

But, lest we forget, banks will almost always have the ability to pay more for an acquisition than non-banks because of their immense cost of funds and leverage advantage. This dynamic was clear when Umpqua Bank agreed to acquire Financial Pacific Leasing Company in 2013 for almost $160 million. Per Umpqua Bank’s press release, the acquisition of Financial Pacific was expected to be 14% accretive to Umpqua’s operating earnings per share, this despite Financial Pacific adding only $279 million in assets to a bank with over $11.5 billion in total assets.

Therefore, you certainly cannot ignore the bank buyer universe when seeking an exit. But the exciting dynamic in today’s market is the emergence of BDCs as a viable alternative for capital raising or a complete sale.

Conclusion

The ingredients are in place for the continued ability of commercial finance companies to raise senior and junior capital from banks and institutional investors. Banks need to find loan growth and improved net interest margins. Private equity groups need to deploy capital to start earning their equity upside, just as BDCs need to find returns on the substantial amount of capital they’ve been able to raise in the public markets. In fact, in today’s market, soliciting new capital could turn out to be far easier than deploying it, given the heavy competition that results from such a fertile environment.

Note: Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.