Smaller U.S. BDCs cash in on larger rivals' woes

BANGALORE (Reuters) - Smaller U.S.-based business development companies (BDCs), armed with strong balance sheets and minimal liquidity concerns, are poised to gain from the woes of larger rivals like American Capital (ACAS.O) and Allied Capital (ALD.N) that are wounded by the credit crunch.

As the bigger players struggle to find capital to invest, look to sell assets and grapple with debt-covenant defaults, the smaller ones are attracting investments and signing huge asset-management pacts.

Just last month, Ares Capital (ARCC.O), a smaller investment firm, raised $250 million from institutional investors for a fund aimed at investments in newly originated and secondary senior secured debt.

It follows the company's signing of two pacts, including one with Wells Fargo (WFC.N), to manage about $1.37 billion of middle-market loan assets.

BDCs, which make private-equity investments by lending to small companies and acquiring venture-capital stakes, will be fewer in number and face less competition, analysts say.

Competition in this space will be reduced as investment activity shrinks at American Capital and Allied, analyst Greg Mason of Stifel Nicolaus said.

Keefe, Bruyette & Woods analyst Sanjay Sakhrani said smaller firms like Ares Capital and Apollo Investment (AINV.O) may be able to access capital markets in the future and benefit from the troubles of bigger firms, despite a lack of capital currently.

American Capital and Allied did not reply to emails seeking comment.

New York-based Apollo Investment, whose shares have tripled in value in the past three months, is also likely to benefit from improving credit markets and remain in compliance with its debt covenants owing to its ability to sell investments.

Analyst Sakhrani said the biggest advantage of companies like Apollo and Ares is their affiliation with larger private-equity firms, which gives them a strategic advantage in terms of both sourcing deals and negotiating with banks.

American Capital and Allied ran very high leverage and were aggressive at the top of the cycle. They carried a lot more equity in their portfolios, which hurt them when valuations in the middle market fell significantly, analysts said.

Also, American Capital grew quite a bit at the peak and Allied sold a lot of its winning investments, causing some adverse selection risk within the remaining portfolio, they said.

American Capital, which was removed from the Standard & Poor's 500 index .SPX in February, has defaulted on $2.3 billion of unsecured credit arrangements as of March 31 and auditors included a going-concern opinion on its financial statements.

Washington-based Allied Capital, which in May posted its fifth quarterly loss in a row, is also battered by frozen credit markets and is also in default on debt.

Fox-Pitt Cochran analyst Matthew Howlett said he recommends Prospect Capital Corp (PSEC.O) and Apollo Investment.

"I think the business model of Ares Capital is also going to thrive," he said.

BIG PLAYERS, BIGGER CHALLENGES

Even if the struggling companies are granted waivers, conditions imposed by lenders may limit their origination activities, analysts say.

With no government funding -- along the lines of the U.S. Treasury's Capital Purchase Program -- in sight, the industry is hoping Washington will consider at least a marginal change in some mark-to-market accounting rules, along with some thoughts on leverage ratios, for some relief.

When it comes to the struggling firms, asset sales seem to be the only logical option.

"I think Allied and American Capital are selling assets because they have to, but in general the other BDCs, even despite the rally in the market, are still holding on to their assets," Fox-Pitt Cochran's Howlett said.

Lack of funding and ongoing negotiations with lenders could mean that larger firms may need to overlook investment opportunities arising from easing financial markets, while the smaller ones benefit from them.

American Capital is sounding out buyers for its European portfolio in a deal that could be worth up to $2 billion, three sources familiar with the situation told Reuters in April.

Allied Capital also said in May it sold some of its assets for about 90 percent of their aggregate fair value to generate liquidity.

(Editing by Vinu Pilakkott)