Sunday, December 4, 2022

Statewide: Private equity’s public appeal

Joe Alala has reason to smile every time he passes a Boot Barn store, where would-be cowboys corral footwear. His Charlotte-based company, Capitala Finance Corp., lent about $15 million to Irvine, Calif.-based Boot Barn Holdings Inc. in 2012 at a 13% interest rate and received shares in the privately held retailer. It paid off the loan a year later, then went public in October 2014 and nearly doubled in value through mid-June. Capitala’s Boot Barn shares were worth $10 million in May, a fivefold gain and one of the best investments in the company’s six-year history. Such is the upside of private equity as practiced by more than 20 groups in the state, including 10 cited below.
Though each invests in privately held companies, the groups take varying approaches. North Carolina’s largest PE firms are spinoffs of the state’s three giant banking companies, formed after new federal laws forced the banks out of direct investing in an effort to prevent another financial meltdown. Ridgemont Partners Management LLC came out of Bank of America Corp., Pamlico Capital Corp. was formerly Wachovia Capital Partners and Five Points Capital Inc. was part of BB&T Corp. Former bank employees now oversee the portfolios, made up of investments in companies such as Raleigh-based Jones & Frank, a servicer of fuel-system equipment that is partly owned by Five Points Capital. Other groups specialize, such as Raleigh-based Cherokee Investment Partners LLC in the reuse of contaminated real estate and Durham-based Intersouth Partners in early-stage technology and life-sciences companies. Intersouth’s funds own 7.7% of Chapel Hill-based Cempra Inc., the state’s hottest stock.
But an emerging, lesser-known part of private equity includes Capitala and other business development companies, a clunky term likely to become common lingo among investors over the next few years. In North Carolina, Raleigh-based Triangle Capital Corp. and Charlotte’s Capitala and Fidus Investment Corp. are so-called BDCs poised to benefit from the sector’s growth. The term refers to lenders that make high-interest loans to small and midsized businesses that don’t qualify for traditional bank financing, while often taking small equity positions that can pay off big.
Triangle, Capitala and Fidus are among 53 BDCs that are publicly traded, with a combined market value of less than $60 billion, or roughly one-sixth the market cap of San Francisco-based Wells Fargo & Co. (Fidus is based in Evanston, Ill., but has many of the same executives as Charlotte-based Fidus Partners LLC, an investment banking advisory company.) BDCs are gaining prominence as more companies borrow from them, partly because regulators are limiting leveraged lending by banks. Goldman Sachs Group Inc. founded a BDC in 2013 that went public in March, and Switzerland’s Credit Suisse Group AG plans to start one later this year. Steven Lilly, chief financial officer of Triangle Capital, compares BDCs with real-estate investment trusts, which grew from less than $50 billion in market cap in the mid-1980s to more than $500 billion today. “REITs have become core holdings for investors,” he says. “As investors better understand our core competency of small-company lending, there’s a wonderful opportunity for BDCs.”
Like REITs, BDCs must share at least 90% of their taxable income with investors, paving the way for big dividend yields, which range from 7% to 14%. Investors are understandably leery of such payouts —richer than Duke Energy Corp.’s 4.5% dividend yield and the 5.5% average of junk bonds in mid-July. “Too good to be true” skepticism is always warranted. But more investors are beginning to understand the BDC strategy, Alala says. “It’s more risky than an investment-grade bond or a CD,” he says. “But BDC lending usually has better covenants, lower leverage and more active management than a high-yield bond, and you are getting paid twice the amount of interest.”
Fears of higher interest rates have pushed down stock prices of Capitala and other BDCs this year, along with other high-yield investments such as master limited partnerships and utilities. But higher inflation won’t necessarily hurt, because BDCs will charge higher interest rates, preserving the spread between the amount charged to borrowers and its cost of capital. “If you have a nice, predictable increase in rates, it’s not a bad thing because it indicates the economy is doing well,” Alala says. The 9.7% average yield of BDCs is “so meaningfully mispriced that [it is] comparable to some of the most speculative government bonds in the world,” Triangle Capital noted in a June report, citing the 8.3% yield of South African debt and Turkey’s 8.9%. Meanwhile, BDCs’ volatility, called beta by investment pros, is about half the level of the largest 20 U.S. banks and Standard & Poor’s 500 index, according to the report.
Since Triangle issued shares in 2007, it has had a 16% annual rate of return, far outpacing all but one of its peers that have operated during the same period, the report says. (The best performer is Houston-based Main Street Capital Corp.) Its 90-plus portfolio companies are spread nationally, with sales ranging from $20 million to $200 million and pre-tax earnings of $3 million to $35 million. Many BDC stocks have been poor performers because of loan losses and excessive administrative costs. But Triangle’s success reflects finding good investments and keeping costs down, Lilly says.
The company is more efficient by managing its portfolio without taking management fees and performance payments common in private equity. On the other hand, Capitala collects a 1.75% transaction fee, plus 20% of profits after thresholds are met, Alala says, because it views its BDC as part of a larger money-management business that includes a private-equity fund focused on small companies. (The fund is not part of the public company.) External managers have extra incentive to enter deals because they get paid more if they manage more assets, which critics say encourages some bad practices. “We have no incentive to just add assets because we don’t get that 2% fee,” Triangle’s Lilly says. “We think internal management better aligns with the interest of shareholders.”
Businesses that receive loans from BDCs typically want to pay back the debt as quickly as possible, so turnover of loans is rapid. “Nobody wants to pay 11% when they can pay a bank 5%,” Alala says. Having a steady flow of new loans is critical, so Capitala now has staffers hunting for business at offices in seven cities, adding Atlanta, Los Angeles, New York and Washington, D.C., since its public offering in September 2013. “It’s all about having a big pipeline of deal flow, then sorting through them and picking the best,” Alala says.
One constraint on the growth of BDCs is a restriction limiting their lending to no more than their equity capital. For example, if a company has $100 million in equity, it can’t lend more than $100 million, unlike banks that often have leverage of 15 times their capital. BDCs are pushing Congress to boost the leverage ratio to two-to-one, though is unclear if that will happen, Alala says.
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