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Franklin Square Capital Chats With LCD About BDCs, Record Leverage Levels

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S&P Capital IQ LCD recently chatted with Michael Gerber, managing director, and Zach Klehr, executive vice president, at alternative asset manager Franklin Square Capital Partners. Franklin Square manages four BDCs – one is publicly traded and three are non-listed. The four funds have an aggregate of $11 billion in assets under management as of March 31. Franklin Square’s first fund, FS Investment Corporation, listed in April on the NYSE under the ticker FSIC. The fair value of FSIC’s portfolio was $4.5 billion, as of March 31. Answers have been edited and condensed.

LCD: FSIC invests in senior secured loans to both large-cap and middle-market borrowers. How does FSIC define middle market?

ZK: We define it as companies with revenue between $50 million and $2.5 billion. We recognize that is a pretty broad definition, but I think it provides a good feel for the breadth of our platform. Our portfolio companies have an average EBITDA of $190 million. That said, we participate across the senior secured loan market. Our directly originated middle-market deals for the first quarter averaged about $40 million in EBITDA.

Why start out non-listed?

ZK: Our model is a little bit different than the traditional BDC, which is usually launched through an IPO on an exchange, and then grows through follow-on equity offerings. We believe the non-listed approach results in a better portfolio. We can continuously raise capital and deploy investments during all market cycles, the good and the bad, when few other BDCs are able to raise capital. We believe our approach results in accessing a wider variety of vintage cycles and better deal terms. Once we seasoned our portfolio, we felt FSIC was well positioned for the public markets.

GSO/Blackstone is FSIC’s sub-adviser. How did that relationship come about?

ZK: When forming FSIC, Michael Forman, our CEO, and other colleagues evaluated several and determined GSO was the best fit. It wasn’t until sometime later that GSO joined Blackstone, which further strengthened the GSO platform. It has proven to be a great partnership.

Are managers with less direct credit experience now entering the space?

ZK: We certainly see more managers coming into the BDC space. Some come from large, experienced firms and others do not. Regulatory changes, including the Volcker Rule, have led experienced managers to turn to BDCs, which enable them to engage in their traditional lending practices, albeit in a more regulated and transparent environment.

How will risk retention’s impact on CLOs affect BDC volume/behavior?

ZK: Most CLOs are in the broadly syndicated space. As the retention rules limit CLO formation, there will be fewer participants in the loan market and a softening of pricing should follow. I could see some deals at the lower end of the market not being able to be syndicated out as they are now. That will create opportunity for other lenders like BDCs.

How optimistic are you about the SEC loosening restrictions on leverage and investments for BDCs?

MG: We are following the BDC legislation closely and believe there’s momentum behind the effort to help BDCs play a more significant role through a modest increase in the leverage limit (to 2:1). The fact is the current limit is very low (1:1) compared to limits on other types of lenders like hedge funds, CLOs, and even traditional banks. While there are some policy makers that have understanding of leverage levels and built-in market protections – many others are unfamiliar with BDCs, so education and outreach is needed.

Where do you see the BDC market five years from now?

MG: I think the market will be much larger – traditional banks do not appear to be coming back to middle-market lending. If anything, we see them continuing to retreat from the space. Non-bank lenders, like hedge funds, private debt funds, and BDCs, will see a growing opportunity. Of all those lenders, the BDC is the most transparent structure.

How so? 

MG: Listed or not, all BDCs must file with the SEC at least quarterly, and sometimes more frequently. We provide a schedule of all our investments. Imagine being a regulator charged with monitoring the capital markets. Would you feel more comfortable with assets flowing into fully regulated, transparent BDCs or more opaque investment structures like hedge funds?

But won’t BDCs be making more plays in opaque investments like hedge funds or private equity if legislation is passed that lifts the ceiling on those types of investments?

MG: There is a proposal in Congress that would permit BDCs to do just that, but we do not support it. The SEC, through Chairwoman White, expressed objection to the proposal because it would allow firms to do an “end run” around the accredited investor rule. We agree.

What do you think about current market conditions? Do record leverage levels for middle-market companies worry you?

ZK: We do take pause at what’s going on, especially in the high-yield market, which is why we remain focused on direct origination, where we underwrite and can limit our exposure to over-leveraged companies. Our portfolio has ranged between 4.5x to 5x EBITDA. While you can’t measure all industries on that alone, it’s an indication of our limited exposure to highly leveraged companies.

What is Franklin Square’s biggest challenge going forward?

MG: The biggest challenge is educating folks on BDCs – they are still a relatively unknown yet growing investment platform. We need to continue to tell the story of the industry, the value it provides in creating robust capital markets, and how that helps companies grow and add jobs.

– Kelly Thompson

Follow Kelly on Twitter  @MMktDoyenne for Middle-Market financing news and trends.