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Business Development Companies (BDCs) and private credit funds are transforming the asset-based lending (ABL) industry at every level – from Apollo via MidCap Financial and Ares at the high-end, to Solar via North Mill and Hercules via Gibraltar at the low-end. It’s no accident this is happening as this has been part competitive response and part growth strategy to compete with banks consolidating independent ABLs or starting their own shops.

The BDC and private credit fund industry has seen prolific growth over the past decade. It’s now at the point where there is too much capital chasing too few deals, mostly originated by Private Equity (PE) firms, in addition to excessive leverage and risk required to win deals. The end-result should be like many other cycles where the remaining large name brands have scale and greater margin for losses, the emerging smaller brands have discipline over growth, and the ones in between are left in a weakened position. Many of the 50-plus public and private BDC and credit funds have started to face difficulties due to competition, excessive risk and margin compression. The competitive saturation and efficiency at the larger BDCs and credit funds have led to merger and acquisition activity in an unlikely place – the ABL industry.

The ABL industry has been experiencing a sea change over the past ten years with a new cycle of independent non-bank ABLs cropping up only to see a wave of consolidation by national and regional banks making sure they have strong ABL capabilities. The most recent acquisition being Fifth Third’s acquisition of MB Financial – which brought MB’s crown jewel with it – the ABL group.

Much of the competitive change over the past several years is evident in the size of ABL facilities, with battle lines being drawn in three distinct facility size ranges:

• $1 million to $5 million
• $5 million  to $15 million
• $15 million to $50 million

Each bucket presents challenges and opportunities as average facility size is usually indicative of an asset-based lender’s comfort level, which is why the competition tends to be very focused within each segment. The reasons for acquisitions are also quite different within each bucket given the implied size and scale of the borrower.

To recap the past few years of M&A activity: Ares purchased First Capital and Keltic to create a national ABL platform; Apollo purchased MidCap Financial; Solar acquired North Mill, Gemino, Crystal and Nations Equipment Finance; Hercules acquired Gibraltar; and White Oak acquired Capital Business Credit and Federal National to name a few. These are just the highlights, but the trend is clear that BDCs and credit funds want to provide a complete solution and expand their respective product offerings.

These firms employ very different go-to-market strategies. Firms such as Solar, which owns North Mill, Gemino, Nations Equipment Finance and Crystal, enable each firm to operate independently in silos under their brand names. Ares re-branded and integrated First Capital and Keltic under the Ares brand to enable a more seamless branding and platform experience. These firms play in different parts of market with Ares being more “up market” so there is clearly no right or wrong way, but it’s interesting to see the contrasting approaches. Solar has strategically assembled a strong portfolio of name brands to deliver a complete solution from ABL, to equipment finance, to second lien financing. This was not a mistake, and by enabling these companies to operate independently they are looking for maximum reach and growth.

Having an ABL product and platform staffed with industry professionals enables these firms to compete on stand-alone non-bank ABL deals that generate strong returns or to be part of a complete package offered to mostly private equity clients. Firms such as MidCap Financial, Ares and White Oak are able to provide cash flow term loans to clients that typically generate greater than $10 million in EBITDA. This is where also providing the ABL product not only provides a one-stop shop, but also enables them to fully control the deal. These firms are fully staffed and have taken market share by providing structure and flexibility that traditional BDC unitranche structures cannot provide. BDCs and credit funds that can offer a broader platform clearly enjoy a competitive differentiation from the many firms that just provide standard solutions – where the ABL component is outsourced in order to deliver a complete solution.

Outsourcing the ABL component adds risk and complexity whether due to execution risk related to a split-lien deal or the more common risk that the ABL partner liquidates. The BDC or credit fund could always purchase the loan, but it just takes away a level of control over the collateral, situation and borrower. It also complicates the relationship with the borrower by having multiple lenders involved.

On the flip side, one positive and often not discussed point is that the non-bank ABL product is highly profitable. From an absolute profit and risk adjusted return on capital (RAROC) perspective, the returns are compelling, and one could argue better than those in the BDC industry as there is less downside risk. Re-discount lender finance groups such as Wells Fargo, Capital One and BMO, among others, are industry leaders that typically provide 4x leverage to non-bank ABLs. From an ABL profit and loss perspective this usually implies an 80% net margin on funds employed. This type of net margin on collateralized deals is hard to come by and much less risky than a BDC’s, as the ABL industry as a whole has been averaging de minimis loss rates over the past decade.

These are presumably better returns on a net margin basis than traditional BDC deals that contain a fair amount of non-collateralized risk. The changes in play have more to do with product capabilities and structure than pricing.  Many of these providers are catering to private equity firms and competing against unitranche and mezzanine lenders. For BDCs, having an ABL division provides two distinct competitive advantages when catering to private equity:  a) product options/flexibility and b) in-house ABL capabilities.

Pricing is obviously critical when catering to PE firms, but structure will always be more critical. BDCs and credit funds with permanent capital bases and leveraged lines provide a great conduit to not only deliver aggressive structures, but also better control and management of the collateral. This is a meaningful departure from how the BDC industry operates and a clear competitive differentiator. It should be fun watching this wave of what should be more M&A activity play out, and potential new future offerings given how the competitive landscape is starting to take shape.

BDCs and credit funds might be at a tipping point in terms of platform expansion and M&A activity. ABLs could be just the start of a wave of M&A activity given the new regulatory changes to leverage and sheer number of BDCs and credit funds. The activity will not all be directed to the ABL industry given the fact that permanent capital enables BDCs to be buyers due to their access to equity capital and new relaxed leverage limits. Product-focused firms fit nicely into platforms as proven by players such as Solar and Ares. That said, and to play devil’s advocate, it should also be stated that the long-term strategic fit remains in question as it pertains to the current trend as not every BDC needs to own an ABL shop. There are also reasons why they should not — such as product features and staffing requirements.

The current market conditions could be partly a result of a saturated and hyper-efficient industry looking for differentiation. There is a good chance that the next market cycle will wash out a large number of firms and cause consolidation, thus changing market dynamics and with that, the need to add products. It will also bring about a return to normalized pricing/returns with less risk taking. This will not change the ABL industry, but what it might do is remove certain exit opportunities and lower take-out multiples for independent ABLs, which at the current moment are at very high levels. There is no telling where this could lead – more ABL acquisitions or BDC/credit fund consolidation or portfolio fire sales, but it should be fun to watch this trend play out.

For avoidance of doubt, all opinions and observations expressed by the author are his own. In addition, the author welcomes feedback from banks and ABLs around the country.