November 2, 2012: We tweeted a few minutes ago about Main Street Capital’s announcement of the extension of it’s $287.5mn Revolver (now targeted to be increased to $400mn) to September 2017. By itself this is not Big News, but we are going to use the opportunity to make a point about how the Main Street credit facility is representative of an evolution in loan agreement construction since the Great Recession, and why this is a very good thing for Business Development Companies and their shareholders in the short term. We are not so certain about the long term, as we’ll explain below. First, let’s have a look at that main Street press release:
“ Main Street Capital Corporation (MAIN) (“Main Street”) announced today that it has amended its $287.5 million credit facility (the “Credit Facility”) to extend the final maturity of the Credit Facility to five years, through September 2017, with the Credit Facility fully revolving for the first three years of its five-year term. In addition, Main Street continues to maintain two, one-year extension options under the amended Credit Facility which could extend both the revolving period and the final maturity of the Credit Facility for up to two additional years. The amended Credit Facility also contains an upsized accordion feature that allows for an increase in total commitments under the facility up to $400 million of total commitments from new and existing lenders on the same terms and conditions as the existing commitments. The amended Credit Facility provides Main Street with access to longer term financing capacity in support of its future investment and operational activities. Main Street currently has $76 million of outstanding debt under the Credit Facility.”
THAT WAS THEN
Prior to the Great Recession, most BDCs own borrowings were in the form of Revolving loans, secured by the portfolio assets, and with a relatively short maturity: typically one to three years. Both the bank and the BDC saw these as evergreen facilities which rolled over on a regular basis. The BDC appreciated the shorter term nature of the loans as an opportunity to negotiate lower rates as their size and credit profile improved. Many BDCs came to market in the years after 2004, and were becoming increasingly popular with lenders and were able to drive better and better loan deals as the go-go years through early 2008 proceeded. Given the very optimistic tenor of the 2003-2008 period, BDCs were not shy in drawing heavily on their Revolvers. The funding was cheap (if I remember subordinated debt lender Pennant Park Investment was able to borrow at LIBOR + 1.0%), the advance rates were generous (even technology lender Horizon Financial-which was not public at the time but will serve to illustrate the point-was able to get a 75% advance rate against it’s portfolio loans from it’s Revolver lender) and easy to access (just calculate your borrowing base, see how much availability you have and send in a request to the lender and get your money wired within 24 hours).
THE GREAT RECESSION CHANGED EVERYTHING
The Great Recession placed this cozy arrangement between the BDCs and their lenders under great pressure. First, as risk in the economy increased and the relatively high leveraged character of many BDCs showed up, their bank lenders became frustrated at the risk-return they had signed up for. The result was that most every lender used any opportunity available to unwind or drastically change their lending arrangements with their BDC customers. Often the banks had the upper hand due to the short term nature of the Revolvers. When the facilities expired, the banks just refused to extend them at any price. Suddenly BDCS like TICC Capital (ticker: TICC), Hercules Technology (ticker: HTGC), Gladstone Investment (ticker: GAIN) and Gladstone Capital (ticker: GLAD) faced an inability to roll over their Revolvers and had to sell off assets in a hurry to avoid default. Worse off were the BDCs which were in technical default (often due to the precipitous drop in the fair market value of their loan assets: up to 40% in a few months, which caused asset coverage tests to be breached). In most cases the lenders were ruthless and the BDCs were scrambling for survival, locked in endless and contentious negotiation with their bankers. Just a few examples are American Capital (ticker: ACAS), which had a mix of different loans and notes in default and took two years to straighten matters out, GSC Investment, now Saratoga (ticker: SAR), which ended up needing a capital infusion and a change of management/ownership, Patriot Capital and Allied Capital, which had to sell themselves to Prospect Capital (ticker: PSEC) and Ares Capital (ticker: ARCC) respectively.
IMPACT ON DIVIDENDS
We often point out that the BDC sector cut it’s dividend pay-out 53% during the Great Recession. The principal reason was not the number of non-performing loans (although they did increase), but the almost across the board need to de-leverage balance sheets to satisfy Revolver lenders. With less assets, you have less income and so dividends drop. No BDC was bankrupted, but it was very close in several cases.
MISMATCHING ASSETS AND LIABILITIES
The irony is that the panicky de-leveraging, dividend cutting and sense of the world coming to an end didn’t need to happen. The principal problem was the capital structures of the BDCs relied too heavily on short term borrowing facilities. It’s a tale as old as time when finance is concerned: lending long (most BDC loans are 5-7 years in length) and borrowing short (1-3 year Revolvers), compounded by relatively tight bank covenants because BDCs wanted to get their cost of capital as low as possible.
Anyway, in the post Great Recession era both the lenders and the BDCs appear to have learned their lesson. Revolver borrowing continues to be a staple at 90% of the BDCs. However, as Main Street illustrates, the length of the facilities has been extended. Three years is the new normal. More importantly, if a banker panics (as they will do at every recession) the BDC has a two year amortization period to pay back the debt. This means no rushed selling of an illiquid asset at a huge discount, or requiring borrowers to pay you back at the worst possible moment. The theory is that in the next recession-if a bank lender wants out-there will be an orderly de-leveraging.
However, this is no panacea. Most BDCs have realized that they cannot rely on fickle bank lenders for the bulk of their debt capital. As we’ve seen in the past two years, whenever possible BDCs have been raising long term convertible debt and unsecured debt. The former has generally been placed with insurance companies and the latter with the public. From the BDC perspective the benefit is a matching of assets and liabilities, and essentially no covenants that could cause the debt to default and be called. Revolver borrowings, in most cases, have been relegated to a supporting role: used for short term funding, and in far smaller quantities than before.For example, in today’s Main Street announcement the balance on the Revolver was given as $76mn, or just 26% utilized. As a percentage of Main’s total investment assets of $800mn plus, the Revolver is funding under 10%.
Short term the consequence of the re-assessment of the Revolver and it’s replacement with long term debt has been higher interest cost on both kinds of debt. The bank lenders, who have to place longer term facilities on their books, are charging more for the privilege. On average BDCs are paying 1-4% more than they did before the Great Recession. Remember PNNT ? They renewed their 1.0% over LIBOR Revolver at 2.75% in 2012. Revolver outstandings (net of cash) amount to 19% of total assets. The revised Revolver has a 4 year maturity (3 year active and 1 year pay-off). Still, the Revolvers are cheap compared to the long term debt capital which ranges between 5.5%-7.75%. There is no free lunch.
The BDCs expect that the long term consequences of reducing their dependence on Revolvers will mean smooth sailing through the next recession. Hopefully with no enforced de-leveraging and availability under their under-utilized Revolvers, BDCs will be able to offset credit losses with earnings on new loans at generous rates (in the Great Recession many BDCs had no funds to lend out, missing many great opportunities for earnings and conservative capital structures). From the management groups viewpoint, it also means steadier management fees, no need for rights offerings and other disruptive capital raising tactics, and the risk of being bought out at a discount.
For the unsecured debt holders the BDC debt should be a relatively safe investment in the next recession given the more conservative approach the industry has taken in it’s lending practices since the Great Recession, and the structural limitations on debt inherent in the BDC structure (maximum debt to equity of 1:1). Many of the issues are rated BBB or have the characteristics thereof. The yields compare very favorably with equivalent risk junk bond issues.
For the common shareholder, the benefits of the new approach are a mixed bag. On an equal amount of leverage, earnings and dividends will be lower as 20-35% of a BDC’s assets will be funded with long term debt which is more expensive than the previously relied upon Revolver. On the other hand, the capital structure of the BDCs should be more stable, and earnings and dividends more consistent, even in a recession. As a result, shareholders should benefit on a risk-adjusted return basis, but I have no way of quantifying that benefit.
WE WORRY ABOUT EVERYTHING
We worry that new loan yields will drop sharply in the years ahead, thanks to a combination of QE Infinity and the ever-more competitive market for leveraged debt (worthy of an article by itself). As many BDCs will have financed themselves with relatively expensive long term debt at 5-7%, the net spread between income and interest cost might become very narrow. Virtually all the reduction will be borne by the shareholders, as the lenders and the external manager will continue to receive their contractual rates. Shareholders will absorb 80% of the drop, and the external manager 20%, as a reduction in their “incentive income”. We do take some comfort from the fact that some of the debt issues can be called by the BDC issuer after a few years, but that’s not universally the case, and depends on the management of the BDC taking such action. We also note that BDC shareholders will benefit greatly should LIBOR rates sharply because the mostly floating rate loans which the BDCs own will generate far greater income but the bulk of their interest expense will be fixed.
We also worry that the perverse result of the safer capital structures which the BDCs are constructing will cause them to increase their use of leverage. Till a year ago most BDCs debt to equity maxed out around 0.5: 1.0. Today many BDCs have reached or exceeded 0.7:1.0, and those that have not for various reasons are anxious to do so. Moreover, there is legislation looming (and I have not had an update in weeks) which would allow BDCs to increase their statutory leverage more. The result would be higher earnings in the short run, but greater reliance on debt capital and eventually greater credit losses, which will be borne by the shareholder. Already a number of BDCs are not counting SBIC debentures in their leverage calculations, with the result that total debt to equity is already greater than the nominal maximum of 1:1. Most BDCs appear to relish the opportunity to leverage themselves more, and therein lies a potential problem down the road.
Of course, that’s all in a hypothetical future. In the here and now, we should see BDC earnings slowed down slightly by their higher interest expense long term debt added in recent quarters, but their exposure to unpredictable bank lenders reduced as well as the the chances of forced de-leveraging. Next time it will be different. But will it be better ? That remains to be seen.