BDC Trends: The impact of higher LIBOR rates
BACKGROUND: There’s a great buzz amongst most Business Development Companies about the rapidly changing LIBOR interest rate landscape. Increases in 1 Month LIBOR and 3 Month LIBOR on which many floating rate loans to borrowers are pegged as well as BDC Revolver and Term Loan financings are affecting both liabilities and expenses.
To date, BDC debt liabilities have registered the greatest impact, raising funding costs, while loan assets have not yet been impacted by higher LIBOR rates due to the almost universal presence of fixed LIBOR “floors” which have to be passed before loan yields will increase. In the IVQ of 2016 results most BDCs have been net losers from the 0.4% increase in LIBOR rates, and BDCs with substantial CLO exposure (with their multiple tranches of LIBOR-linked financings) have been battered. (TICC Capital cut its distribution by one-third largely because of this phenomenon and BDC-like CLO investor Oxford Lane Capital reduced its distribution by one-third).
HAPPY DAYS WILL BE HERE AGAIN ?
However, with 3 month LIBOR now at 1.06% (a 40% jump from last year), many of the “floors” are being passed (albeit on a minuscule basis). As a rule of thumb the average “floor” rate is 1.0%, but every BDC has a different mix. Moreover, the financial markets are giving a 75% certainty to a 0.25% rise in the Fed Funds rate this month, which should result in an equal increase in LIBOR.
Fed members have not been shy to predict 3 rate rises in 2017 for a total of 0.75% or more.
(By the way, as the BDC Reporter has been pointing out for years after having reviewed the long term relationship between LIBOR and Fed Funds, there is no guarantee the two will necessarily march in lockstep. However, for this purpose we are using the common assumption that the two are twins and will act in sync).
As a result, many BDCs have been inundated with questions from investors and analysts about the possible impact on their profitability from these potential rate increases. Understandably, many BDCs are not shy and suggest a possible earnings windfall may occur, without getting into specifics. Just about every BDC publishes a table at the back of its quarterly filings showing the “hypothetical” benefit from an increase in rates of 100, 200 or 300 basis points. If you look at those charts and took them at face value, you’d have every reason to expect that a major increase in rates will result in a major boost in BDC earnings. We’d guess that part of the Never Ending Rally in BDC stock prices is predicated on growing investor expectation that there will be a big payday from what’s happening to LIBOR, and what might be coming down the pike.
As we’ll explain (and we are definitely in the minority on this subject) we’re far from convinced that this payday will occur. The subject is a very complicated one, even if you accept that Fed Funds/LIBOR will increase up to 1.0% this year, and another 1.0% each year for the next two to three years as some of the Fed projections show. (We doubt that will happen but we are not professional Fed watchers, just skeptics about the current theme that GDP, inflation and rates are all going to take off after a decade of modest moves). You can’t just take a BDC’s floating rate loan assets, impute a rate increase; take floating rate borrowing balances and deduct out higher interest expense from that interest rate increase and count the net amount as an incremental Net Investment Income gain. Some of the more candid BDCs will say as much, if not on their Conference Calls then in the text of their quarterly filings.
Here are some of the complexities:
Unfortunately for BDC shareholders, there’s another wide scale process going in the market on which is going to offset much of the advantage that might be reaped from a higher LIBOR: loan spread compression. Rarely have there been more lenders in the leveraged finance, and deal activity for new buy-outs and recapitalizations is relatively low. Nonetheless, there is and going to continue to be a furious pace of refinancings as borrowers (very much in the driver’s seat thanks to the laws of supply and demand) seek to avoid the very thing which BDCs are looking forward to: a higher cost of capital. At first, many BDCs will seem to benefit from the early termination fees and new deal fees they’ll be able to charge these companies, but in the longer term spread compression will result in lower all-in loan yields anywhere from 0.25%-2.00% per annum, or more.
A RISE FOLLOWED BY A DROP
Also, it’s important to remember that should rates rise most BDC borrowers will undeniably and initially all be paying more for their loans. That could result in higher bottom line profits in the quarters immediately following a rate hike. However, the restructuring and refinancing process-and the subsequent hit to BDC earnings-will take several quarters to play out. We may see a quarter or two where BDC yields are boosted by the higher rate phenomenon, only to be followed by a roll back as borrowers strike back.
THE FIX WILL BE IN
Moreover, we may see some companies who previously were happy to borrow at low and stable floating rates look to switch to a fixed rate Term Loan, rather than sign up for what might be a rollicking ride if floating rates do rise. BDCs, unlikely to turn away a company’s request, will have to fix a corresponding amount of their borrowing costs if they want to be match funded, and miss out in any potential further gravy train of higher floating rates.
Furthermore, not all the increase in income from higher rates will necessarily benefit shareholders. A big beneficiary will be the External Managers of the BDCs who might see income over their Incentive Fee thresholds jump up, and many will be harvesting a fifth or more of those gains. We say “or more” because certain BDCs where Incentive Fee contracts are written with a multiple quarter rolling look-back formula and those that have not been paying out their full 20% could go into catch-up mode and grab a good portion of the extra income.
RATHER SAFER THAN RICHER
Finally, there’s another subtle phenomenon that’s likely to play out over time. For several quarters many BDCs have been booking second lien and other riskier higher yielding loans in an attempt to maintain their distribution levels. If rates do rise and Net Investment Income (after all the other issues we discuss above are taken into account) heads higher, we would expect to see most BDCs use the opportunity to re-deploy their capital into somewhat lower risk loans (with lower all-in interest rates) even at the cost of losing their higher rate pay-day. There is a real and constantly referred to concern by most of the BDC managers that the U.S. economy is late in the current cycle, and caution should be the by-word. If there is an opportunity to trade some short term income gain from fast accelerating short term rates for lower credit risk, expect most BDCs to make that bargain, which will see Net Investment Income make a return trip to pre-interest rate raised levels.
DON’T FORGET THE SBIC
Nor will all interest rate rises be necessarily a boon for BDCs even in the short term. Many BDCs finance themselves on a fixed rate basis. The biggest source of fixed rate capital is that sourced from the SBA under the SBIC program, which over half the BDCs participate in. Of course, many of the SBIC debentures outstandings held by BDCs have already had their interest rate fixed and have many years to maturity. This has been one of the best deals available in the market for those BDCs that have qualified for an SBIC license. For years BDCs have been able to issue long term, fixed rate debentures at rates as low as 3.0% thanks to record low Treasury rates, which the debentures are linked to in the same way that LIBOR is tied to floating rate loans. In some cases BDCs have been able to borrow more cheaply for 10 years than on a short term Revolver and with fewer covenants.
The SBA recently increased the total amount a SBIC licensee can issue of fixed 10 year debentures to $350mn. Many BDCs have rushed to add a third license and increase their SBIC debt (including Main Street Capital, Hercules Capital, Fidus Investment and many more).
However, the Treasury rates have risen a full percent from their low and might be going higher. If the 10 year Treasury reaches 3.0 or even 4.0% as some commentators are projecting (from 1.5% a few months ago), BDCs will be fixing their debenture rates at much higher levels than in the past, just as yields being paid by borrowers march down, largely because of all those debentures issued by a generous SBA in recent years. With 100-200 basis points higher cost of debt and 100-200 basis points lower yields, the net margin of new SBIC-funded investments made could be hugely squeezed. This will not destroy the very successful SBIC program but will take much of the shine out of the program, and out of the latest licenses recently authorized.
- The BDC Reporter believes that if there is a major and sustained increase in short term interest rates, there will not be a corresponding increase in returns for shareholders.
- There may be a short term boost as many loans get re-priced with a higher LIBOR rate, and there may be indirect benefits from higher fees from refinancings.
- However, over a few quarters spread compression; borrowers switching to fixed rate structures and portfolio re-positioning will leave earnings per share pretty much where started in the IVQ of 2016.
- Instead of an enduring increase in earnings BDC investors will have to start worrying about potentially higher credit losses as the minority of weaker borrowers are not able to take the evasive action & will see their profits squashed by a Fed seeking to tamp down business activity.
- We say to BDC investors looking to higher interest rates: beware what you wish for.