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BDC Extra Debt: S&P Weighs In

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NEWS

On April 3, 2017 S&P Global Ratings (S&P), triggered by the passing of the Small Business Credit Availability Act, changed its “outlook” for all BDCs.

For our prior article on the new BDC law, click here.

In addition, S&P placed the ratings on its “CreditWatch with negative implications”.

Here’s a summary of the rating action:

“On April 3, 2018, S&P Global Ratings revised its outlooks to negative on Corporate Capital Trust, Goldman Sachs BDC Inc., Hercules Capital Inc., Main Street Capital Corp., Oaktree Specialty Lending Corp., Solar Capital Ltd., TCP Capital Corp., and TPG Specialty Lending Inc. At the same time, we affirmed our issuer credit ratings on those companies. In addition, we placed our ratings on CreditWatch with negative implications for Ares Capital Corp., FS Investment Corp., and Prospect Capital Corp. Also, we affirmed our issuer credit ratings on Apollo Investment Corp., BlackRock Capital Investment Corp., and PennantPark Investment Corp. The outlooks remain negative on those companies”.

S&P is concerned that adoption of the new law would allow BDCs to “effectively increase a BDC’s maximum allowable debt-to-equity ratios to approximately 2:1 from 1:1 under the previous requirement”.

The rating group goes on: “We believe the reduced leverage restrictions increase risk in the BDC industry, and we likely would downgrade any BDC that seeks approval to reduce its asset coverage requirement.”

Given that 3 BDCs have already taken action to adopt the new lower asset coverage rules, S&P has begun to react:

“As a result, we have placed on CreditWatch with negative implications the ratings of FS Investment Corp. and Prospect Capital Corp., which have received approvals from their boards of directors to decrease their asset coverage ratio requirements, as well as Ares Capital Corp., which announced that it intends to discuss plans for implementation with its board of directors. The CreditWatch listings indicate that there is at least a one-in-two chance we will lower those ratings within 90 days. During that time, we will consider the details of their plans for leverage as well as any associated changes to their strategy or financial management”.

S&P went on to discuss its approach towards all other BDCs that have not yet explicitly address the new rules:

“We have negative outlooks on all remaining BDCs we publicly rate, none of which has announced plans to seek approval for reduced asset coverage following the legislative change. We are uncertain whether these companies will decide to pursue higher leverage and in what time frame they will come to that decision. As a result, the negative outlooks reflect a somewhat lower probability of downgrade (at least a one-in-three chance) over a longer time frame than the CreditWatch negatives. However, we could lower ratings quickly on any of these companies that announces an intention to increase leverage. Conversely, we could revise the outlook to stable on any company that definitively decides to maintain its current leverage. We will likely look to resolve the negative outlooks–either by lowering ratings or revising outlooks to stable–in the coming months as each BDC’s leverage and strategic plans become clearer”.

In a major move S&P announced that BDCs – thanks to the greater leverage – will now be initially rated (“preliminary anchor”) bb+ as opposed to bbb- “in line with other U.S. nonbank finance companies”.

Relative to other finance companies, BDCs’ creditworthiness has benefited from a stronger institutional framework that includes asset diversification, reporting and disclosure requirements, and, most significantly, leverage constraints. Moreover, the potential for increased leverage comes at a time when we believe there is intense competition among private credit funds that is causing underwriting and loan terms to weaken while pressuring yields. While we have lowered the preliminary anchor, for now we apply entity-specific anchor adjustments to all our BDC ratings, resulting in final anchors of ‘bbb-‘, given that none of these companies has yet implemented a change in their 200% asset coverage requirement”.

S&P spelled out its likely future approach:

“We likely will downgrade by one notch BDCs that have obtained approval or seek approval to increase leverage by removing the entity-specific notch adjustment in our anchor assessment. At that point, further downgrades would depend on how significantly each BDC individually increased leverage. We will also consider how the change in leverage may affect each BDC’s lending strategies as well as competitive conditions in the industry. Alternatively, we could revise the outlook to stable on BDCs that publicly signal that they intend to maintain the 200% asset coverage requirement”.

Even more worrisome for BDC issuers of Unsecured Notes and their holders, S&P warned that the unsecured debt issues could get an even greater downgrade than the funds themselves, as explained in the press release:

“If we lower our issuer credit rating on a BDC from ‘BBB-‘ or higher to ‘BB+’ or lower, we may lower our rating on its senior unsecured debt even further. That is because we generally rate senior unsecured debt equal to the issuer credit ratings on companies rated ‘BBB-‘ or higher. Conversely, we rate such debt up to two notches below the issuer credit rating on companies rated ‘BB+’ or lower, depending on the amount of priority debt and unencumbered assets.”


ANALYSIS

Going Down

Effectively, S&P is signalling that BDCs with existing investment grade ratings for both the fund and their Unsecured Notes are almost certain to be reduced to below investment grade status.

In some cases, BDC debt issues rated BBB- could drop two notches, which would be a considerable reduction.

Which Way ?

All BDCs that have raised investment grade debt have expressed in the past their commitment to maintaining their investment grade status and the favorable interest rates and investors that come with the designation.

This may leave many BDCs with the difficult choice of taking advantage of the new higher leverage or facing the loss of its prized investment grade status.

However, and judging from the tone of press releases and  by both the rating group and by some of the BDCs themselves (most notably ARCC) there appears to be a willingness to compromise.

Cooling Off Period

Given the way the new law was written, BDCs that have adopted the new leverage level by a majority vote of its outside directors still have to wait a year before being able to take advantage of the 150% coverage calculation.

(BDCs that want to leverage up can also ask for shareholder approval. If the answer is Yes, the new rules would apply right away. Notice that no BDC so far has dared to put the most important question in its history as a public company to a vote of its owners/shareholders).

However, if the rating groups do not lose their nerve (and access to clients paying their fees) and some BDCs push the leverage envelope regardless, we may see one or more larger BDCs lose their investment grade rating in the year ahead.


VIEWS

We are at a critical moment where BDC risk management is concerned.

Congress has – willynilly  and fecklessly- opened a door that allows BDC External Managers to boost compensation by 20%-30% without nary a shareholder approval.

There is very little chance there will be ANY push-back from the tame “independent directors” at ANY of the BDCs about moving up the leverage scale, or renegotiating fee terms to ensure shareholders benefit.

Exhibit A is the already long list of BDCs that have gone to their “non-interested directors” and received a green light for higher leverage within days of the new rule passing. Skeptical minds have to wonder how much independent analysis went into this Soviet-style unanimity in such a short period. Expecting these same independent Board members to renegotiate compensation arrangements to ensure shareholders at least receive some benefit seems – given the history of the relationship between managers and their supposed overseers- pollyannish.

You’re Up

The next line of defense against BDCs overleveraging themselves and risking outsized losses in the years ahead are the rating groups.

Still,tThere is only so much S&P and Moody’s and Fitch can do, and only a handful or two of BDCs receive a rating. Most BDCs issue Unsecured Notes without ratings.

However, if the tough talk referenced above prevails AND if the Managers don’t just ignore the groups strictures and raise debt without a rating, both BDC common stock and debt investors might benefit. The advantage would be less extreme use of leverage than might otherwise have been the case and the presence of an outside authority providing guidance.

Self Governance Never Fails…

If the rating groups don’t staunch the leveraging up of BDCs we are left with  a conservative approach by the managers themselves. Don’t hold your breath. In the last few days we’ve had BDCs both Big and Small, Successful and Otherwise all receiving Board approval to forge ahead. Here are some of the tickers involved: PSEC, FSIC, ARCC, GARS, KCAP, AINV and MRCC.  Don’t be surprised if you’ve not seen a press release on the subject. Most of these BDCs have slipped the news into their SEC filings but kept their PR person out of the loop.

Banks To The Rescue.

Then there are the Secured lenders. Maybe the banks who provide BDCs with financing will serve as a restraint. That seems to be happening in one instance  – if we understand the filing at ARCC – where covenants are still requiring a 200% asset coverage.

Beware What You Wish For

However, that’s likely to mean that BDCs will turn all the more to Unsecured Notes to take advantage of the new borrowing/fee generating capacity. That could ensure secured bank lenders remain credit problem free under any scenario but Unsecured Note holders have to deal with much thinner asset coverage than before. Frying pan to fryer ?

Risk And Reward

The final line of defense are BDC stock and debt investors themselves. Will the latter stump up capital at the relatively low rates and with the absence of any material covenants that has been the case in the past ? Or will both tighten up in reaction to the potential doubling of BDC leverage ?

Likewise, how will BDC shareholders react when earnings barely increase (if at all) but the underlying credit risk doubles ? Will investors be happy to get what they can or will the famous BDC valuation discount to book only grow. That could have the consequence of initially flooding BDCs with new debt capital to grow portfolios but make add-on equity issuances as rare as a Lakers Championship team.

Musings

There are typically unintended consequences to developments like this new law.

Maybe the long term – and ironic impact – will be reducing “small business credit availability” as BDCs capital erodes from credit losses and new equity capital cannot be teased out of once burnt-twice shy retail and institutional investors.

History Lesson

In a way this happened before when Congress launched BDCs in 1980 as a way to provide capital for truly small and needy start up and early stage companies. Many BDCs came to market but soon found that the economics did not work and the sector effectively shriveled up. Until the early 2000’s that is when Private Equity groups broadening into asset managers saw the opportunity to use the BDC model to provide leveraged finance for well established and cash flow profitable middle market companies.

The rest is history.

Or is it ?

Laissez Faire

Will the  asset managers who’ve come to dominate this corner of the non-investment credit world while risking very little capital of their own take that bridge too far and will there be anyone (except the BDC Reporter, whining from the sidelines) to Just Say No ?

Our Early Take In Two Sentences

Our initial “feel”: Most everyone will run to the edge of the cliff and a few will fall off before the Next Recession.

When the Next Recession comes around, the odds of massive losses across a wide number of sector players is far higher than would have been the case before.

One Theatrical Reference To Close

We’ll keep readers apprised on what may the first steps of a Long Day’s Journey Into Night.

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