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BDC Leverage: Fitch Weighs In

BDCs:
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NEWS

Weeks after the Congress passed the Small Business Credit Availability Act on March 23, 2018, another rating group has come out with an early assessment:

Fitch Ratings believes “additional Business Development Companies (BDCs) are likely to seek board and/or shareholder approval to increase leverage to 2.0x from 1.0x”.

The rating group noted, in a press release on April 12, 2018, that FS Investment Corporation (FSIC) and Apollo Investment (AINV) had already received Board approval for the change, and Ares Capital (ARCC) was making similar noises.

[No word on Prospect Capital’s (PSEC) election to increase leverage, followed by its change of heart, which the BDC Reporter mentioned last week

From Fitch’s standpoint :

“The passage of the Act, allowing for higher leverage, did not result in immediate rating actions; however, Fitch generally views the potential leverage increase as a ratings negative.

“Increased leverage could negatively pressure BDC ratings; however, it depends upon how individual managers utilize the relaxed leverage guidelines relative to their portfolio risk profile in regards to asset seniority, issuer credit strength and secondary market asset liquidity,” said Meghan Neenan, Managing Director, Fitch Ratings.

Environmental Factors

In more general terms, Fitch indicated that-  in its view – fundamental conditions in the BDC space were relatively weak:

“Aggregate originations, for BDCs covered in Fitch’s report, were up 50% in 2017, but net portfolio growth remains muted at $1.7 billion in aggregate (down 78.8% from the 2013 post-crisis peak), given strong repayment activity. Fitch believes portfolio growth will be moderate in 2018 as BDCs exercise caution and repayment activity remains strong.

“Low interest rates continue to drive demand for higher-yielding middle market paper and underwriting conditions remain competitive,” said Johann Juan, Director. “Portfolio yields fell modestly and will likely remain pressured in 2018 despite rising interest rates, given the competitive sector dynamics.”

Fitch looks to underlying leverage levels and interest coverage as indicators of portfolio risk. Managing concentration limits may be out of a BDC’s control, to some extent, as investments appreciate or depreciate in value. However, weaker performance of larger investments can pressure leverage and earnings metrics. BDCs that are overly exposed to cyclical industries also have higher portfolio risk. While commodity prices have rebounded, the sharp decline in energy prices led to significant investment losses and/or restructurings for most BDCs with elevated exposure to energy firms. Remaining exposure to energy investments is manageable, in Fitch’s view, but additional losses are possible.

Market dynamics and elevated levels of non-income producing investments have pressured dividend coverage for some BDCs. Dividend coverage is expected to improve in 2018 as BDCs with portfolio challenges have rightsized dividends to a more manageable level.

Increased interest rates will have mixed results for the sector. Most BDCs are positioned to benefit from rising interest rates as most investment portfolio assets are floating rate, while funding profiles include a large fixed rate component.

However, Fitch believes rising interest rates could increase asset quality issues at the underlying portfolio company level, if borrowers are unable to manage higher debt service burdens. Still, if interest rate increases are gradual in nature and accompanied by a strengthening economy, revenue and EBITDA at the portfolio company level would be expected to benefit, which would make higher payment burdens more manageable.

The report, “Competition, Potential Leverage Hikes Cloud BDC Outlook,” is available at www.fitchratings.com or by clicking on the link.


ANALYSIS

The response by Fitch has been far more muted than S&P, which warned that any BDC which adopted the new leverage would be downgraded.

When FSIC and AINV adopted the new rules, S&P placed both on CreditWatch.

Fitch is correct that more BDCs will be adopting the new rules.

Not mentioned in the press release but noted by the BDC Reporter is that several BDCs have already thrown their hat into the ring.

These include Stellus Capital Management (SCM) , OHA Investment Capital (OHAI), Garrison Capital (GARS) and several others.

See the BDC Daily News Table for regular updates.


VIEWS

Mild Mannered

Fitch’s first contribution to the increased leverage debt debate was muted.

The ratings group has effectively avoided taking any action on existing issuer or Unsecured Note ratings till further information about each BDC’s strategic approach to the new limits is made available.

Later ?

That leaves open the possibility – on an ad hoc basis – that a number of downgrades could be coming, but may be many months away.

Giving An Inch

Furthermore – Fitch may have given the impression to BDC debt issuers that they will be able to retain their current investment grade ratings while having the capacity to effectively double their current leverage.

This may encourage BDC issuers to push the envelope in the future when crafting their business plans.

What You Don’t Say

Left out of the press release was any discussion of the already high leverage levels at many BDCs, both on their balance sheets and by using off balance sheet entities.

Underwhelmed

Where Fitch is concerned at least – and these are early days – we get the impression that there will be a very weak push-back against the potential huge increase in additional debt and lower asset coverage cushions.

Existing Note Holders in BDCs are on their own and will have to draw their own conclusions as a result.

The BDC Reporter will seek to help by digging into the economics of the BDCs involved, as we’ve already done for FSIC and AINV.

Preliminary Results

So far, the numbers seem to show that the mounds of debt that could be raised to purchase new investment assets will generate little – if any – long term benefit for shareholders.

For Note holders, the risks are increasing with no compensating benefit.

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