NEWS 

On May 20, 2019 David Brooke wrote an article on Reuters about the BDC sector.

The article was entitled: “BDC leverage reform grows divide between large and small players”.

ANALYSIS

Given that the BDC sector only rarely gets coverage in the broader financial press, the BDC Reporter has annotated the article with our analysis and commentary.

The article seeks to tackle one of the perceived consequences of the implementation of the Small Business Credit Availability Act (SBCAA) in March 2018.

We seek to offer additional color and also suggest what we believe is the most important impact of the new law which allowed BDCs to increase regulatory debt to equity to from 1 to 1 to 2:1.

As always, the BDC Reporter’s annotations are in bold italics to distinguish them from the source article.

NEW YORK, May 20 (LPC) – A legislative change that has doubled the leverage cap for Business Development Companies (BDC) is set to fuel further bifurcation between larger and smaller platforms, as many start to get approval to increase debt on the balance sheet.

Larger BDCs benefit from their management of bigger asset pools to attract a lower cost of debt funding compared with smaller rivals, handing them an advantage when pricing on individual transactions.

“There are several BDCs managed by firms that pay a huge amount of fees to Wall Street banks every year, so those banks are going to be there for the BDCs from a funding perspective. There are benefits to having affiliations with a larger platform,” said Meghan Neenan, managing director and North American head of non-bank financial institutions at Fitch.

BDCR Notes: Of course, the larger asset managers are avidly courted by investment bankers, but these are secured, non guaranteed debt facilities so the key to pricing is less facility size but the quality and the diversification of the assets that are included. Put in large, syndicated senior loans which are highly liquid and easy to value and lenders will charge 1.75% to 2.25% over LIBOR. Only offer second lien loans to smaller companies, which are very illiquid and valued mostly with the aid of smoke and mirrors and you’ll have to pay LIBOR + 2.50% – 4.00%. Plus your advance rate will drop from as high as 75% to 40% or below.

BDCs, which lend to middle market companies, favor the use of leverage because of the lower cost of capital on individual loans, which means funds can be selective in chasing deals and not be required to stretch for yield by investing in riskier tranches to meet yield targets.

Following last year’s passage of the Small Business Credit Availability Act that increased the leverage limit to a ratio of 2:1 total debt to equity, from the previous 1:1, many BDCs are upping this funding tool.

The legislation was a culmination of years-long lobbying efforts from the BDC industry and the vast majority have been quick to take advantage by either seeking board or shareholder approval, which is required because BDCs are publicly traded. A one-year waiting period is required for board approval, while a shareholder vote means a BDC can pursue higher leverage immediately.

BDCR Notes: By our count 21 BDCs have received shareholder approval for the new rules, 17 settled for Board only consent and 2 more are going to have shareholder votes shortly. That leaves only 5 BDCs out of the 45 we track on the sidelines. Two BDCs have stated that they will not be making the change (Main Street and Prospect Capital) and 3 others have not made a move one way or the other. One of those is otherwise engaged Medley Capital. (We keep a running total, with the dates of adoption and whether by Board or shareholders on the BDC Reporter website in the Shareholder Tools section).

The extra leverage has prompted larger funds to rotate their portfolio toward less risky senior investments and away from more subordinated facilities, as well as dissolving balance sheet vehicles and joint ventures they had set up to circumvent the 1:1 cap.

BDCR Notes: This is both right and wrong. Many BDCs promised to only add safer assets with their new found borrowing capacity in advance of the SBCAA being approved. However, subsequently most adopting BDCs have announced their intention not to change their investment strategy one jot and just promised to be careful with the amount of leverage they would use.

Yes, a few BDCs have folded their JV assets back into their balance sheets. However, many more have both grabbed at the higher leverage AND retained and (sometimes) expanded their JVs. Even those BDCs clearing out their JVs seem to be doing so to make room in their non qualified asset basket for more non traditional investments. The basket is 30% of assets and with the new rules that basket has just grown bigger !

Wait, there’s more ! There are numerous BDCs with SBIC debentures. These can add up to hundreds of millions. The SEC has chosen – for reasons that are unclear to us – to allow BDCs not to count any of this debt against the regulatory limit used to cap out maximum leverage.

That means a BDC can load up debt in one or more off balance sheet JVs; add more in an SBIC subsidiary and adopt the higher on balance sheet leverage allowed by the SBCAA. That’s a trifecta of risk and right at the end of longest economic cycle in memory, and when – as every BDC will tell you without any sign of irony – new loans are being added on the weakest terms and narrowest spreads. At a time when only a third of BDCs are trading above book, 90% have adopted the SBCAA. That’s allowed many players to grow AUM when under the old rules they would have been stymied by not having access to capital.

Goldman Sachs BDC completed the shutdown of its joint venture with University of California Board of Regents this month and has ramped up its senior investments, which comprised 75% of all deals the firm had completed over the last year, according to its first quarter earnings report.

Concurrently, the firm signed off on a US$100m increase of its revolving credit facility (RCF) to US$795m. Total debt commitments including convertible debt brought the firm’s commitments to US$950m.

BDCR Notes: GSBD is the exception that proves the rule here. Only GSBD has dared to cut its management fee on ALL assets to 1%. To offset that loss of fee income, it made sense to quickly boost assets by rolling all those off balance sheet assets back into its own balance sheet and get paid for them. However, that does not mean GSBD won’t be using its 30% basket in the quarters ahead. We’ll be betting GSBD will be announcing some new venture to fill that basket before long.

Ditto at Solar Capital- covered by Mr Brooke later in the article – which has also dropped it’s JV assets back onto its balance sheet. Management has made clear that they’re clearing the decks only to have more room to acquire financial companies, which is best done via the 30% basket.

Most other BDCs which have adopted the SBCAA and have existing JVs are planning to grow both. A few BDCs have almost as many assets sitting on their JVs as on their own balance sheet. Given that JVs can borrow as much as the market will bear some entities are VERY highly leveraged.


Last month, Ares Capital Corporation increased the size of its RCF to US$3.4bn from US$2.1bn, as well as expanded its letter of credit facility to US$200m from US$150m, the firm reported.

Prospect Capital Corporation recently increased its RCF, which includes an accordion feature that can stretch to US$1.5bn from the US$1.045bn commitment the firm has secured.

BDC Notes: The irony here is that Prospect Capital – a master at synthetically creating highly leveraged vehicles on its own balance sheet (a whole subject to itself) has not adopted the SBCAA. Or rather: they did and changed their mind and have made the pledge to stay away, with an eye on their credit rating given the BDC borrows almost exclusively in the unsecured debt market. The increase in their RCF has nothing to do with the SBCAA theme.

BlackRock TCP Capital Corporation and PennantPark Investment Corporation both increased their credit facilities in the first quarter.

“Larger BDCs are having an easier time with their credit providers,” said Steven Boehm, partner at law firm Eversheds Sutherland.“Smaller BDCs or ones not performing as well seem to be having a harder time with increasing leverage. Those are the two biggest factors and the better your size and performance the more leverage you’re going to have with a potential lender.”

BDCR Notes: These new facilities do not prove that larger BDCs are adding more debt or more easily than smaller BDCs. In fact, very poorly performing and under $500mn in assets Garrison Capital recently set up an on balance sheet CLO securitization facility at some of the best advance rates and lowest interest rates in the industry. Here is a link to the 10-Q. See pages 33-35.


BRANCHING OUT

As the more senior end of the market becomes crowded, other funds unable to utilize the leverage on the same terms as larger players are seeking to expand their offering in more niche areas of the credit market.

On its first quarter earnings call, Solar Capital executives reported on double digit internal rate of return for its specialty finance and equipment financing lending business steering away from traditional middle market loans.

And contrary to the moves to dissolve JVs, Barings BDC announced the formation of a JV structure with South Carolina Retirement Systems Group that will target real estate debt in addition to corporate loan instruments.

BDCR Notes: The author seems to be drawing the wrong conclusion. Yes, there are niche strategies being adopted by many BDCs, but that was a theme underway long before the SBCAA came along, and has nothing to do with being “unable to utilize the leverage on the same terms as larger players”. The  BDC industry has been exploring – like the Starship Enterprise – new financial frontiers for some time. PSEC has added commercial real estate, consumer finance and direct lending to their investment repertoire. Hercules Capital owns a commercial finance operation. Alcentra Capital, Bain Capital and others are booking more non US assets. Saratoga owns and manages its own CLO. Apollo Investment owns oil companies and shipping companies and has made a huge bet in aircraft leasing and maintenance. Newtek is joint venturing with Blackrock TCP in SBA loan origination. The list is very long, and getting longer. We are a long way from when BDCs almost exclusively served as the debt sources for private equity buyouts. That’s still the bread and butter but there are other elements being added to the BDC sandwich.

FS-KKR, one of the larger BDCs, said it will pivot towards more asset-based finance investments and away from higher yielding equity investments that it aims to reduce to less than 5% of the total portfolio.

“The cash flow lending market is super competitive at the moment, so some BDCs have branched out into other products, like asset-based loans and life sciences, that can offer pretty attractive yields,” Neenan said.

Some analysts have expressed concerns that the extra capacity for leverage can heighten the risk across the sector that targets investments in less liquid middle market companies.

But as BDCs start to finally get shareholder and board approval for added leverage, few are seeking to reach the maximum limit allowed, instead maintaining a cushion by sticking to more conservative levels.

“Anytime you’re looking at increasing leverage you have to be mindful of the tail risk. The thinking of many BDC managers seems to be more prudent, rather than automatically go to 2:1,” Boehm said.

(Reporting by David Brooke. Editing by Michelle Sierra and Lynn Adler) ))

BDCR Notes: We happen to track in our database the Target Leverage of every BDC out there because we’re trying to estimate how much AUM and debt will increase once the SBCAA is fully played out. It’s true that very few BDCs are setting new Target Leverage levels near the 2:1 debt to equity now allowed by the SBCAA. Some BDCs are formally pledging to remain anywhere between 1.0x and 1.5x debt to equity. Others are drawing soft lines in the sand while yet others won’t commit themselves. However, just because the BDCs are not driving all the way up to the edge does not mean credit risk will not materially worsen once target leverage limits are reached.  

We calculate every quarter what pro forma assets and debt will look like and compare against each BDC’s corresponding level from March 2018, just before the new law was announced. We estimate that BDC on balance sheet AUM will increase from just over $50bn in March 2018 to over $80bn when all is said and done (probably by 2021). Effectively that means total regulatory debt at BDCs, which clocked in at $22bn in March 2018 is going to more than double.

Those numbers do not include non regulatory debt on BDC balance sheets that we’ve discussed above such as those in their JVs and SBIC subsidiaries, not the third party debt in financial companies owned. (That data isn’t even always available in the filings so your guess is as good as ours). You can be pretty sure that in aggregate terms that debt will be increasing as well.

We like to say that the SBCAA is the most important development in the BDC industry since the format was founded in 1980. The fact of the matter is that BDCs were envisaged – admittedly in a different time and context – as a vehicle for individual investors whose structure was supposed to mitigate risk. That’s why the rules require a focus on U.S. assets; portfolio diversification and (not so long ago) a maximum debt to equity of 1:1.  Of course, Wall Street has been doing its level best for years to push the envelope as we’ve seen with the exclusion of SBIC debt from regulatory leverage; the use of the 30% bucket to invest in leveraged JVS or CLO equity. Some might argue these were necessary evolutions. Now the SBCAA has come along and the risk potential has been super sized. Moreover, all this extra borrowing capacity has come along at a time when dog is eating dog in the loan markets.

To our way of thinking – one year after the new law was passed – the story here is that the BDC sector is in the midst of of a major shift in risk levels that might or might not be offset by higher returns. Each BDC’s performance will play out differently, but the stakes will be higher, especially if and when the next recession hits. Admittedly the rubber will not fully meet the road till 2020 or 2021 as business plans get implemented. Nonetheless, it’s worth noting that Garrison Capital, which was an early SBCAA adoptee, reported that its asset coverage at March 31, 2019 was already at 159%, just over the new 150% standard. That calculation did not include SBIC debt. If that had been included asset coverage would have been only 141%…

VIEWS

We don’t mean to denigrate anything Mr Brooke has written in this article.

We’re glad to see Reuters providing coverage of our under-reported and often misunderstood industry.

Our principal purpose was to use the occasion to highlight some of the possible consequences of the SBCAA that might not be getting coverage in the financial press.

Much of what we have covered above won’t be fully impactful for one or two years more.

Nonetheless, forewarned is forearmed