Keeping Tabs

Ever since the Small Business Credit Availability Act (SBCAA) was enacted in the dark of the night, and much to the surprise of many of its beneficiaries, back in March 2018, the BDC Reporter has been keeping track. For our readers, we’ve included in our Investor Tools a “SBCAA Adoption Table”, which lists where each BDC stands in regards to the new law; the dates thereof and whether approval was undertaken by the Board or by the shareholders. This is updated every time we learn of a change. We’ve also calculated – based on pronouncements made by the BDCs themselves or by common sense assessments – what the “target leverage” of every BDC under the new rules of play. (When you see a E by the leverage multiple that represents the BDC Reporter’s best guess. Otherwise, we’re just inputting what management has guided toward).

Bigger and Better

That was just a starting point. We’ve also assembled a much bigger table of every BDC out there which includes – as a baseline – the investment assets and regulatory debt outstanding as of March 2018. That has allowed us to project what – on a pro forma basis – what total investment assets will reach on an individual and aggregate basis. Ditto for regulatory debt. Every quarter, as the latest results are published, we update the table and measure how close or how far each BDC remains from its pro-forma target. When we’ve completed the IQ 2019 data collection we’ll be publishing the data every quarter for our Premium subscribers.

Big Deal

Why all this data collection and calculation ? As we’ve said from the outset, we believe the SBCAA will prove to be the most important change in the history of the BDC sector since the launch of the format in 1980. Back in the earliest days after the passage of the law, we predicted that most every BDC would eventually adopt the new rules – either by dint of getting shareholder approval or by a simple Board vote. As of today, 40 of 45 BDCs have said yes, only 2 have formally announced their intention to remain bound by the prior leverage/asset coverage rules and three are undecided. Over time we expect most of the five to sign up.

Spelt Out

This broad adoption of the new rules – even though many BDCs have promised to maintain “target leverage” levels well within the limit allowed by the SBCAA – will greatly increase total sector assets and debt without a dollar of new equity capital being raised. At the moment, our table indicates investment assets and regulatory debt will increase by 54% and 107% respectively over the level of March 2018.

Even those impressive numbers do not tell the full story. After all, we include in our table all the BDCs – including those with no change in target leverage. Some individual BDCs will be increasing their assets and regulatory debt by substantially higher percentages by the time their self imposed ceiling is reached.

Moreover, that’s just our estimate of what will happen to “regulatory” leverage. Indirectly affected will be a myriad of other ways that BDCs have used to goose up earnings, which has required “leveraging up” in manners not affected by the SBCAA. It’s important to understand a BDC’s “real leverage” to properly evaluate the risks.

Untouched

Let’s start with SBA financing – long term debentures used by about half all BDCs in discrete subsidiaries to fund investments. As before, BDCs have – to a man – been granted exemptive relief from counting SBIC debt in their SBCAA calculations. Some time ago, the SBA increased the dollar limit of debentures that a single entity could issue to a theoretical $350mn, spread over multiple licenses. Admittedly, no BDC has yet reached that level, but many have either unused borrowing capacity or have applied for more. This source of debt could also grow materially, unaffected by the SBCAA limits, in the years ahead.

Out Of Sight 

Moreover, most BDCs had established off balance sheet joint ventures in the years before the SBCAA was announced. These joint ventures vary in size, form and terms. However, in every case, these vehicles use third party debt to increase their asset size and income. The JVs are allowed under a long standing BDC rule permitting 30% of the portfolio to consist of “non qualifying assets”. Overnight, with the advent of the SBCAA the potential size of the “non qualified” assets has grown because total BDC assets have expanded, Admittedly, a few BDCs have chosen to close down their joint ventures and fold the portfolio loans onto their main balance sheet. This will reduce JV assets and third party borrowing – at least in the short term. (We discussed this subject as part of our annotation of a Reuters article on this subject on May 20, 2019). However, we expect the BDCs involved will shortly be announcing new joint ventures of one sort or another, and most likely supplementally financed with third party debt.

Ever More

Regardless, most BDCs with existing joint ventures appear to be standing pat or increasing their assets outstanding; drawn by the favorable yields often generated by these vehicles, which boost the parent’s “portfolio yield” and help managers beat incentive fee thresholds. Furthermore, some BDCs that have not had joint ventures in the past are setting up their first vehicles, probably for the same reasons as their peers. We expect joint venture assets will also increase in the years ahead as the 30% basket limit grows and more BDCs join the movement. Of course, the amount of leverage employed by the JVs is not regulated by the SBCAA or by any BDC rules and relies on what the market will bear and the manager deems appropriate. To date, depending on the assets involved and other factors, the third party leverage employed – in some cases – has met or exceeded the debt to equity levels allowed by the new SBCAA rules. We predict that several BDCs will end up having as many assets in off balance sheet JVs than on their own balance sheet, even with the new limits.

Hard Labor

In what is proving a Herculean task, the BDC Reporter is seeking to add to its table format the amounts of the SBIC and JV third party debt to provide investors with a picture of every BDC’s “real leverage”. We hope to have loaded in all the appropriate numbers by the time the next earnings season rolls around and then keep those numbers up to date with every new quarterly report.

Related Issue

The SBCAA, despite allowing much higher on balance sheet leverage; ignoring SBIC leverage and  effectively boosting off balance borrowing, has not addressed another method some BDCs have employed to boost earnings- investing in the equity tranches of Collateralized Loan Obligations (CLO).

To illustrate why investing in the lowest levels of CLOs is controversial we point you to a just off the presses article from Bloomberg, quoting Pimco’s Beth Maclean predicting even bigger losses in the Next Recession than occurred in the Great Recession for CLO owners:

The warning that bundled leveraged loans will be the hardest-hit part of the loan market during the next slump comes as these structured securities face increased scrutiny by regulators. Cumulative leveraged loan default rates in last few cycles were 25% to 30%, with about 70% recovery, MacLean said. In the next cycle, assuming the same cumulative default rate with 60%-65% recovery, there will be increased losses for investors, she said.

“Those losses are going to be borne primarily by CLO equity investors,” MacLean, a bank loan portfolio manager in the Pimco’s Newport Beach office, said in a Bloomberg Radio interview earlier this week. “CLOs own two-thirds of the loan market and CLO equity is the first loss. So even in that scenario where you have 15% cumulative losses, most of that actually hits just the CLO equity, and maybe the BBs.”

Minority Report

The CLO subject has been much debated in the BDC sector and due to shareholder hostility and the high volatility involved in owning these securities, most BDCs have taken the pledge of not investing therein.

Nonetheless, there remain a minority of BDCs with a substantial commitment to these securities. Furthermore, some BDCs opportunistically add CLO assets at times to boost portfolio yields. With the increase in the size of the 30% basket the theoretical amount of CLO investments that could be tucked into BDC assets has increased.

We’ll be adding to our table disclosures about CLO assets owned by each BDC and in aggregate in order to provide a full picture.

Big Change

Put all these factors together and you’ll understand why we believe the SBCAA is such a game changer, drastically changing over time BDC’s portfolio size leverage and – potentially – asset composition. Not to mention vastly growing manager compensation and – to a lesser degree in percentage terms – earnings and distributions. Furthermore, the new regulations has exacerbated the natural tension between managers and shareholders about the division of any spoils to be earned from the adoption of the new rules. To date, we’ve seen a trickle of BDCs announcing lower management fees on assets acquired over the old limit, but plenty have been silent on fee concessions or are “considering” the matter.Moreover, shareholders must be quietly re-calculating what are acceptable risk-return criteria, with both elements subject to material change in the years ahead as the SBCAA rolls on.

Slow

However, due to the requirement in the new rules that one year should pass between Board approval and the application of the new leverage limits; as well as the time involved in acquiring new assets; setting up new borrowing facilities as well as the time required for the internal debates at each BDC about how to proceed the impact of the SBCAA to date has been modest.

Showing Up

Appropriately enough, though, with the publication of the IQ 2019 results for 44 of the 45 BDCs out there, we have begun to see the SBCAA tangibly impact some individual BDCs. Many BDCs have leveraged themselves above their pre-SBCAA target leverage levels. A few have breached the old 1:1 debt to equity regulatory leverage.(If the “real leverage” of BDCs were considered, the number of players over the 1:1 debt to equity would be much higher).

In one case we’ve even seen a BDC (Garrison Capital or GARS) reach the very limit of the new rules with asset coverage at March 31, 2019 of 159%, just off the limit of 150%.

Headed This Way

The impact of the SBCAA in all its forms will show up only the more as 2019 progresses, though we continue to believe the full impact will not be felt until 2020 or 2021.

Different

Every BDC – depending on the strategic approach chosen and its actual performance – will be affected differently by the SBCAA. Naturally enough, we are concerned that whatever the benefits in higher earnings and dividends; the risk of higher credit losses will increase with the substantial growth in assets funded exclusively with debt.

That in turn – if we’ve learned anything from past sector behavior – will also increase price volatility as investors seek to get ahead of prospective credit losses. BDC stocks – prone at times to daily moves of 3% or more and short term moves of 20% or more when investor sentiment becomes negative – could see even higher swings.

Possible Winners

On the other hand, some BDC players may benefit from the SBCAA; reaching new earnings highs and having increased liquidity.

(There are numerous BDCs thinking aloud on Conference Calls about having firepower – thanks to the SBCAA – to pick up assets from troubled BDCs or other lenders on the cheap when the environment darkens, which is both intriguing and terrifying. Even the BDCs themselves see an upsurge in credit problems coming down the pike, but expect to be buyer rather than seller when the opportunity presents itself).

New Tools Needed

In either case, the advent of the SBCAA requires investors to keep abreast of a fast changing environment.

As a result, we’ve chosen to begin a new article series for our Premium subscribers, which draws from the data we’re collecting.

On a periodic basis, we’ll be looking at individual BDCs which have adopted the SBCAA to review their progress towards reaching their “target leverage”, and what that means where both risk and return are concerned.

We’ll be looking at both regulatory leverage and “real” leverage; while also adding details about any CLO investment assets.

One More Way

To make the picture completely full, the BDC Reporter will be detailing another way BDCs indirectly “leverage up”: by investing in the junior capital companies (as opposed to JVs) that are themselves borrowers of more senior third party debt.

If these portfolio companies debt was counted, the effective leverage employed by the BDC would necessarily be higher.

Bottom Lining

Finally, we’ll be projecting future earnings and dividends for each BDC.

That will allow readers to get a full sense of what the changing risk and return looks like for the profiled BDCs.

Coming Up

We’ll begin with an update on Apollo Investment (AINV), which will be posted shortly.