We are re-publishing below an article from S&P Market Intelligence’s Leveraged Commentary & Data (LCD), written by Shivan Bhavnani,  for two reasons. First, we are shamelessly publicizing the BDC Reporter’s contribution being featured. You’ll find us quoted a couple of times below.  Second – and inarguably more important – the article contains some very interesting and fresh data about the changing nature of who is financing middle market transactions. As the article makes clear, broadly syndicated loans (“BSL” to those in the know) are being overtaken by “non-broadly syndicated loans”, where an asset manager underwrites an entire financing and doles out the debt to its managed funds. That’s been an ever increasingly important feature of leveraged lending outside the lower middle market as asset managers – flush with cash AND armed with exemptive relief from the SEC allowing this sort of banding together – in recent quarters. 

Prime Example

Very recently, Golub Capital (GBDC) discussed its approach to the perceived market opportunity to offer borrowers an alternative to BSL. In this case, GBDC is a proponent of unitranche loans, whose own importance is another growing trend in leveraged lending. We’ll quote from what CEO David Golub – who now controls over $30 billion in assets – said on GBDC’s latest Conference Call, in dialog with analyst Ryan Lynch:

David Golub

…Until relatively recently, one-stops were a middle market product and not a larger market product. And what happened, Ryan, over the course of 2019 is that’s changed. In 2019, we have tracked 23 one-stop executions in excess of $500 million. And Golub Capital has been that clear market leader in these executions. We led or co-led 13 of the 23. So we led or co-led more than all of our competitors combined.

The capacity that we built to meet these transactions is unmatched in the industry. We combined both the capacity to hold a significant portion of these larger one-stops and we have a capital markets capability to bring in partners. And I think what we have done, over the course of 2019, is proven for sponsors in larger transactions that one-stop executions are worth considering as an alternative to the traditional first lien/ second lien. I think what we are also seeing is as sponsors do try one-stops in these larger executions, they are finding that they like them.

And so, in my opinion, we are at the beginning of the adoption curve. We are not even remotely close to the conclusion of the gaining of market share of one-stops. And I think we at Golub Capital are very well positioned to maintain our leadership as this larger one-stop market grows. And I believe that’s a very good thing for shareholders of GBDC, because we are strong believers that these one-stops represent very good risk/rewards for investors.

 Ryan Lynch

Well, that’s helpful color. And yes, there is no doubt that that Golub has been the premier player in some of these large one-stops and I definitely see the benefits for GBDC shareholders to be able to access that very unique deal flow.

Big Club

Golub is far from alone amongst asset managers in seeking an ever bigger presence in the middle and upper middle market, though not always with a unitranche product.  The key players include Ares Management (ARCC); Apollo Global (AINV); KKR (FS-KKR); The Carlyle Group (CGBD); Bain Capital (BCSF); Goldman Sachs (GSBD); Capitala Group; Monroe Capital (MRCC); New Mountain Finance (NMFC); Oaktree (OCSL & OCSI); Owl Rock (ORCC); BlackRock (BKCC & TCPC) and TPG Specialty (TSLX). Each BDC – as we see with GBDC – has a different approach and targets different market segments, but that’s a very large number of players and capital ready to finance larger transactions. The days when BDCs were primarily lenders to smaller PE-supported borrowers and loans were booked in a single entity are long past. 

Ambitious

For several years BDCs have been making the pitch to investors that they are moving into the space being left by banks withdrawing from the leveraged loan market. Now it’s becoming clear that the BDCs – and their Masters Of the Universe asset management overlords – are part of an even bigger expansion into leveraged lending from the smallest companies to some of the largest. Even the high yield bond market should be paying attention. Just a few years ago, BDCs barely got mentioned when commentators discussed the leveraged lending market. Now – boosted by all the firepower from their affiliated funds – BDCs are becoming synonymous with leveraged finance. 

Earnings Impact

As the LCD article shows, all those willing lenders inevitably has an impact on spreads, which seem to be tightening. That could be the result of the imbalance of supply and demand or from the BDCs re-positioning themselves into new markets with already lower pricing.  Still, barring some market-wide crisis of confidence, it’s hard to imagine spreads blowing out any time soon. More likely we’ll seen leveraged lending – along with everything else – being done at ever lower yields. 

Wither ?

Whether these changes in where BDC lenders are active – and how and at what price – are Good or Bad for the industry and for investors (two different constituencies) is impossible to tell at this stage. All we know for sure – and the article below is a useful reminder – is that tectonic shifts are underway that will remake the sector’s leverage; risk; and returns in the next few years.

3Q BDC Wrap: Assets grow, and larger BDCs take center stage

While U.S. leveraged loan issuance was down last year, assets at business development companies jumped in 2019’s third quarter, bolstered by larger BDCs hunting big-game loans and by increased focus on the still-growing direct lending space.

For the record, the total par amount of assets managed by publicly traded BDCs topped $99 billion in 3Q19, an increase from $95 billion the previous quarter and nearly twice the amount in 2013, when LCD began tracking this info.

As total BDC assets grow, more large concerns have entered the space, looking to play in bigger deals and/or in more substantial ways. Indeed, 11 of the more than 40 publicly traded BDCs now have net assets topping $1 billion, with a total of $30 billion in assets.

“The large BDCs are investing in large loans to support larger LBOs,” says Nicholas Marshi, editor of the BDC Reporter. “They are trying to eat away at the syndicated loan market. It’s a big question whether that strategy will succeed, but this is where all the asset growth is coming from. The small BDCs are remaining very small, and the BDC space, in general, is really being taken over by the large asset managers.”

In fact, concerns such as Ares, Owl Rock, KKR, and Golub each have BDCs with net assets well over $2 billion.

More broadly, middle market borrowers continue to move away from syndicated executions, in favor of the direct lending route. This trend is clearly reflected in publicly traded BDC portfolios, with non–broadly syndicated loans making up over $66 billion of volume, versus $33 billion for syndicated loans. Just three years ago, in 3Q16, non-BSL ($39 billion) and BSL volume ($37 billion) were roughly even.

This trend is more starkly illustrated by issuer count.

The number of broadly syndicated loan issuers in BDC portfolios has been relatively stable over the past three years, while the count of non–broadly syndicated loan issuers has shot up. In 3Q16 there were 1,020 broadly syndicated issuers represented in BDC portfolios, and 1,578 non–broadly syndicated issuers. In 3Q19 the broadly syndicated issuer count dropped 4%, while the non–broadly syndicated issuer count increased by 48%.

With the S&P 500 up roughly 28% since Jan. 1, 2019 (as of Feb. 10, 2020), BDC stock prices are doing well also. As of Feb. 10, 2020, 19 publicly traded BDCs were trading above their net asset value. However, diving into the underlying credits tells a different story.

“Stock prices have been high, but this does not truly reflect the fundamentals,” Marshi says. “Roughly 75% of all publicly traded BDCs are headed downwards with respect to book value per share, since the end of 2017.”

Loan yields
First-lien loan spreads in BDC portfolios were relatively stable over the past year of quarterly reporting, contracting marginally, from 596 bps in 3Q18 to 585 bps in 3Q19. But these numbers do not reflect the competitive environment middle market lenders confront nowadays (nor do they reflect some of the record-low pricing the broadly syndicated markets have seen in 2020, of course).

Due to the push toward direct lending by credit funds with billions of dollars of capital to deploy, and as borrowers seek a simpler, streamlined lending process insulated from execution risk, the competition in direct lending has skyrocketed over the past few years, significantly lowering spreads for these loans. Just three years ago the average non–broadly syndicated loan in a BDC portfolio had a spread over LIBOR of 726 bps. In 3Q19, that figure was 617 bps.

What does this mean for BDC portfolio income? Net interest income over total assets has steadily declined since 2012. According to Janney, in 2012, the average public BDC net interest income (for the BDCs Janney tracks) was 9.21% of total assets. That figure has declined every year, and projected net interest income for 2019, as a percentage of total assets, is 7.03%.

“This is the proof that the BDC space is becoming more competitive,” says Mitchel Penn, managing director at Janney.

Credit
Overall, underlying credit in BDC portfolios is deteriorating. In 2019’s third quarter, the non-accrual rate was 3.35%, up from 3.28% the previous quarter. In 2Q17 the non-accrual rate was 1.98%.

Unrealized losses over average assets is another way to gauge credit losses in BDC portfolios. The projected unrealized losses for 2019 are 1.76%, according to Janney. Unrealized losses for 2018 were 1.99%, and 2.02% for 2017. Unrealized losses in 2020 are expected to be “1.25% to 2%,” according to Penn. To be clear, non-accruals and unrealized losses are different, rough measures of credit quality in BDC portfolios. Unrealized losses are due to changes in the fair value in loans. A non-accrual is when a loan is not performing due to non-payment from the borrower.

“Average losses should be around 100 bps through a cycle,” Penn says. “In the beginning of a cycle, when the economy’s expanding, there are likely few or no losses, and typically there are gains. Then losses normalize, and finally, in the late stages, we likely see relatively high losses. When you average them altogether through the cycle, they should equate to around 100 bps. Over the last few years BDCs appear to have been stretching on credit, as evidenced by covenant-lite loans and relatively optimistic assumptions of EBTIDA, which has likely contributed to recent losses. These losses in the last couple years are idiosyncratic, though, and don’t represent any credit troubles in any specific industries.”

Leverage
And leverage within BDC portfolios is on the rise. According to Janney, average GAAP leverage is 1.07x, up from the three-year average of 0.83x. Average GAAP leverage is likely to increase to roughly 1.2x, Janney estimates.

That said, most of the mega-BDCs managing over a billion dollars have lower GAAP leverage ratios, due to pressure to maintain ratings. For example, ARCC is at 0.91x, FSK is at 0.87x, and ORCC is at 0.42x. — Shivan Bhavnani