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BDC Sector: Potential Revolver Rush – Annotated

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Mergers & Acquisitions wrote an article on March 20, 2020 entitled “BDCs that got funding prior to crisis ready for revolver rush”

The subject fits into the BDC Reporter’s belief – that we’ve been communicating to readers on our News Feed and in earlier articles – that liquidity is going to be the key issue facing all BDCs in the weeks ahead.

This article deals with one aspect of a multi-faceted subject.

Remember This

In the Great Recession, BDCs that were not able to handle liquidity challenges adequately saw huge and unnecessary drops in book value that were not recovered from; cuts or suspension in dividends; the need for “rights issues” at unfavorable prices, etc.

On the other hand, BDCs that managed liquidity well emerged – after an initial period – in a very strong financial position and took advantage thereof.

The most obvious example – and one we’ve used before – is Ares Capital (ARCC) which survived the Great Recession to buy both its biggest rivals: Allied Capital and American Capital.

Hercules Capital (HTGC) managed to overcome the defection of its top lender at a critical time during the crisis to continue its growth, which was no mean feat.

Main Street Capital (MAIN) – thanks to being principally funded with ten year SBIC Debentures – was also successful.

Not So Much

Other BDCs like GSC Investment; Patriot Capital and the afore mentioned Allied Capital  and American Capital did not fare so well causing the first to need rescuing by Saratoga Partners, which renamed, recapitalized and re-focused the BDC; Patriot was purchased by Prospect Capital (PSEC) and Allied Capital and American Capital merged into ARCC in stock deals and at prices way below the level of their heyday.

Of the 21 or so BDCs in the market at the time, many were forced by liquidity constraints into selling assets at terrible prices and/or engaging in seemingly endless negotiations with their lenders to avoid bankruptcy.

A Close Run Thing

We like to say that no public BDC has ever filed for bankruptcy – which is true in the current era (we can’t speak for what might have happened in the 1980’s)  – but in 2008-2009, a few came close.

In each case, the central issue was the underlying BDC’s liquidity – its ability to pay bills and meet funding and borrowing obligations.

Over the subsequent years, even the worst performing BDCs have had  no material liquidity problems and investors – and the BDC Reporter – have not been much concerned about the subject from a risk standpoint.

Now the subject is back on the front pages – as this article implies by its very existence – and it’s time to evaluate where the sector and every individual BDC stands.

This might last a few months or could go on much longer.

Read On

We’ve re-published the Mergers & Acquisitions article below and annotated the text with the BDC Reporter’s comments (in bold) , as we often do with conference call transcripts. 

“Private credit firms that are flush with funds after raising money in debt markets just weeks ago may soon be asked to lend that cash to their middle-market borrowers.

Business development companies, which make up a $112 billion corner of the private credit universe, hit the high-grade bond market in droves earlier this year to manage their own debt loads.

BDCR Notes: The article seems to be referring to the multiple unsecured debt raises by all sorts of BDCs in the institutional market and at very low yields, compared to historical levels. Less active was much issuance in the public Baby Bond market, as we’ve discussed on these pages for months. This debt raising has been mostly opportunistic – grabbing lower yields while the going was good. In some cases, though, the debt was raised to refinance obligations coming due shortly. 

Now companies already in their credit portfolios need that cash to boost liquidity as the continuing spread of the coronavirus wreaks havoc on their businesses.

BDCR Notes: We made the above point because the debt raised – sometimes several months ago – is not sitting in cash on BDC balance sheets, or even in the form of additional liquidity. Prior to the coronavirus many BDCs have been on a AUM growth binge, so proceeds from the debt raised months ago may be actually invested in assets such as loan or equity investments. Investors will have to look at each BDC in turn to track what liquidity looks like at December 31, 2019 – the last reported numbers. Unfortunately, much has happened in the past 3 months, both before and after the crisis, so those numbers about BDC assets, debt and liquidity (including cash) will look very different from the current status. You can be sure, though, that repayments of existing investments; sales to third parties in the open market and new deal financings have ground to a half for the past month. It’s like a game of “Statues”, where suddenly balance sheets are frozen in place. Based on what we’ve heard on BDC conference calls, no BDCs seems to have seen this incredible disruption in the global economy coming and everyone was in some form of business as usual through the end of February. 

Fitch Ratings said in a report this week that the BDCs it tracks issued nearly $6.4 billion of term debt over the last 14 months, pushing out maturities for most of the vehicles the ratings grader follows.

BDCR Notes: Fitch only rates a fraction of the BDC issuers involved but the statement is true: the debt issued recently was – in almost every case – for 5 years, so that’s good news for the players involved.

Also worth noting – but getting far less attention – secured Revolver lenders to BDCs (typically bank groups) have also been extending financing facilities in recent months. As a result, there should be very few BDCs – unlike in the Great Recession when Revolver maturities were often short in duration – facing down secured borrowing maturities and being forced into uncomfortable conversations with their bank groups. Bank lenders – who receive very low rates for providing debt – tend to pull back in this kind of unsettled environment, which can create a liquidity crisis as the debt has to be paid off just when capital is unavailable at any price and selling assets is virtually impossible at anything but huge discounts. At the moment, that does not look like a problem for the sector, but a review of every BDC’s individual circumstances is appropriate. We will be looking at this factor – and many other liquidity components and communicating what we’ve found in a new BDC table to be found in the Tools section. 

“BDCs are now going to be able to fund draws on their revolvers, which have ticked up in recent days,” said Fitch analyst Chelsea Richardson in a phone interview. “Those could certainly continue and we don’t know how meaningful the borrower draws could get.”

Ares Capital Corp. and FS KKR Capital Corp., which recently tapped the investment-grade market, have $1.7 billion and $678.1 million in exposure to unfunded commitments, respectively, Raymond James & Associates said in a research note Thursday. Goldman Sachs BDC Inc., another firm that went to the high-grade market, said in a Thursday statement it has $68 million in unfunded commitments, no near term maturities and is “actively working” with the sponsors of its portfolio companies to address the evolving situation.

BDCR Notes: As you can see from the numbers mentioned, unfunded commitments vary widely between BDCs. Moreover, the devil – as ever – is in the details. Sometimes – as in the case of Ares Capital mentioned above – some of the undrawn commitment is subject to release only on the borrower meeting certain financial targets, or at the BDC’s discretion. That’s very much true with the venture-debt BDCs as well. Also, investors who want to get a complete picture have to also consider if there are unused commitments – as ARCC does – in their unconsolidated joint ventures.

We should say that unused commitments – and the drawings thereof by companies – is not necessarily a Bad Thing. The use of this capital should allow the borrowers to operate through the ongoing crisis. Many BDCs are probably happy to be “in control” of the situation, as opposed to relying on some other lender who might or might not to step up to the plate. Given the unusual nature of this crisis, we wouldn’t be surprised to see many BDCs offer/accept to fund additional loans to borrowers in the weeks ahead. Investors should worry when the BDCs turn off the spigot rather than turn them on. 

“As ‘cash crunch’ concerns persist due to the ripple effects of coronavirus,” borrowers that rely on BDCs “may find it beneficial to tap the entirety of their undrawn debt facilities to preserve liquidity,” Raymond James analysts Robert Dodd and Matthew Tjaden wrote in the note.

Representatives for Goldman Sachs BDC and FS KKR declined to comment. A request for comment from Ares Capital wasn’t immediately returned.

BDCs are likely to face pressure in the coming months on falling asset prices due the current virus pandemic, according to Fitch.

There are likely to be at least some temporary mark-downs in debt asset values when BDCs report first-quarter earnings later this year, with broader potential implications to come, Fitch analyst Meghan Neenan said in an interview.

“The credit picture is going to take a little bit longer to play out,” she said.

BDCR Notes: “Temporary mark-downs in debt asset values” is under-selling what will be coming. As we’ve been noting on our News Feed all week, the market price of leveraged loans – typically to the bigger borrowers – has been dropping precipitously, even to strong companies. As a rule of thumb expect 8%-10% drop since the IVQ 2019 when IQ 2020 results come out, assuming no further change one way or the other from here till month end. Then there are the numerous companies that BDCs lend to in the energy, retail, logistics, entertainment, restaurant,health care and other sectors on the front lines of the crisis whose market values have imploded as the market – not unreasonably – worries about their ability to service their debt in the months ahead.

Besides the coronavirus, we have an oil price emergency, which will roll out affecting both E&P producers, but also service companies of every stripe and all sorts of ancillary industries. Then there’s health care where many segments will be affected by the postponement of procedures in the dental, dermatological and multiple other areas. We could go on but we won’t because this is still an evolving  situation where the response to Covid-19 is concerned and anyone who tells you they know where the chips will ultimately fall is plain wrong or relying too much on their algorithms. The credit reassessment will have to wait until the U.S. – and the rest of the world – passes through the current “shelter at home” stage – which can only be a temporary solution – and finds a more lasting approach. Given that we don’t know if the sheltering will last a few weeks or many months – or what the governmental reaction will be (debt servicing holidays for everyone ?) and how quickly or slowly business activity will revive, no predictions are possible. 

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