BDCs move to boost leverage

Gladstone Capital

17/04/2018 15:33

By Leela Parker Deo
    NEW YORK, April 17 (LPC) - Some Business Development
Companies (BDCs) have already received board approval to
increase the amount of debt that they can borrow after US
legislation passed in March allowed them to double leverage on
their funds.
    BDCs are vehicles that lend to small and mid-sized US
companies, and both listed and privately owned BDCs have mixed
performance records. The changes are expected to further
differentiate performance between managers as adding more
leverage, debt and risk could amplify any underperformance.
    Apollo Investment Corp (AINV), FS Investment Corp (FSIC),
PennantPark Floating Rate Capital Ltd (PFLT), and Gladstone
Capital Corp (GLAD) have received board approval to modify asset
coverage requirements to allow them to increase leverage.
    Ares Capital Corp (ARCC) also said it would discuss specific
implementation plans for the provision with its board and other
constituents.
    A one-year cooling off period is required for funds
receiving board approval, but BDCs that seek approval via a
shareholder vote at an annual or special meeting will be able to
make changes one day after a majority vote.
    The passage of the Small Business Credit Availability Act
was attached to the US$1.3trn spending bill that was signed into
law by President Trump. The legislation effectively increases
maximum leverage to 2:1 total debt to equity from 1:1 by
lowering asset coverage requirements for BDCs to 150% from 200%
previously.
    The industry had been working for more than five years to
secure this change, which will give the funds more money to lend
and allow them to compete more aggressively in the already
congested US middle market loan space.
    Using additional leverage will allow BDCs to maintain
returns while reducing the portfolio risk profile by investing
higher in capital structures, and greater funding flexibility
will give them access to growth opportunities.
    Although BDCs have had leverage capped at a relatively low
1:1, many have invested in riskier junior debt or highly
leveraged loans. Fund performance has diverged widely in terms
of asset quality, credit risk, portfolio yields and the ability
to meet quarterly dividends to shareholders and some BDCs have
already been trading at a discount to asset value.
    “Relaxed leverage constraints will likely bring forth an
‘Act 2’ of manager differentiation we haven’t seen in recent
years even without credit duress as seen in energy, retail, etc.
as the impact of underperforming returns should be
amplified/underpinned by more risk,” Wells Fargo analysts wrote
in their 2Q18 BDC Scorecard.
    RATINGS PRESSURE
    Standard & Poor’s said the potential for increased leverage
in an already competitive environment increases credit risk for
the industry and the agency now has a negative outlook on all of
its publicly-rated BDCs.
    The ratings agency placed its ratings for ARCC, FSIC and
Prospect Capital Corp (PSEC) on CreditWatch with negative
implications, which prompted PSEC to halt plans to raise
additional leverage after initially securing board approval.
    PSEC said in an April 6 regulatory filing that it had,
“determined to no longer modify, beginning March 25, 2019 (one
year from prior board determination), the asset coverage ratio
test.”
    Fitch Ratings did not take any immediate rating actions on
BDCs. Potential negative ratings pressure depends on how
individual managers utilize extra leverage with respect to
investment strategy and the underlying credit quality of the
portfolio as well as the management of funding maturities and
liquidity, the agency said.
    “Fitch is not taking blanket action following the leverage
limit increase, but there could be more differentiation in BDC
ratings over time,” said Meghan Neenan, managing director at
Fitch Ratings. “Assuming all else equal, if you double leverage
unsecured creditors are worse off.”
    Ratings for the group of BDCs currently rated by Fitch range
between BBB and BB+.
    Implementing the new leverage rules will take time and not
all BDCs are expected to be able to take advantage of extra
leverage. Underperforming BDCs will have less funding
flexibility than more diversified platforms with established
managers and strong underwriting track records that have
consistently outperformed peers.
    Funds that do increase leverage are expected not to take it
to the limit and will likely maintain a cushion, as previously.
Additional leverage is also likely to come via the unsecured
debt markets, including bonds, private placements or
convertibles, rather than from bank credit facilities.
    “Banks are unlikely to want to materially dial up exposure
to BDCs. Any increase in leverage these guys get will likely not
come from banks, but rather from unsecured debt issuance via the
capital markets,” Neenan said. 

 (Reporting by Leela Parker Deo
Editing by Tessa Walsh and Michelle Sierra)
 ((Leela.Parker@thomsonreuters.com;))