Fitch: BDC’s Off Balance Sheet Loan Programs Distort Leverage
Business development companies (BDCs) are increasingly using off balance sheet investment vehicles called senior secured loan programs (SSLPs) to increase their effective portfolio leverage without running afoul of regulatory limits on balance sheet leverage, a trend that adds incremental risks, according to Fitch Ratings. SSLPs are receiving greater interest from BDCs seeking ways to combat portfolio yield pressure in the currently tight credit spread environment.
Fitch says the incremental risks of SSLPs, which include increased effective leverage and the potential for increased net asset value (NAV) volatility, warrant attention given current competitive underwriting conditions and the increased use of SSLPs by BDCs. These concerns are balanced against the additional portfolio diversification provided, the fact that, to date, BDCs have partnered with established market participants with track records of underwriting middle-market loans, and the fact that the magnitude of leverage employed is modest (typically 2.0x-3.0x) relative to other potential yield-enhancing investments such as subordinated debt or CLO equity.
The largest SSLP program is a partnership between Ares Capital Corporation (BBB, Rating Outlook Positive) and GE Capital, which had about $9.4 billion of committed capital at June 30, 2014. Fifth Street Finance (BBB-, Rating Watch Negative) recently announced a $305 million partnership with investors through Natixis and a $210 million partnership with Kemper, while Solar Capital (BBB-, Rating Outlook Stable) recently announced a $600 million partnership with PIMCO.
SSLPs typically invest in first lien senior secured loans of middle market companies, with the financing of such investment activity shared by a BDC (in a subordinated position) and a large institutional partner (in a senior position). Given the joint financing, a BDC can use the SSLP to invest in larger deals or underwrite bigger positions in traditional deals. Given the BDC’s subordinated investment position, the SSLP can also be used to invest in lower yielding investments that would not otherwise meet the BDC’s expected economic returns without the application of additional leverage at the SSLP level. BDCs are subject to a leverage cap of 1.0x, as measured by balance sheet debt/equity, imposed by the Investment Company Act of 1940.
To read the entire news release, click here.