Fitch Ratings will have a negative view of business development companies (BDCs) that intend to increase their leverage following the passage of the new U.S. $1.3 billion spending bill.
The new legislation includes the Small Business Credit Availability Act that allows BDCs to double their leverage. Although Fitch does not anticipate immediate or sector-wide BDC rating changes, Fitch predicted it would generally view a BDC’s intention to increase leverage as negative for its ratings unless accompanied by an offsetting improvement in the portfolio’s risk profile.
Under the legislation, regulatory asset coverage requirements for BDCs will decline to 150% of debt from 200% of debt, effectively allowing BDCs to increase debt to equity leverage to 2.0x from 1.0x. Fitch believes the previous regulatory leverage limit of 1.0x contributed to stronger recovery prospects for debt holders, even when portfolio investments were exited at meaningful discounts. Average leverage for the rated peer group was 0.65x as of December 31, 2017.
The potential for negative ratings pressure for BDCs from increased leverage depends upon how individual managers utilize the relaxed leverage guidelines relative to their portfolio risk profile in regards to asset seniority, issuer credit strength and secondary market asset liquidity. The use of incremental leverage will vary by company, with some being more aggressive than their peers, which could differentiate ratings among Fitch-rated BDCs. Ratings for BDCs currently range between ‘BBB’ and ‘BB+’, constrained by the relative illiquidity of BDCs’ assets, the market value sensitivity of the BDC structure, the dependence on capital markets to fund portfolio growth and a limited ability to retain capital due to dividend distribution requirements.
The bill’s supporters argue that the higher leverage limit will increase the availability of lending to the middle market and view a leverage increase as a means to increase portfolio credit quality, seniority and liquidity while improving BDC equity returns. However, the majority of current BDC portfolios originated in a relatively benign credit environment. Fitch believes that when a credit cycle emerges, asset quality performance will weaken and recovery prospects will decline as competitive market conditions have yielded higher underlying leverage and weaker creditor protections. Increased BDC-level leverage in this environment will further challenge performance, all else equal.
While asset coverage cushions would immediately increase, Fitch expects cushions to decline over time as BDCs increase leverage. BDCs may elect to invest in more senior positions that offer lower yields relative to current investments when accompanied by higher leverage allow for modestly higher levered equity returns. Under previous regulatory leverage constraints, it was not economically feasible for a BDC to invest meaningfully in asset-based loans and up-market middle-market loans given that these types of investments typically could not generate levered returns above BDCs’ hurdle rates.
Before adding additional leverage, BDCs will need to receive shareholder approval and amend their bank credit facilities. Currently, all Fitch-rated BDCs use credit revolvers for working capital needs and/or longer term financing. The majority of these credit facilities have a 200% asset coverage covenant. In order to take leverage above 1.0x, banks would need to amend the asset coverage covenant to 150%. If banks were to agree to the amendment, this would ultimately be a governor of how much additional leverage BDCs could employ.
