Tighter risk spreads and continuing signs of over-heating in debt markets have led some U.S. business development companies (BDCs) to look for new growth opportunities. Several BDCs, which are largely cash flow lenders to middle-market companies, have expanded their platforms through acquisitions of asset-based lenders, with a focus on senior loan products, according to Fitch Ratings. Over time, BDC's commitments to these types of investments are likely to increase.
Fitch sees the expansion of BDC platforms as a positive driver of increased middle-market loan diversification at a time when frothy credit markets have raised the risk of increased asset quality problems for leveraged loans. Still, these acquisitions bring an added layer of leverage to BDCs, given borrowings at the lender level. These investments are generally accounted for as equity investments, which could yield more valuation volatility for the firms quarter to quarter.
BDC portfolio growth has slowed recently as a result of increased prepayment activity in a low interest rate environment where refinancing volumes have been high. Asset quality trends for BDCs have improved, and portfolio concentrations have ticked down.
The top 10 investments of Fitch-rated BDCs, on average, totaled 37.1% of assets and 59.6% of equity as of year-end 2012. While the acquisition of asset-based lenders decreases portfolio diversification because the acquisitions are accounted for as portfolio company investments, Fitch believes the concentration risk is somewhat mitigated by the fact that the underlying portfolio is relatively diverse, consisting of loans to a number of different borrowers.
Fifth Street Finance Corp's announced acquisition of HealthCare Finance Group (HFG), an asset-based lender to healthcare providers, for approximately $110 million, is the latest example of BDCs' desire to expand the platform through acquisitions of specialty lenders. HFG's outstanding loan portfolio of approximately $270 million was comprised of 57 loans to multiple borrowers at May 6, 2013. The Fifth Street acquisition follows a similar expansion seen in Solar Capital's $275 million December purchase of asset-based lender Crystal Capital Financial Holdings, whose $400 million portfolio included 23 loans at year-end 2012.
Other diverse portfolio company investments include Ares Capital Corporation's partnership with an affiliate of GE Capital Corporation, valued at approximately $1.3 billion at March 31, which invests primarily in unitranche loans to middle-market borrowers across a number of industries. American Capital Ltd. (ACAS) also has a diversified portfolio of European senior loans in its European Capital (ECAS) investment, which was valued at approximately $918.7 million at March 31.
In the near term, Fitch believes BDCs may also look to deploy capital into products that complement their current platforms, including, energy/project lending products, aircraft leasing and/or equity REITs.