The removal of business development companies (BDCs) from the S&P and Russell indices will likely reduce the liquidity of their shares and increase their cost to raise equity in the near-term, according to Fitch. The removals involved 33 BDCs, including all seven that Fitch rates.
Forced sales of BDC shares from the indices will likely pressure share prices in the near term. In the longer term, the exclusion could reduce institutional interest in BDCs and hamper the liquidity of the shares. Reduced equity liquidity could impact growth rates and the companies' flexibility to raise equity to support existing investments or capitalize on investment opportunities.
Debtholders are not directly impacted by this event given the closed-end nature of the BDC structure, as equity price pressure does not force the sale of assets nor does it impact leverage levels. But limitations on the ability to raise additional equity may hinder BDCs' ability to make further investments in portfolio companies during a period of stress.
Access to equity markets is important for BDCs because dividend distribution requirements limit their ability to retain capital. Therefore, they rely heavily on the equity markets to fund portfolio growth. Fitch believes a reduction in trading volumes may impact the cost of raising equity in the future, as investors seek a premium to hold relatively less-liquid shares.
BDCs have grown considerably since the onset of the financial crisis, raising over $15 billion of cumulative equity capital since 2007. Banks have pulled back from middle-market lending as they face tougher capital requirements, and BDCs have expanded to fill the void. Pending legislation permitting an increase in BDCs' leverage caps would allow them to expand further. However, a supportive equity market will still be necessary for balanced future growth.
On Feb. 24, 2014, S&P announced it was removing BDCs from its indices as a result of client concerns related to reporting requirements, expenses and investment restrictions relating to the industry. We believe expenses are the key issue, since the inclusion of BDCs can inflate the expense ratio of a fund investing in BDC shares. BDC's expenses are treated differently than the expenses of other companies held in the indices, because they are fall under the Investment Company Act of 1940. Their management fees and other costs become "acquired fund fees" for a fund owning BDC shares.
The S&P decision took effect on Feb. 28, 2014 and impacted Apollo Investment Corporation and Prospect Capital Corporation.
On March, 3, 2014, the Russell Indices said they planned to follow suit, unless the SEC removed acquired fund fee reporting requirements for BDCs by May 15, 2014. The decision by Russell is more significant as it impacts 33 BDCs, including all seven that Fitch rates.