Depressed share price valuations and governance concerns have ignited shareholder activism campaigns against three business development companies (BDCs) over the last several months, including two rated by Fitch Ratings. Fitch believes the heightened dialogue may lead to strengthened oversight, which would be beneficial for BDC creditors, provided other equity-friendly measures are not over emphasized.
The Fitch-rated universe of BDCs was trading at an average discount to net asset value of 14.3% as of Nov. 19. Given the significant number of new BDCs operating, variations in governance quality have emerged. Activist presence may trigger more widespread attention to management vulnerabilities among these companies.
Four fund managers, including TPG and Highland, Elliot Management and River North, have presented arguments for changes at TICC Capital Corp., American Capital. Ltd. (ACAS, 'BB-', Stable), and Fifth Street Finance Corp. (FSC, 'BB+' Outlook Negative), respectively. Key areas of focus include the appropriateness of investing in broadly syndicated loans and CLO equity, the lack of high water marks in incentive fee compensation structures, and the deployment of share repurchase programs.
BDCs are paid a relatively high management fee (often 1.375% to 2% of assets) for originating illiquid loans in the middle market. CLOs, which manage broadly syndicated loans (BSLs), charge investors a much lower fee (often 0.5%) given less complexity in the origination and underwriting process and the focus on liquid collateral. Therefore, BDC investments in BSLs raise the question of the appropriateness of the strategy relative to the associated management fee. Fitch acknowledges that arbitrage opportunities may periodically exist in the liquid market, but BDC investors are not likely to appreciate outsized investments in BSLs as part of a BDC's core strategy.
CLO equity is another asset class to which some BDC shareholders have aversion. Fitch believes the valuation of CLO equity investments is often less transparent, can yield heightened valuation volatility for the BDC, and can have an outsized impact on BDC leverage. These investments also add an extra layer of leverage to portfolio investments, as CLOs are themselves levered structures.
Incentive fees generally come in two parts: an incentive fee earned on net investment income, which excludes credit gains and losses, and an incentive fee earned on total income, which includes credit gains and losses. Within this construct, many BDC managers earned incentive fees even while generating significant realized credit losses 'below the line'. The establishment of a high water mark (or total return concept), as some newer BDCs have implemented, ensures that the manager can only earn incentive fees if credit performance is strong. This better aligns the interests of investors and managers and helps preserve more debt service capacity for the BDC creditors, in Fitch's opinion.
Finally, Fitch views share repurchases as generally shareholder friendly and a contributor to higher leverage ratios. However, given the requirements on BDCs to distribute 90% of taxable earnings on an annual basis, repurchases can help manage a BDC's dividend burden. If the earnings per share accretion through a buyback is greater than any accretion otherwise achievable through new loan investments, then the BDC's creditors benefit from the reduction in share count, lowering cash outflows to support dividends.
Generally speaking, activist campaigns on Fitch-rated entities do not have a rating impact unless Fitch believes the activist has a credible chance of implementing its desired changes and that the changes will be materially adverse to creditors. Fitch believes that not all activist activities have weakened credit profiles, as some have been neutral to mildly positive.
A related Fitch report on activist activity on non-bank corporations, "Activist Activities: Fall 2015: Nonfinancial U.S. Corporate Campaign Case Studies and Profiles of Notable Activists," dated Nov. 6, 2015, can be found on www.fitchratings.com.