The run-up in business development company (BDC) equity prices in recent months should lead to further opportunistic equity issuance by some BDCs, says Fitch Ratings. For those firms trading above net asset value (NAV) and able to access equity markets for new capital, it will provide a competitive advantage, resulting in improved funding flexibility, leverage management and investment capacity for new deals.

BDC stocks have risen significantly over the past several months, with the Wells Fargo BDC index returning 20% year to date, its best performance since 2012. The average of 17 BDCs that Fitch actively monitors is now trading close to NAV, while the average valuation for Fitch-rated BDCs is at a 7.5% discount to NAV. These are up markedly from the 7.8% and 16.1% average discounts to NAV for the broader group and rated group recorded back in early April, respectively, when Fitch published its last BDC industry report.

In Fitch's opinion, among the likely drivers of improved equity valuations were relatively stable asset quality in recent quarters, right-sized dividend policies and the impact of improved/stabilized oil prices on energy investments, combined with broader favorable equity market condition.

Several BDCs have taken the opportunity to issue equity as a result, including TPG Specialty Lending ($94.4 million in March), TCP Capital ($30.2m in June and $35.3 million in July), Main Street Capital ($43.8 million in July) and Golub Capital ($25 million in July and $32.1 million in August). However, overall issuance remains low. Public equity capital raises for rated BDCs to date in 2016 have totaled just $95.3 million, which is up modestly from 2015, but low by historical standards.

Improving valuations will help to mitigate or manage some of the challenges BDCs have been facing, including capital constraints and rising leverage. However, difficulties for the sector remain and not all firms will be in a position to benefit significantly.

Pressures to ensure incremental capital is deployed into accretive investments will continue to be a challenge for some BDCs given supply/demand dynamics, which continue to contribute to a competitive underwriting environment. Underwriting yields widened at the start of 2016 but have since tightened again, underscoring the fact that earnings pressures for the sector as a whole remain. Some BDCs have cut dividends recently, which should help to alleviate some of the earnings pressure, but dividend coverage will remain in focus for those firms raising new capital.

Energy exposures could also remain a drag on earnings and dividend coverage, notwithstanding the recent rebound in energy valuations linked to improved commodities prices. Given the scale of the downturn in the energy sector over the past several years, some energy investments' credit issues will continue to weigh on valuations for some time to come. Overall, Fitch believes that the energy sector should remain relatively muted for BDCs in the short term.