Additional Business Development Companies (BDCs) are likely to seek board and/or shareholder approval to increase leverage to 2.0x from 1.0x following recent changes from the Small Business Credit Availability Act, which was signed into law on March 23, 2018, according to a new BDC industry report from Fitch Ratings.
Since the changes were announced, FS Investment Corporation (FSIC) and Apollo Investment Corporation (AINV) have received board approval to modify their asset coverage requirements. Ares Capital Corporation (ARCC) is likely heading down the same path. The passage of the Act, allowing for higher leverage, did not result in immediate rating actions; however, Fitch generally views the potential leverage increase as a ratings negative.
"Increased leverage could negatively pressure BDC ratings; however, it 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," said Meghan Neenan, Managing Director, Fitch Ratings.
On March 5, 2018, Fitch affirmed the ratings on eight business development companies (BDCs). The Rating Outlooks on AINV and BlackRock Capital Investment Corporation were revised to Stable from Negative and the Rating Outlook on TPG Specialty Lending was revised to Positive from Stable. Fitch's sector outlook remains negative.
Aggregate originations, for BDCs covered in Fitch's report, were up 50% in 2017, but net portfolio growth remains muted at $1.7 billion in aggregate (down 78.8% from the 2013 post-crisis peak), given strong repayment activity. Fitch believes portfolio growth will be moderate in 2018 as BDCs exercise caution and repayment activity remains strong.
"Low interest rates continue to drive demand for higher-yielding middle market paper and underwriting conditions remain competitive," said Johann Juan, Director. "Portfolio yields fell modestly and will likely remain pressured in 2018 despite rising interest rates, given the competitive sector dynamics."
Fitch looks to underlying leverage levels and interest coverage as indicators of portfolio risk. Managing concentration limits may be out of a BDC's control, to some extent, as investments appreciate or depreciate in value. However, weaker performance of larger investments can pressure leverage and earnings metrics. BDCs that are overly exposed to cyclical industries also have higher portfolio risk. While commodity prices have rebounded, the sharp decline in energy prices led to significant investment losses and/or restructurings for most BDCs with elevated exposure to energy firms. Remaining exposure to energy investments is manageable, in Fitch's view, but additional losses are possible.
Market dynamics and elevated levels of non-income producing investments have pressured dividend coverage for some BDCs. Dividend coverage is expected to improve in 2018 as BDCs with portfolio challenges have rightsized dividends to a more manageable level.
Increased interest rates will have mixed results for the sector. Most BDCs are positioned to benefit from rising interest rates as most investment portfolio assets are floating rate, while funding profiles include a large fixed rate component.However, Fitch believes rising interest rates could increase asset quality issues at the underlying portfolio company level, if borrowers are unable to manage higher debt service bu
rdens. Still, if interest rate increases are gradual in nature and accompanied by a strengthening economy, revenue and EBITDA at the portfolio company level would be expected to benefit, which would make higher payment burdens more manageable.