Business development companies (BDCs) will face continued challenges heading into 2020, including competitive underwriting conditions, earnings pressure from lower interest rates and unsustainable asset quality metrics, according to Fitch Ratings' 2020 BDC outlook report. Fitch believes competition in the middle market will continue to pressure deal structures and terms in 2020 as low interest rates drive elevated demand for higher-yielding middle-market paper.

"BDC leverage has been on the rise, in the wake of the passage of the Small Business Credit Availability Act, but so far has generally been accompanied by a reduction in portfolio risk and/or improved cushion to asset coverage requirements. Still, Fitch believes execution risk will be heightened in 2020 for BDCs looking to increase leverage at a time when deal structures and terms are weaker," said Chelsea Richardson, associate director, Fitch Ratings.

The majority of middle-market deals continue to include maintenance covenants; however, Fitch believes the terms of these covenants are weakening as EBITDA addbacks are generous. Additionally, market participants have noted more aggressive terms allowing for the deterioration of collateral protection, such as restricted payment baskets with EBITDA based grower amounts and provisions that more easily allow for investments in unrestricted subsidiaries.

"There has been a recent decline in middle market covenant-lite volume; however, we expect pressure on terms to continue, which could ultimately lead to weaker recoveries on problem assets when the next credit cycle materializes," added Richardson.

While sector dynamics remain challenging, some firms are better positioned, given strong platforms and consistent track records. Fitch's outlook for BDC ratings is stable, as rated firms are expected to remain selective on originations over the course of 2020 while maintaining sufficient funding flexibility, solid dividend coverage, and appropriate cushion to asset coverage requirements to account for potential market volatility and credit normalization. Fitch has Stable Rating Outlooks on eight of the nine publicly rated BDCs.

At Oct. 24, 2019, rated BDCs were trading at a 1.8% average discount to net asset value (NAV), compared to a 7.9% average discount a year ago, but four rated BDCs were trading above NAV, providing them access to the equity markets for growth capital. Trading levels vary significantly given differentiated asset quality performance, leverage utilization, fee structures and dividend actions. Fitch believes BDCs that consistently trade at premiums to NAV will have a competitive advantage if underwriting conditions improve, while some BDCs will likely continue to trade below NAV in 2020 given concerns about credit performance, portfolio valuations, dividend coverage and/or management alignment of interests.

2020 Trend Watch:

• Competitive dynamics in the middle market and their impact on asset quality deterioration and earnings pressure for BDCs.
• Increases in leverage following the passage of the SBCAA and the extent to which these are offset by portfolio rotation into more senior securities.
• Regulatory asset coverage cushions (and associated covenants) relative to valuation volatility and/or credit losses.
• Unsecured debt market access relative to secured funding sources such as bank financing and collateralized loan obligations (CLOs).