May 20, 2019 / 3:16 PM / 2 months ago

BDC leverage reform grows divide between large and small players

NEW YORK, May 20 (LPC) - A legislative change that has doubled the leverage cap for Business Development Companies (BDC) is set to fuel further bifurcation between larger and smaller platforms, as many start to get approval to increase debt on the balance sheet.

Larger BDCs benefit from their management of bigger asset pools to attract a lower cost of debt funding compared with smaller rivals, handing them an advantage when pricing on individual transactions.

“There are several BDCs managed by firms that pay a huge amount of fees to Wall Street banks every year, so those banks are going to be there for the BDCs from a funding perspective. There are benefits to having affiliations with a larger platform,” said Meghan Neenan, managing director and North American head of non-bank financial institutions at Fitch.

BDCs, which lend to middle market companies, favor the use of leverage because of the lower cost of capital on individual loans, which means funds can be selective in chasing deals and not be required to stretch for yield by investing in riskier tranches to meet yield targets.

Following last year’s passage of the Small Business Credit Availability Act that increased the leverage limit to a ratio of 2:1 total debt to equity, from the previous 1:1, many BDCs are upping this funding tool.

The legislation was a culmination of years-long lobbying efforts from the BDC industry and the vast majority have been quick to take advantage by either seeking board or shareholder approval, which is required because BDCs are publicly traded. A one-year waiting period is required for board approval, while a shareholder vote means a BDC can pursue higher leverage immediately.

The extra leverage has prompted larger funds to rotate their portfolio toward less risky senior investments and away from more subordinated facilities, as well as dissolving balance sheet vehicles and joint ventures they had set up to circumvent the 1:1 cap.

Goldman Sachs BDC completed the shutdown of its joint venture with University of California Board of Regents this month and has ramped up its senior investments, which comprised 75% of all deals the firm had completed over the last year, according to its first quarter earnings report.

Concurrently, the firm signed off on a US$100m increase of its revolving credit facility (RCF) to US$795m. Total debt commitments including convertible debt brought the firm’s commitments to US$950m.

Last month, Ares Capital Corporation increased the size of its RCF to US$3.4bn from US$2.1bn, as well as expanded its letter of credit facility to US$200m from US$150m, the firm reported.

Prospect Capital Corporation recently increased its RCF, which includes an accordion feature that can stretch to US$1.5bn from the US$1.045bn commitment the firm has secured. BlackRock TCP Capital Corporation and PennantPark Investment Corporation both increased their credit facilities in the first quarter.

“Larger BDCs are having an easier time with their credit providers,” said Steven Boehm, partner at law firm Eversheds Sutherland.”Smaller BDCs or ones not performing as well seem to be having a harder time with increasing leverage. Those are the two biggest factors and the better your size and performance the more leverage you’re going to have with a potential lender.”

BRANCHING OUT

As the more senior end of the market becomes crowded, other funds unable to utilize the leverage on the same terms as larger playersare seeking to expand their offering in more niche areas of the credit market.

On its first quarter earnings call, Solar Capital executives reported on double digit internal rate of return for its specialty finance and equipment financing lending business steering away from traditional middle market loans.

And contrary to the moves to dissolve JVs, Barings BDC announced the formation of a JV structure with South Carolina Retirement Systems Group that will target real estate debt in addition to corporate loan instruments.

FS-KKR, one of the larger BDCs, said it will pivot towards more asset-based finance investments and away from higher yielding equity investments that it aims to reduce to less than 5% of the total portfolio.

“The cash flow lending market is super competitive at the moment, so some BDCs have branched out into other products, like asset-based loans and life sciences, that can offer pretty attractive yields,” Neenan said.

Some analysts have expressed concerns that the extra capacity for leverage can heighten the risk across the sector that targets investments in less liquid middle market companies.

But as BDCs start to finally get shareholder and board approval for added leverage, few are seeking to reach the maximum limit allowed, instead maintaining a cushion by sticking to more conservative levels.

“Anytime you’re looking at increasing leverage you have to be mindful of the tail risk. The thinking of many BDC managers seems to be more prudent, rather than automatically go to 2:1,” Boehm said. (Reporting by David Brooke. Editing by Michelle Sierra and Lynn Adler) ))

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