June 26, 2012 / 3:03 PM / 7 years ago

TEXT-Fitch revises American Capital Ltd rating outlook

June 26 - Fitch Ratings has completed a peer review of six rated Business
Development Companies (BDCs) in concert with its publication of an industry
report, titled 'Business Development Companies - A Comparative Analysis 
1Q12', which is available on Fitch's website. Based on this review, Fitch has 
affirmed the long-term Issuer Default Ratings (IDRs) of American Capital, Ltd.
 (ACAS), Apollo Investment Corporation (Apollo), Ares Capital
Corporation, Fifth Street Finance Corp., PennantPark
Investment Corporation, and Solar Capital, Ltd . The IDRs of
the all of the affected BDCs are in the 'BBB' rating category 
with the exception of ACAS which is rated 'B+'. A full list of ratings is 
provided at the end of this release.

The Rating Outlook for ACAS has been revised to Positive from Stable; the Rating
Outlook for Apollo has been maintained at Negative; and the Rating Outlook for 
the remaining BDCs has been maintained at Stable.  

The rating affirmations reflect relative stability in the industry in terms of 
core operating performance and asset quality, and the maintenance of leverage 
levels below management's targeted range. Portfolio growth has slowed from 2010 
levels, as more recent market entrants mature and gain scale, but remains 
relatively robust. Still, BDCs' investment focus has centered on more senior 
positions in the capital structure of underlying companies, given reduced 
competition in the space, while equity exposures have generally declined. 
Valuation volatility remains, as evidenced by the meaningful unrealized 
portfolio depreciation recognized in the third quarter of 2011 (3Q'11), but 
Fitch believes quarterly movements have been more digestible given reduced 
leverage ratios. 

Net realized losses on portfolio investments have been meaningful since the 
start of the crisis, as BDCs have recognized declines in value, participated in 
portfolio company recapitalizations, or exited underperforming investments in an
effort to redeploy proceeds into higher-yielding securities. Portfolio losses 
have declined over the past five quarters, and several BDCs recognized modest 
gains in early 2012. Over time, Fitch does not expect realized gains and losses 
to be a meaningful component of net income, given declines in portfolio equity 
holdings and improvements in asset quality.    

Funding flexibility has improved in recent quarters, with several BDCs accessing
the unsecured debt markets via the issuance of convertible notes and/or retail 
notes. Fitch views an unsecured funding component favorably as it provides 
funding diversity, as well as flexibility to encumber assets if necessary for 
liquidity purposes. Debt maturity profiles have also been improved, with many 
BDCs amending and extending bank facilities to allow for three year revolving 
periods followed by one-year of amortization. This term debt structure provides 
for better matching with the three-to-four year average life of portfolio 
investments. 

Public equity issuance in early 2012 is close to surpassing all of 2011, as 
share prices have generally moved closer to net asset values. BDCs are expected 
to continue to access the markets opportunistically for growth capital and Fitch
expects additional issuance over the balance of 2012.    

On the downside, portfolio concentrations have generally ticked-up across the 
industry, despite declines in leverage, given follow-on investments in existing 
companies and larger positions in new portfolio investments. Fitch believes 
portfolio diversity is critical, as the underperformance of one or more large 
investments can have an outsized impact on leverage. As a result, BDCs with 
higher concentrations as a percent of book equity, are expected to manage 
leverage more conservatively, all else equal.  

Another point of focus for Fitch is net investment coverage of dividends, given 
the regulatory requirement that BDCs distribute 90% of taxable income on an 
annual basis. While several BDCs instituted dividend cuts in the past several 
years to better match core earnings and distributions, coverage of dividends 
remains weaker than expected for some, particularly when adjusting for non-cash 
income accruals. Fitch would view core cash earnings coverage at or near 100% on
a consistent basis favorably.        

 

Fitch believes positive rating momentum for the industry is limited to the 'BBB'
category given the relative illiquidity of portfolio investments, limited 
funding flexibility, an inability for BDCs to retain capital due to distribution
requirements, and the impact that fair value accounting has on leverage. 
However, negative rating action for any one issuer could be driven by 
deterioration in asset quality or core operating performance, increases in 
equity holdings without commensurate reductions in leverage, weakening cash 
income coverage of dividends, and/or the recognition of sizeable unrealized 
portfolio depreciation which forces leverage above management targets for 
extended periods or reduces cushions on debt covenants.   

The Positive Outlook assigned to ACAS' ratings reflects the reduction in 
non-accrual levels, improved core operating performance, and reduced leverage. 
While exposures to equity investments remain large relative to peer BDCs, Fitch 
expects leverage will remain well-below the peer average for some time. 
Additionally, about half of the equity exposure is attributable to the 
relatively diverse portfolio of European Capital, Ltd. and the asset manager, 
American Capital, LLC; the valuation of which is driven largely by management 
fees received from funds with permanent capital.

Fitch has also revised the recovery ratings for ACAS' secured debt to 'RR1' from
'RR2' and upgraded the debt and recovery ratings for its unsecured debt to 
'B+/RR1' from 'B-/RR6' to reflect improved recovery prospects for creditors 
given an increase in available collateral, reduced balance sheet leverage, and 
in shortened risk horizon to maturity. Fitch expects remaining unsecured debt of
$11 million will be repaid with balance sheet cash when it comes due in August 
2012.     

The Negative Outlook for Apollo's ratings continues to reflect recent corporate 
announcements, including the replacement of the firm's Chief Investment Officer 
and Chief Financial Officer and the expansion of the investment mandate beyond a
focus on subordinated/mezzanine financing. Fitch will assess the impact of these
announcements over the next 12-18 months. Still, negative rating action could 
occur more quickly should there be an inability to deploy investment capital 
into accretive middle market investments, an extended increase in leverage above
the targeted range, resulting from increased borrowings or material unrealized 
depreciation, deterioration in portfolio asset quality, and/or a decline in cash
income coverage of the current dividend.  

Fitch has affirmed the following:

American Capital, Ltd.

-- Long-term IDR at 'B+'.

Apollo Investment Corporation

-- Long-term IDR at 'BBB'; 

-- Secured debt at 'BBB'; and

-- Unsecured debt at 'BBB-'.

Ares Capital Corporation

-- Long-term IDR at 'BBB'; 

-- Secured debt at 'BBB'; and

-- Unsecured debt at 'BBB'.

Allied Capital Corporation

-- Unsecured debt at 'BBB'.

Fifth Street Finance Corp.

-- Long-term IDR at 'BBB-'; 

-- Secured debt at 'BBB-'; and

-- Unsecured debt at 'BBB-'.

PennantPark Investment Corporation

-- Long-term IDR at 'BBB-'; and 

-- Secured debt at 'BBB-'.

Solar Capital, Ltd.

-- Long-term IDR at 'BBB-'; and

-- Secured debt at 'BBB-'.

Fitch has also taken the following rating actions:

American Capital, Ltd.

-- Secured debt revised to 'BB/RR1' from 'BB/RR2'; and

-- Unsecured debt upgraded to 'B+/RR1' from 'B-/RR6'.
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