NEW YORK, April 15 (LPC) - Fitch Ratings in an industry update for Business Development Companies (BDCs) said it is focused on leverage differentiation among funds looking to employ greater leverage following the passage the Small Business Credit Availability Act in 2018, amid continued competitive challenges.
The Small Business Credit Availability Act, signed in to law by Congress in 2018, allows BDCs to access additional capital to make more loans to middle market companies, but Fitch believes the change poses elevated execution risk for those BDCs opting to pursue lower asset coverage requirements.
“Not surprisingly, over the last year we have been focused on increasing leverage as a result of legislative changes in 2018,” said Chelsea Richardson, associate director at Fitch. “Leverage increases overall have been offset by shifting portfolio composition to favor first-lien investments.”
At year-end 2018, 65.3% of BDC portfolios, on average, consisted of first-lien investments, up from 58.6% at the end of 2017, reflecting a rotation of portfolios up the capital structure into lower yielding, but less risky investments, a move afforded by the use of increased leverage, the report said.
BDCs with greater exposure to first-lien investments generally have less portfolio risk because those assets have higher recovery prospects in default scenarios.
BBDC, TSLX and GBDC had the greatest exposure to first-lien investments in 2018, while AINV and NMFC each showed large increases in that direction as both firms focused new originations on senior positions following the approval to use higher leverage, according to the report.
Fitch follows a group of 18 BDCs, nine of which are rated by the agency. Six of those are pursuing higher leverage, the report said.
“We haven’t seen any negative rating actions yet, aside from two outlook revisions,” said Chelsea Richardson, associate director at Fitch. “Most have strong track records, solid investment strategies and affiliations with larger platforms, which has helped us get comfortable.”
Fitch views higher leverage as credit negative, generally, and said in the report that rating movement will depend on how BDCs utilize higher debt capacity relative to portfolio risk and how funding profiles evolve.
Fitch is also evaluating the funding profiles for BDCs and views increases in secured debt as a percentage of funding unfavorably. Last year, total unsecured debt issuance for the group was lower than the year before, and some of the offerings completed after the legislative change had higher pricing and/or additional covenants.
Unsercured debt issuance for the group declined to US$1.7bn in 2018 from US$2.8bn in 2017.
“We believe that an unsecured funding component enhances funding diversity and allows for greater flexibility during times of stress since a lower portion of assets would be pledged as collateral,” Richardson said.
Overall, Fitch Ratings for the fourth consecutive year maintains a negative sector outlook for Business Development Companies (BDCs) in 2019, citing continued competitive underwriting conditions, unsustainable asset quality metrics and limited access to growth capital.
An unfavorable supply/demand dynamic in middle market lending has resulted in aggressive deal structures and pricing, which together have led to earnings pressure and in the future could lead to asset quality deterioration.
“Despite the competitive underwriting environment, we have seen relatively robust origination volumes. However, portfolio growth has been more modest due to elevated repayment volumes,” Richardson said.
For the BDCs covered in the report, total originations were up 18% in 2018.
“We believe portfolio growth will pick up in 2019 as additional BDCs are able to take advantage of the higher leverage capacity, and higher rates have made refinancing less attractive for borrowers more recently,” said Richardson. (Reporting by Leela Parker Deo. Editing by Michelle Sierra and Jon Methven) )