BDC fees could be thrown into spotlight after changes in leverage statutes – updated

Additional leverage may mean higher fees for shareholders if BDC managers do not alter their fee structure.

UPDATE: Monroe Capital Corporation also decided to poll its shareholders on whether the BDC should increase its leverage profile, according to a proxy filed with the SEC. Prospect Capital Corporation, which had approved the extra borrower capacity by board vote, decided to not increase its leverage capacity, citing new industry regulations by Standard & Poor’s.

Original story:

Business development company managers won a victory when US federal lawmakers tucked the Small Business Credit Availability Act in a large omnibus spending bill, a move that allows BDCs to increase their allowable leverage from a 1:1 debt-to-equity ratio to 2:1.

Whether it’s a net positive for shareholders might be a different question, though. Since BDCs charge money on gross assets, shareholders would end up paying more in fees should BDC managers take on additional leverage and not change the fee structure.

“If you’re charging [a management fee] on gross assets, you should lower the management fee,” Cliffwater chief investment officer Stephen Nesbitt said. “In terms of the incentive fee, I would want to see a higher hurdle and longer look-back to better address alignment of risk.”

To access the additional turn of leverage, a BDC manager can seek approval from its board of directors or shareholders. If a manager asks its board to OK the additional borrowing capacity, the BDC must wait a year to lever above the 1:1 ratio. Should it seek the shareholders’ blessing, the BDC could access the additional leverage the next day.

“The storm is visible on the horizon,” one market source said. “You can use more leverage and have a wonderful impact on management fee income.”

Some BDCs have already approved the new rules. The boards for Apollo Investment Corporation, FS Investment Corporation, Garrison Capital, Monroe Capital Corporation and Prospect Capital Corporation have already approved the capacity to use extra leverage. They will be able to start running their books with a debt-to-equity ratio of more than 1:1 in 2019 should they choose to do so.

Apollo said in its announcement it plans to use the extra leverage to invest in less risky loans.

“We intend to use the incremental investment capacity to invest in lower risk assets which we believe will continue to support our strategy and provide consistent and stable returns for our shareholders,” Howard Widra, president of Apollo’s BDC, said in its statement.

“Over the next year, we will work closely with all constituents – our lenders, our shareholders, the rating agencies, and our board – to discuss how this additional capital will be deployed, and the impact to the company.”

The firm, which charges a 2 percent management fee, declined to comment on its management fee schedule.

For Garrison’s part, the firm charges a 1.5 percent management fee, which it reduced from 1.75 percent last year. The firm did not respond to request for comment about the fee schedule.

“We believe that the company’s focus on first lien loans is conducive to fully utilizing the increase in permissible leverage,” chief financial officer Brian Chase said in a regulatory filing.

“We expect the increase in leverage to be accretive to the company’s earnings once the reduced asset coverage requirements become effective with respect to the company in March 2019 and we begin to grow the company’s balance sheet.”

Monroe chief executive Ted Koenig said he wouldn’t be surprised if the BDC also sought shareholder approval at some point in the future, but declined to comment on any potential future fee changes. Monroe charges a 1.75 percent management fee.

“We’re evaluating the options right now,” he said.

Representatives for FSIC and Prospect could not be reached for comment.

Elsewhere in the space, Triangle Capital Corporation announced Wednesday that Barings is set to become its new external advisor. Barings’ Eric Lloyd told analysts and Triangle shareholders on a conference call that the firm planned to seek shareholder approval for extra leverage levels. The firm set a management fee of 1 percent for 2018. A firm representative could not be reached for additional comment.

Ares Capital Corporation, which charges a 1.5 percent management fee, has recommended it increase its leverage capacity. A source familiar with the matter said the firm hasn’t decided whether it would progress via a board or shareholder vote or if there would be a change in fee structure.

“Some managers have fairly attractive fee schedules and I expect will use the leverage change to enhance shareholder value,” Cliffwater’s Nesbitt said. “Those that do not are going to have difficulty executing on a larger leveraged strategy. They’ll either get blowback from their investors, or they will start selling at deeper discounts.”

A bulwark for shareholders could be the given BDC’s ability to access capital markets. After all, if a BDC is to take on additional leverage, doing so is at the discretion of its lenders or investors willingness to invest in debt securities that the BDC issues.

“There’s some protection in the fact that they still have to get the borrowing to do this,” said John Cole Scott, the chief investment officer and chief compliance officer at Closed End Fund Advisors. “I would say there are some BDCs that are going to improve their bottom lines. It would be nice if managers got paid on net assets, but that would change the business model.”