A Fitch report released yesterday (25 April) assigned a negative sector outlook to business development companies, citing increasing leverage and the likelihood of heightened share repurchase activity among the factors influencing its judgement. Evaluating 18 US BDCs' 2015 performance and looking ahead for issues that will impact their performance this year, Fitch downgraded Apollo Investment Corporation and Fifth Street Management as part of the review.
“Competitive underwriting conditions, underperforming energy investmentsand limited access to growth capital are some of the factors contributing to Fitch's negative outlook for the BDC sector,” said Fitch Ratings senior director Meghan Neenan in a statement. “In addition, BDC managers face mounting shareholder activism, scrutiny over compensation and pressure to maintain dividends,” she added.
Fitch said in the report that wider market dynamics had played an important role in the slowdown in overall activity experienced in 2015. The ratings agency expected the decline to continue this year due to lighter deal flow and capital constraints facing much of the sector. The average investment size for the group covered in the report was $24.8 million, with Prospect's $47.5 million average investment the largest and Golub BDC's $9 million average the low end of the range.
The report noted that BDC leverage is increasing, with a 7 basis point year-over-year increase in leverage among the companies included in the study. This was attributed to a rise in unrealised portfolio depreciation, given negative marks on energy investments and widening market spreads. Another factor in increasing leverage was what Fitch labelled “meaningful” share repurchase activity, citing the fact that $732 million in BDC stock was repurchased last year by 14 of the 18 companies examined in the study.
“One challenge of the BDC model is that share prices often decline when underwriting conditions (i.e. market spreads) improve, as spreads widen in response to asset-quality concerns, lower earnings predictions or broader economic pressures,” Fitch wrote in the 37 page report.
Fitch also discussed potential regulatory changes that could impact BDCs in the years ahead. It noted that legislation currently being discussed (the Small Business Credit Availability Act, HR 3868) would allow BDC leverage to increase from 1x to 2x through a decrease in asset coverage requirements from 150 percent from 200 percent. The bill would also change the definition of non-qualifying assets, which generally include non-US securities, public companies with capitalizations above $250 million, CLOs and finance company investments.
Such changes, Fitch said, would not necessarily lead to any downgrades, but would have the cumulative effect of increasing the amount of risk in the sector. Fitch also added that new industry verticals, including Apollo's aircraft lending business, Ares' venture lending business and Solar's life sciences vertical have the potential for attractive rewards but also require appropriate in-house expertise.
In an interview, Neenan added that the BDC sector was “ripe for consolidation,” but that complications, such as those related to external management structures, would likely make potential deals more difficult to close. She said she sees the potential for some sales within the sector but the possible regulatory changes addressed in the report would not likely pass until after the US presidential elections.