Nerves around the cliff edge

Will BDC investors remain on safe ground or will they be imperilled by new regulations around the use of leverage?

For those worried that rules allowing business development companies to bump up their use of leverage might plunge the financial system into another crisis, a little perspective could help. While the sub-prime mortgage market was worth more than $1 trillion in 2007, the total assets held by BDCs at the end of last year were around $60 billion. The world seems safe.

However, this does not mean there are no grounds for concern. As soon as the proposal to raise BDCs’ maximum leverage from a ratio of 1:1 debt to equity to 2:1 debt to equity was signed off as part of the $1.3 trillion spending bill in the US this week, some grumblings were heard.

Notably, ratings agencies – keen to avoid the disastrous underestimation of risk that proved their undoing pre-crisis – were quick to make clear their worries. Fitch said any moves by BDCs to take advantage of the new rules to increase leverage would be negative for ratings – while adding that any assessment would take the nature of a BDC’s portfolio into account rather than tarring everyone with the same brush.

Of particular sensitivity is the fact many investors in BDCs – listed companies compliant with the 1940 Investment Act that provide finance for small to medium-sized businesses – are ordinary members of the public. Even for sophisticated institutional investors, working out whether increased leverage is appropriate or not can be a challenging task.

Some BDCs will be only too happy to max out on debt, seeing it as a way of staying in with a chance of winning deals in an increasingly competitive market. Here, there may be a danger of piling too much risk into their portfolios. In other cases, where highly conservative portfolios are weighted to plain vanilla senior loans, it may be entirely sensible to use extra leverage. But can casual day traders be relied upon to fully appreciate these different scenarios?

Those BDCs that choose to take advantage of the greater flexibility they have been given will no doubt point out that a 2:1 ratio is still relatively modest given that banks have had much more hubristic debt/equity ratios than this in the past.

However, a recent Bloomberg article pointed out that some BDCs have found ways to exploit exemptions to the 1:1 rule and incorporated significantly more leverage than the rules were designed to allow. Added to which, some BDCs have supported deals that banks would pass on based on the level of risk and amount of leverage. There are also concerns that a more highly leveraged BDC market could help fuel an already buoyant CLO market – potentially nudging the latter closer to bubble territory.

Will BDCs use their new freedom wisely, or has the spending bill built a house of cards that will ultimately come tumbling down? The answer will tell us much about the long-term sustainability of the market.

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