The risk of rising leverage from possible energy-related valuation write-downs and/or realized losses for 10 Fitch-rated business development companies (BDCs) is manageable, even under a scenario where oil and gas-related investments are written off completely, says Fitch Ratings. The agency is anticipating an increase in unrealized portfolio depreciation for BDCs with energy exposure when firms release fourth-quarter results next month.
In a new report, Fitch shows that stress tests on BDCs' energy and, more specifically, oil and gas portfolios, would leave all 10 firms with sufficient equity cushion to not overstep the 1.0x debt-to-equity leverage threshold required for a BDC to maintain full compliance with the Investment Company Act of 1940 and, in many cases, debt covenants. Even under a highly unrealistic scenario reflecting a total write-down of all oil and gas exposures, leverage levels for all but one firm would remain under the 1.0x mark.
Fitch conducted one test by applying haircuts to the Sept. 30, 2014 fair values of each of the 10 BDCs' oil and gas investment positions. We found that when first-lien investments were stressed 10%, second-lien investments 20%, subordinated investments 30% and all other investments 50%, the average leverage ratio for the group would increase about 0.02x, and by no more than 0.04x for any individual firm. Expanding the scope of the stress test to all energy-related exposures resulted in little difference in the resulting average leverage changes. A further stress was applied by completely writing off the oil and gas investments, which yielded a 0.08x increase in average leverage for the rated sector.
The combination of modest starting leverage levels, limited outsized exposures to the energy sector and an emphasis on investments higher up the capital structure structures explain the limited leverage increases under our stresses.
PennantPark Investment Corporation (PNNT) and Apollo Investment Corporation (AINV), the two firms with the most significant exposure to oil and gas, and energy broadly, would experience leverage increases of 0.03x, (to 0.67x) and of 0.04x (to 0.80x), respectively, under the partial write-down scenario on their oil and gas-related books.
The leverage starting points for the 10 BDCs in our rated universe averaged 0.54x as of Sept. 30, 2014, while exposure to oil and gas investments accounted for about 7.1% of the aggregate portfolio investments for the group. Most of the oil and gas investments are relatively high up in capital structures, with 60.6% of the total exposure being first liens, 17.5% second liens, 18.8% subordinated loans and 7.1% other investments.
Fitch recognizes that not all investments would perform the same under a stress scenario and thus, the test is not associated with any specific oil price scenario over the near term. While some investments may be categorized as oil and gas, their ultimate performance may not be directly affected by movement in oil prices. Conversely, other investments will be directly affected, but the impact could be muted by effective hedging strategies.
The focus of Fitch's stress test was direct portfolio company investments, but some BDCs may have additional exposure to the energy sector through their investments in structured products, such as CLOs.
Fitch also identified seven oil and gas investments that are common across more than one BDC. For the same investment, relative valuation adjustments may differ for firms invested in different parts of the capital structure, but Fitch believes valuation marks for similar investments could highlight differing valuation approaches and views of the magnitude of the stress energy exposures are undergoing.
While BDCs appear well positioned to weather energy price declines, in isolation, a number of other industry challenges, including heightened competition, declining asset yields, dividend coverage pressure, increased leverage and expanded investment strategies support Fitch's negative sector and rating outlooks for BDCs and could pressure ratings in the future.
Fitch's complete report can be found at www.fitchrating.com titled, "Business Development Companies: Energy Stress Test," dated Jan 29, 2015.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
Applicable Criteria and Related Research: Business Development Companies: Energy Stress Test (Balance Sheets Positioned to Withstand Energy Portfolio Writedowns)
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=859989
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