Fitch: Leverage Limit Increase Could Differentiate BDC Ratings

Proposed regulation to increase business development companies' (BDC) maximum leverage level (legislation H.R. 31/1800) won't likely result in immediate or sector-wide rating changes, according to Fitch Ratings. However, Fitch generally views the potential leverage increase as a negative for credit quality.

The manner in which individual managers utilize a potential leverage limit increase relative to the seniority and liquidity of their portfolios will determine which BDCs might be exposed to negative rating pressure. This could increase rating differentiation amongst Fitch-rated BDCs, which are currently centered in the 'BBB' rating category.

Under the proposed legislation, asset coverage requirements for BDCs would decline to 150% of debt from 200% of debt, effectively allowing BDCs to increase debt to equity leverage to 2.0x from 1.0x. While the legislation process is ongoing, the bill has passed the subcommittee and could go to the House of Representatives for a vote as early as the first half of 2014. Supporters of the bill argue that the higher leverage limit would increase the availability of lending to the middle market, an activity that banks have pulled back from due to regulatory capital limitations. Supporters also view a leverage increase as a means to increase portfolio credit quality, seniority, and liquidity, all while improving equity returns.

Fitch believes ratings for BDCs are capped at the 'BBB' rating category due to the relative illiquidity of BDC's assets, the market value sensitivity of the BDC structure, dependence on the capital markets to fund portfolio growth, and a limited ability to retain capital due to dividend requirements. A key factor underpinning this rating view is the current leverage limit of 1.0x, which contributes to stronger recovery prospects for debt holders, even if portfolio investments are exited at a meaningful discount.

Absent a corresponding increase in leverage, an increase in the regulatory leverage limit would increase a BDC's asset coverage cushion. This could better mitigate the illiquidity of BDCs' assets and the mandatory deleveraging inherent in the BDC structure. However, during a prolonged period of economic stress, a more rapid deleveraging and/or sale of assets may be more advantageous from a debt holders' perspective, although that would likely be accompanied by reduced asset valuations.

While asset coverage cushions would immediately increase at the time the bill is passed, Fitch expects cushions would decrease over time as BDCs increase leverage. For example, BDCs may elect to invest in more senior positions, such as middle-market asset-backed loans (ABL) and bank loans. These offer lower yields relative to current BDC investments, but when accompanied by higher leverage allow for comparable levered equity returns. It is not economically feasible for a BDC to invest meaningfully in ABLs and bank loans now given that these types of investments cannot generate returns above BDCs' hurdle rates. While ABL and bank loans may generally exhibit increased asset liquidity relative to current BDC investments, this differential may be limited in a stress scenario.

The use of incremental leverage will vary by company, with some being more aggressive than others, which could differentiate ratings among Fitch-rated BDCs. BDCs with a senior secured investment focus could feel pressure to raise internal leverage targets if competition is running at higher leverage levels and earning higher returns for shareholders. The use of increased leverage simply to increase equity returns by levering up riskier assets with lower recovery prospects would negatively pressure ratings.

Before any additional leverage could be added, BDCs would need to amend their bank credit facilities. Currently, all Fitch-rated BDCs use their credit revolvers for working capital needs and/or longer-term financing, and the majority of these credit facilities have a 200% asset coverage covenant. In order to take leverage above 1.0x, the banks would need to amend the asset coverage covenant to 150%. If banks agree to the amendment, this would ultimately be a governor of how much additional leverage BDCs could employ, given advance rates on different asset classes.

Additional information is available on www.fitchratings.com.

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.

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