Business development companies (BDCs) were trending ever healthier prior to the pandemic, but if the economy remains in the deep doldrums it may ultimately be their affiliated asset-management companies that investors should look to for assurance.
Initial jobless claims for the week ended May 23 fell slightly, the first drop since the pandemic’s onset, but the consensus anticipates record unemployment for the foreseeable future. (The jobless claims topped 40 million since mid-March when the “shelter in place” strategies and business closings ensued from the coronavirus outbreak in the U.S.)
The small and midsize enterprises (SMEs) that BDCs lend to are especially vulnerable given their typically limited cash on-hand and restricted access to financing.
In a webinar Thursday, analysts at Kroll Bond Rating Agency acknowledged the significant challenges BDCs face.
Option-adjusted spreads on BDC bonds rated single B to Ba by Kroll saw spreads widen from just over 200 basis points in December to more than 900 basis points in March. They’ve since fallen to below 600 basis points, still wide historically as nonaccruals mount.
Nevertheless, BDCs took significant steps before the pandemic that should help them weather the downturn.
“We believe a lot of the BDCs we rate are in a position of strength and better able to absorb the market downs without breaching any regulatory asset coverage,” said Teri Seelig, a director at Kroll.
Seelig noted that many BDCs had issued unsecured debt and extended maturities, giving them more flexibility to support their portfolio of companies. BDCs have also moved toward investing more in first-lien, senior securities, “which we believe will provide somewhat of a cushion going forward,” Seelig said.
In addition, many of the 12 BDCs Kroll rates publicly as well as those with unpublished ratings had already started shifting their portfolios to more defensive sectors, including software, business services and healthcare.
And although the Securities and Exchange Commission allowed them in March 2018 to reduce asset coverage to 150% from 200%, effectively enabling 2 times leverage, most have maintained relatively conservative leverage over the last 18 months of 1.25 times or less.
That’s important, Seelig said, because exceeding asset-coverage limits nixes their ability to issue senior securities if additional capital is required to support their existing portfolios of companies.
“In times of liquidity shortages, those companies have viable businesses but need short-term liquidity to survive the pandemic, and this allows the BDCs to provide that,” Seelig said. “We believe BDCs that have breached or come close to breaching asset-coverage ratios will either issue debt or equity, sell assets, or just allow the portfolio to run off, since a lot of BDC loans are short term.”
Seelig noted that federal government relief has permitted BDCs close to breaches to use 4Q 2019 portfolio valuations rather 1Q 2020 valuations when issuing senior securities.
Looking ahead, said Boris Alishayev, senior director at Kroll, anticipates BDCs using third-party valuation agents to price entire portfolios rather than just portion, as was still prevalent before the crisis. He added that a number of BDC equities trade at a significant discount to their net asset values (NAVs), a valuable reference point implying BDC leverage is “substantially higher than what they’re reporting.”
Alishayev said that most BDCs have sufficient liquidity should portfolio companies tap into their undrawn facilities, and many of those loans carry covenants that give BDCs negotiating power to push private equity sponsors that own the companies to provide additional equity.
One concern is that leading up to the pandemic, BDCs were participating in ever larger loans, as big as $500 million—three times the size of loans they traditionally invested in—resulting in more concentrated exposures.
“When we think about scale, we also worry about concentration on some of those positions, and how well the BDCs and their larger asset-management platforms can actually manage those exposures,” Alishayev said.
He noted the importance of understanding the support of the overall asset-management platform to which the BDC may be a part of, especially in light of new “co-investment relief” provided by the SEC. On April 8, the regulator made it easier through year-end for BDCs and their affiliated private funds to make follow-on investments in portfolio companies through.
“This should provide the necessary liquidity for portfolio companies to get through the crisis,” Alishayev said.
