Most BDCs will need time to boost lending capacity

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When limits were lifted on the amount of borrowed money that business development companies could put to work, there were concerns that they would rush to take advantage of the new rules, adding to the competition to lend to small and medium-sized companies.

New research from DBRS suggests that’s not the case.

The Small Business Credit Availability Act (SBCAA), which became law in late March 2018, increases the amount of debt BDCs can employ, relative to their equity, to 1.5 from 1.0 previously. There are two ways BDCs can get approval to access the higher leverage levels. The simpler and less expensive option involves getting approval from the BDC’s board of directors. However, this method requires a one-year cooling-off period before the lenders can borrow in excess of 1.0 their equity. A faster, but more labor-intensive option is to get shareholder approval; this allows BDCs to increase leverage on the following day.

Since the law took effect, 25 of the 40 BDCs that DBRS tracks have received approval from their boards to operate under a higher regulatory leverage limit, putting them in a position to increase leverage toward the middle of this year. DBRS only cited a single example, the $729 million Goldman Sachs BDC, in its report. Others include industry heavyweights Ares Capital Corp. ($12.3 billion of assets), Apollo Investment Corp. ($20 billion) and PennantPark Floating Rate Capital ($2.7 billion), according to company press releases.

Of the 25 BDCs tracked by DBRS that sought board approval, 14 also sought shareholder approval, allowing them to increase leverage right away.

Still, DBRS characterizes the industry's overall approach to increasing leverage as “measured.” The report, which was published Wednesday, notes that the BDCs that have adopted the higher leverage limit have committed publicly to target ranges that provide a “solid cushion” below the new regulatory limit. Typically, these new target leverage ranges are between 0.9x and 1.25x.

"Setting the range at a conservative level ensures that the BDCs have a sufficient cushion below the regulatory limit to cope with adverse events" that might cause them to mark down the value of a holding or sell it at a loss, the rating agency notes in its report.

Importantly, DBRS says, BDCs still face restrictions if they breach the regulatory leverage limit. These include a prohibition from issuing additional debt or preferred stock or declaring dividends on its common stock, the report states.

Shareholder consent and rating agency concerns are not the only things keeping BDCs from stepping on the gas, however. In many cases, covenants with their existing lenders and creditors also restrict the amount of debt they can take on. These agreements need to be amended to put restrictions in line with the new higher regulatory limit.

In November 2018, eight months after the regulatory limit on leveraged was increased, Apollo announced that it has amended its senior secured revolving credit facility to decrease the minimum asset coverage financial covenant from 200% to 150%, according to a company press release. The BDC's lenders also increased borrowing capacity under the facility by $400 million from $1.19 billion to $1.59 billion. The maturity was also extended by approximately two years to November 2023.

In the press release, Gregory W. Hunt, Apollo’s CFO, said the company intends to “prudently increase leverage over the next 18 to 24 months with a target debt-equity ratio of 1.25x to 1.40x.” And CEO Howard Widra said Apollo would use the incremental investment capacity to "shift the portfolio mix to more senior, first-lien floating rate loans."

The same month, PennantPark announced it had completed all necessary amendments to its secured credit facility to enable it to use the incremental leverage provided by the SBCAA; the facility was also upsized to $520 million from $405 million.

In some cases, credit facilities cannot be amended; the only option is to wait until they can be replaced. Gladstone Capital, a BDC with $327 million in assets, has obtained board approval to increase its permitted leverage that takes effect in April 2019. However, the company has said it will not be in a position to act on this approval until it refunds its existing preferred stock, which has a covenant restricting leverage. This will not be possible until September 2019. Gladstone will also have to modify covenants with bank lenders, but the company does not expect this to be difficult.

“Once completed, you should expect us to see us move to the 0.9 to 1.25 debt-to-equity range, which is intended to provide us the flexibility to be more competitive on senior secured assets that we originate in the marketplace while providing incremental cost efficiencies and enable us to improve the returns to our shareholders,” Gladstone President Bob Marcotte said in November during an earnings conference call.

BDCs are an important source of credit for small and medium-sized businesses as banks increasingly focus on lending to larger companies. But before the SBCAA was enacted, many BDCs were starved of capital. They were unable to raise equity capital because their stocks had been trading below net asset value, and without new equity, they were unable to take on more debt.

Research published last year by William Blair indicates that the number of IPOs and follow-on offerings by BDCs plummeted in recent years after surging to a high of 39 in 2012. From the beginning of 2015 to March 2018, there were only 45 BDC equity offerings. On the debt side, activity peaked in 2013, according to the investment bank.

Increasing leverage limits could create a positive feedback loop, as BDCs put more money to work, enhancing the value of their common stock, which in turn could allow them to issue new shares. (BDCs must seek shareholder approval for follow-on offerings when their stock is trading below net asset value.) That's assuming they can find enough attractive investment opportunities.

Not all BDCs are starved for capital, however. Golub Capital BDC’s shares have traded at an average premium to net asset value of 15% over the past few years, giving it serious buying power. In November 2018, the company announced an agreement to acquire a sister BDC, Golub Capital Investment Corp., in a stock-for-stock transaction. Following the merger, GBDC is expected to be the fourth-largest externally managed, publicly traded business development company, with $3.5 billion of assets.

Golub executives said on a conference call that the combined company would have improved access to funding in the securitization market. (Golub recently got a green light from the Securities and Exchange Commission for the BDCs preferred method of complying with risk retention rules.)

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