NEW YORK--(BUSINESS WIRE)--Despite the varied strategies and risk appetites of business development companies (BDCs), one consistent trend across the sector is increasing leverage, according to a new report from Fitch Ratings on the 18 largest BDCs. Against the current market backdrop, it will be challenging for BDCs to manage leverage within targeted ranges, keeping rating pressure on a sector that Fitch has maintained a negative outlook on over the last two years.
"Fitch expects BDCs will have trouble managing leverage in 2016 due to heighted share repurchase activity and the potential for incremental valuation marks, resulting from market movements and deteriorating asset quality, particularly in the energy sector," said Meghan Neenan, Senior Director, Fitch Ratings. "BDCs with elevated leverage and outsized portfolio credit issues could face negative rating actions."
Under the provisions of the Investment Company Act of 1940, BDCs must have an asset coverage ratio of at least 200%, which is equivalent to a maximum debt to equity ratio of 1:1. Failure to maintain asset coverage prohibits the BDC from incurring additional indebtedness or paying dividends. While there have been discussions about potential changes in BDC legislation, effectively allowing BDCs to increase leverage to 2.0x from 1.0x, Fitch does not expect any major developments in the near term. While Fitch's reaction to higher leverage would be negative, it would not automatically result in negative rating action. Instead, Fitch would need to assess a BDC's leverage target in the context of its portfolio risk profile.
On March 9, 2016, Fitch took a variety of negative rating actions as part of its annual peer review of BDCs. Fitch downgraded the ratings for Apollo Investment Corporation (Apollo) to 'BBB-' from 'BBB' and the ratings for Fifth Street Finance Corp. (FSC) to 'BB' from 'BB+'. The Rating Outlook or Watch for five of the 10 rated BDCs is now Negative, which reflects expectations for continued performance and funding challenges in 2016.
"Competitive underwriting conditions, underperforming energy investments and limited access to growth capital are some of the factors contributing to Fitch's negative outlook for the BDC sector," added Neenan. "In addition BDC mangers face mounting shareholder activism, scrutiny over compensation and pressure to maintain their dividends."
The rated peer group was trading at a 14% average discount to net asset value (NAV), as of April 19, 2016, precluding most BDCs from accessing the equity market for growth capital without significantly diluting existing shareholders. With limited access to the equity markets and relatively high leverage, Fitch expects most BDCs will rely on cash from portfolio repayments to originate new deals over the near term. However portfolio repayments are also challenged by decreased middle market M&A volume and slower refinancing activity. A decline in origination and prepayment volume will reduce fee income for the year and, potentially, pressure dividend coverage for some BDCs.
The 'Business Development Company Industry Overview' report includes a comparative analysis of 18 BDCs in the U.S., covering the operating environment, portfolio size, growth, composition, concentrations, asset quality trends, profitability metrics, funding, leverage, liquidity, and valuation.
Additional information is available at 'www.fitchratings.com'.
Business Development Company Industry Overview (A Comparative Analysis of 2015 Financial Performance)