By Andrew Hedlund and David Brooke
NEW YORK, March 27 (LPC) - Business development companies (BDCs) are seeking to reassure their investors as they face a one-two punch from the coronavirus pandemic and fears of a deep recession rattle the US.
BDCs are closed-ended funds that trade on public stock exchanges. The funds invest in small and medium-sized companies. Because of the added risk of financing smaller, less diversified businesses, BDCs present yield-seeking investors with the opportunity for higher-than-average returns.
Some of the largest funds, including those run by Ares Management, TPG and venture lender Hercules Capital, have released letters to stakeholders saying the credit managers are monitoring their holdings and are prepared for the uncertain times ahead.
“We believe the ongoing implications of Covid-19 will have a significant impact on the real global economy, and we, like many others, are executing contingency plans for this public health and economic event,” wrote Joshua Easterly, chairman and chief executive officer of TPG’s BDC, TPG Specialty Lending, in a note to stakeholders.
Ares’ BDC, Ares Capital Corp said it has been “in constant dialogue” with its borrowers and owners as they “evaluate each situation independently,” Kipp deVeer, the fund’s chief executive officer, wrote in his correspondence to stakeholders. Meanwhile, Hercules has been “maintaining close communications” with the vehicle’s portfolio companies to “proactively assess and manage potential risks” across their borrowers, according to the company’s statement.
Ares, TPG and Hercules spokespeople could not be reached for comment by press time.
Since the Small Business Credit Availability Act doubled the amount of leverage BDCs can take on in 2018, many of the funds increased their leverage capacity.
But in a downturn scenario, this regulation, aimed at bolstering earnings power for BDCs, could also mean that losses will hit these funds harder.
“It’s comforting that BDC liabilities are set up really well, but they do have more leverage than 2007. And that higher debt level can have a magnifying effect on loss rates,” said Ryan Lynch, an analyst at investment bank KBW.
The average leverage for publicly traded BDCs increased for the ninth straight quarter to a debt-to-equity ratio of 1.05 times, up from a five-year low of 0.73 times in the third quarter of 2017, according to Refinitiv LPC data.
BDCs borrowed US$6.4bn over the last 14 months, and the debt held by BDCs is, on average, due to mature in 2022, according to Fitch Ratings.
WAIT AND SEE
It is too early for some portfolio companies to assess the impact of the potential recession that could result from the pandemic. The obvious problem areas remain the energy and travel and leisure sectors, but that could spread.
“The primary issue for companies is going to be liquidity,” Robert Dodd, a BDC analyst at investment bank Raymond James, said. “You’re going to have businesses that are in a seemingly OK segment of the economy that have a significant problem because of their liquidity position.”
BDCs have only recently reported fourth-quarter results through year-end, which showed an increase in non-accruals, or defaulting assets. There was an increase across the market to 3.4% in the last three months of 2019 from 3.2% at the end of the third quarter, according to Refinitiv LPC data. For context, the four-year high of non-accruals was 4.6% in the first quarter of 2016 and the four-year low of 2.8% came in the second quarter of 2018.
In addition to non-accruals, paid-in-kind income, or when a lender defers an interest payment until the loan comes due, is an important indicator of a BDC’s portfolio health, Dodd said. To accommodate financial difficulties, BDCs may defer a cash interest obligation into a PIK payment, a sign the borrower may not have the funding to service their debt, before putting the borrower on non-accrual. (Reporting by Andrew Hedlund and David Brooke; Editing by Michelle Sierra and Kristen Haunss)