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LPC: Falling loan pricing and repayments weigh on BDC earnings

By Leela Parker Deo

NEW YORK, Aug 16 (Reuters) - Sliding loan pricing and increased repayments are continuing to curb the profitability and growth of Business Development Company (BDC) funds that lend to private U.S. midsized companies.

BDC share prices have been under pressure as investment income has fallen, which is raising fears about dividend coverage and even dividend cuts, as the funds report results for the three-month period ended June 30. An upturn in the rates of non-performing loans is also seen as a threat.

Of the 67 BDCs that have reported earnings to date, 20% have shown an increase in the value of their loan investments from when the loan was booked to its fair value today, according to BDC Collateral.

The sector is trading at an average 7% discount to Net Asset Value (NAV), which measures mutual funds’ price per share. At the beginning of May the sector was trading at book value.

“Earnings are still under pressure. It’s more of the same. A very competitive environment marked by tight spreads, and more opportunistic refinancings taking out high-yielding assets. Growth continues to be difficult when you are getting repaid faster than you can originate deals,” said Meghan Neenan, senior director at Fitch Ratings. “We do expect to see some dividend cuts by the end of the year.”

The red-hot US leveraged loan market has been repricing loans for more than a year, which is hitting BDC’s interest income and shrinking portfolios or curbing growth as companies slash borrowing costs on leveraged loans. The funds are also absorbing increased loan repayments which are eroding portfolio yields as the proceeds are reinvested into lower-yielding loans.

PennantPark Investment Corp’s (PNNT) portfolio shrank after US$199m of repayments exceeded US$89m of new investments, which left the fund with US$103m in cash at quarter-end, Wells Fargo BDC analysts said in a report.

Capitala Finance Corp (CPTA) deployed a total of US$6.5m in the most recent quarter, but had US$49m in repayments, which is curbing portfolio growth, Jefferies analysts noted.

FS Investment Corp (FSIC) reported that its total commitments to direct originations, including unfunded commitments, in the second quarter was US$197.1m while the investments that it exited, including partial paydowns, totaled US$218.3m.

FSIC also said that although it declared its third quarter dividend unchanged, it expects to cut its dividend by 15% in the fourth quarter and the fund’s adviser agreed to waive a portion of its 1.75% base management fee starting in October.

The wall of cash that has flowed into U.S. middle market lending strategies in the last 18 months has made leveraged loan origination and underwriting significantly more aggressive on terms and price.

Around US$35bn has been raised for middle market lending in 2017 so far, compared to US$60bn raised in 2016, according to Thomson Reuters LPC data. Nearly two thirds of the money raised in 2017 has been allocated to direct lending funds while BDC’s equity capital makes up less than 5%. Middle market Collateralized Loan Obligation funds account for 20% of 2017 fundraising and mezzanine strategies make up close to 13%.


HEAD OF THE CLASS

Despite an increasingly crowded and competitive field, some BDCs are continuing to outperform their peers, which is differentiating them from the pack. TPG Specialty Lending Inc (TSLX) was praised by analysts for its continued strong yet conservative dividend coverage and emphasis on extracting prepayment fees when loans are refinanced.

TSLX generated an annualized 13% return on equity on repayments, Wells Fargo analysts said, noting that “credit quality was again pristine … and NAV increasing slightly to $16.15/share.”

Ares Capital Corp’s (ARCC) also turned in a strong performance in the second quarter. Jefferies analysts said that while yield compression drove lower than forecast interest income, ARCC remains one of the best positioned BDCs for growth based on leverage capacity and existing liquidity.

“Ares has seen significant repayments and yet is consistently able to generate a significant amount of underwriting every quarter showing that scale and deal origination capabilities do differentiate platforms,” said Neenan.

With its quarterly results, ARCC also announced the purchase of the remaining US$1.6bn in loans in the Senior Secured Loan Program which concludes the winding down of a legacy joint venture with GE Capital. The resolution provided an immediate portfolio yield boost which increases the fund’s capacity to invest in higher yielding assets and ramp up its replacement—the Senior Direct Lending Program—more quickly. (Reporting by Leela Parker Deo; Editing By Tessa Walsh)