In Part I of our bromide about the Biggest Threat to the BDC sector we showed how leveraged lending to middle market companies has become increasingly popular amongst a range of old players and new players, less than a decade after lending was left for (almost) dead by the Great Recession. Furthermore, we added that the combination of additional sources of capital flooding into the sector combined with a limited supply of transactions was affecting the 45 public BDCs we tracked. More ominously, we suggested the “biggest threat” to those BDCs was contained in this change of circumstances. Let us proceed to identify the guilty party. We warn you, it may not be what or whom you expected.
Readers might expect that we would suggest the threat to the existing BDC players from all these new competitors would be the now-famous “spread compression”. We’ve been known to bang on about this phenomenon, which is forcing lenders to drastically reduce loan yields to “win” transactions, for months. We wrote an article about the subject on April 10, 2017 simply called “Bothered”. It’s an undeniable problem for all the BDCs we track, whatever segment they’re in, and is not going away soon. In recent weeks the groups that follow such things have been suggesting that spread compression has stopped and there is a mild push back on pricing by lenders. However, that’s after a substantial cuts in yields, which were not that high to begin with, given we are in Year 8 of an expansion. More importantly, this is the curse that keeps on giving. The leveraged loan market does not re-price itself in one quarter, but takes several periods for borrowers to get out of their existing commitments and take advantage of ever cheaper and looser money. BDCs – and all other lenders – will be feeling the impact of the loan compression story, for many, many months to come. We’ve said elsewhere than we expect “loan compression” to rob most BDC lenders of the expected benefits from higher LIBOR rates and the phenomenon of being able to charge borrowers more as “floors” are breached. Even if the Fed continues to raise rates and LIBOR continues to climb, we expect average yields for the same level of risk will continue to go down and down as refinancings occur.
BAD BUT NOT THAT BAD
Yet, “loan compression” is not – in and of itself – a dire threat to the BDC sector. Yes, earnings could/should be affected by the ineluctable mathematics involved in lower income yields on assets at risk, while further down the income statement BDCS have to contend with higher interest expense on any floating rate borrowings, BDC Management Fees are tied to asset values and remain unchanged and other operating expenses remain stubbornly high as a percentage of portfolio assets even as the funds grow. If everything else remained unchanged BDCS would necessarily face lower earnings per share from the phenomenon. That would not, though, be an existential threat to the BDC sector even if unhappy shareholders might face drastically lower distributions and some managers marginally lower Incentive Fees.
WHAT SHALL WE DO ?
The threat (yes, we’re finally getting to the point) lies in how the public BDCs react in the quarters ahead, and we’re not optimistic. We are certain that in the face of tougher pricing and worse loan credit quality none of the BDCs we track will choose to sit out this phase. You will not hear a BDC CEO step up on the next Conference Call and say: “Given that we can’t earn a decent risk-adjusted return, we’re not going to book any new loans and just live with the portfolio that we have today, even if that means a shrinking balance sheet and lower absolute returns”. Of course, BDC are permanent equity vehicles and will seek to be fully invested at all times – even these times. In fact, BDCs can readily justify to themselves and others raising new capital – even if it’s to be invested in loans yielding the lowest spreads in 8 years and the highest debt to EBITDA levels ever (even higher than 2007). In recent weeks Golub Capital (GBDC), Monroe Capital (MRCC) , PennantPark Floating Rate (PFLT) , Goldman Sachs BDC and Alcentra Capital (ABDC) and several others have essentially made that argument by issuing new shares and seeking to grow. Their defense would be – besides the unconvincing and counter-logical claims in their Prospectuses – is that their shareholders expect them to stay active in the markets in all conditions. The BDC Reporter has heard it said on Conference Calls and in conversations with the BDC principals: “We’re not here to time the credit markets any more than investors can time the stock markets. We’ve just got to continue achieving the best return we can”.
It’s a compelling point and the way things work. The question is how the BDCs are going to go about earning their daily bread with so many competitors and few “good” deals to choose from. (Their words, not ours). Furthermore, we wonder how BDC managers -whether internal or external – are going to contend with the expectations of their shareholders anxious to see their pay-outs unchanged. (We hear there are even a few optimistic should hopeful for dividend increases !).
We know it’s been nearly a decade and the landscape looks different in many ways, but in this regard BDCs have been down this route before and every lender has faced this dilemma in every lending cycle: How and where to lend in an increasingly unfavorable environment ? Back in 2007 and early 2008 BDCs were up against the same problem, and things did not go well. We like to remind ourselves late at night that no BDC has ever gone bankrupt but that doesn’t mean that a huge amount of investor capital cannot be lost forever. That’s what happened to many famous and not-so-famous BDC participants because of decisions they made in an attempt to remain “competitive” in the Go- Go Days of a decade ago. What they did then was instructive because the same strategies are being repeated now – even by the Wise and The Good – in the BDC community, and they risk an equal or even worse result than before. In some cases, what the Great Recession began in terms of bringing low certain BDCs might “finish them off” this time round. Other Big Names face the risk of falling and not getting back up all the way.
OBVIOUS BUT NEEDS TO BE SAID
First of all, most BDCs “leveraged themselves up” in order to sustain their earnings and distributions. The BDC regulations require that total assets owned exceed by at least 200% all debt outstanding. Effectively that limits debt to equity to one to one. Currently many BDCs are even more leveraged than they were or could have been as what would become known as the Great Recession began to occur. Thanks to various loopholes in the rules – blessed in part by the regulators and demanded by the asset managers – many BDCs effective debt to equity is way above the 1.0 limit due to use of SBIC subsidiaries (2:1 leverage is the standard there) or Joint Ventures (3:1 leverage in many cases) or investing in structured products (up to 14: 1 leverage).
This all worked well the last time till it didn’t.
Leveraged lending is a highly cyclical business and most of the credit problems get bunched up in one year of a cycle that has usually lasted between 5 and 10 years. When that change comes the losses begin to register. Before that happens, though, the credit markets freeze up as everybody re-adjusts their expectations and the value of existing loan assets drop sharply in value. Even outside of great recessions these moves can cause asset values to drop 10%-20%. (Nobody listens when we mention the 30% drops that occurred at times in the past so we’ll go with the milder version). That’s an average, of course, and the experience of your BDC will vary depending on how they’ve been lending. However in 2008 even the most liquid, highest non investment grade big cap senior loans dropped sharply in value. Unfortunately for a highly leveraged BDC with rules to follow that can cause catastrophic consequences. Asset coverage limitations are broken, dividends are suspended as per the rules and loans have to be sold into an unresponsive market where everyone is in the same boat, or kept on the books at their temporarily diminished values.
Either way, imagine what a 20% drop in loan prices value does to your book value when half your portfolio is funded with debt ? That’s a 40% drop and usually occurs in the blink of an eye, or at least within a quarter or two. We ask readers to pull up the balance sheet of their favorite BDC and look how it would fare if next quarter the value of the assets was reduced by 20%. We looked down our own handy list of every BDC and were hard pressed to find anyone who could pass that test.
BDC DENIALS NOTWITHSTANDING
Besides “leveraging up” BDCs also boost earnings in a declining yield environment by booking riskier assets. Of course, BDCs are already typically participants in the higher risk zone of the non investment grade credit markets at the best of times. To go hunting for even more risk at the end of an economic cycle is begging for trouble. Of course that’s just what happened last time. Investors found out after the fact that their BDCs had been involved in effectively equity risk like investments posing as standard loans. Only strong fund flows and generous valuations kept anyone from noticing until it was too late. It wasn’t just that loans temporarily lost value in 2008-2009. Once the dust had cleared shareholders found in many cases that there was plenty of fire to go with that smoke. Or,in other words , there were plenty of very poor loans on the books, which took several years to work off in one way or another. We won’t name names but the BDC Reporter estimates that three-quarters of the 23 BDCs that were around at the time ended up fessing up to very troubled portfolios. Only 4 of the 21 BDCs that came through to the other side (Allied Capital and Patriot Capital were absorbed by other BDCs) were able to avoid cutting or suspending their distributions.
NOTHING REALLY CHANGES
Today, the situation is not so different and the managers at many of the BDCs are the very same who were there a decade ago. They once again face the pressure to maintain the dividend and believe themselves forced to take on ever higher levels of risk to meet their fiduciary obligations. Of course, no BDC ever admits to moving up the risk scale. On the contrary most are claiming to be eschewing “riskier loans” for “first lien secured debt”. However, this is in conflict with what the BDC Credit Reporter finds when we look at each portfolio in turn. Risk reduced in one area will be added elsewhere in order to generate the necessary yields. A great example are the Joint Ventures. Many BDCs are lending to relatively lower risk borrowers at 6-8% yields but then “leveraging up” the JV vehicles with two extra turns of debt for every dollar invested. Or a “unitranche loan” will be made, which effectively is a mixture of debt and equity, and be titled a “senior secured” financing.
Also disturbing is that some BDCs are entering new market segments (“verticals” as they’re called) to find enough appropriate transactions for the origination tunnels. The disadvantage is that credit committees and Board members do not have familiarity with the risks involved. Moreover, a commitment to a “vertical” usually results in a greater-than-average amount of capital getting committed to that specific area. Fine if everything works out but increases concentration risk when that sector happens to blow up. We can’t help mentioning Energy in this context. If the bottom falls out of certain major segments of Healthcare – for example – we could have a similar consequence in terms of credit losses than we had in 2014-2015.
This time is no different than before. Like in 2007, new entrants are rushing into the leveraged lending market, leading with lower yields and weaker protections. As they were 10 years before, BDCs are still public companies with a need to maintain earnings and distributions or face shareholder backlash (and lower management fees). Worse than before, BDC appetites for taking on leverage have only increased. (Most of the players are still lobbying Congress for even more borrowing capacity). Many creative ways have already been found to get round the 1:1 Debt To Equity rules which were not sufficient even last time to keep four-fifths of BDCs from cutting their distributions. Yet, like before, BDC rules require 200% asset coverage at all times, tested quarterly. Like always, nobody knows when the next recession is coming, and that adds to the risk as none of the BDC players want to pull out or cut back prematurely.
By Nicholas Marshi, BDC Reporter