RATING ACTION COMMENTARY
Fitch Affirms Solar Capital Ratings at ‘BBB-‘; Outlook Stable
Fitch Ratings – Chicago – 17 Apr 2020: Fitch Ratings has affirmed Solar Capital Ltd.’s (Solar) Long-Term Issuer Default Rating (IDR), senior secured debt rating and senior unsecured debt rating at ‘BBB-‘. The Rating Outlook is Stable.
KEY RATING DRIVERS IDR and Senior Debt
The affirmations reflect Fitch’s view that Solar’s asset coverage cushion will remain appropriate for its rating, despite expectations for negative portfolio valuation marks in the near term and an increase in credit issues in the medium term, given its relatively low leverage as of Dec. 31, 2019. The rating affirmations also reflect Solar’s first-lien portfolio profile, low non-cash income, prudent dividend management and a demonstrated willingness to moderate portfolio growth in a highly competitive underwriting environment.
Rating constraints specific to Solar include higher relative exposure to nonqualifying assets, which were 22.9% of total assets as of Dec. 31, 2019, and a lack of affiliation with a broader investment platform, which could be a headwind should bank financing become more constrained for the sector.
Rating constraints for the business development companies (BDC) sector more broadly include the market impact on leverage (given the need to fair-value the portfolio each quarter), a dependence on access to capital markets to fund portfolio growth and a limited ability to retain capital due to dividend distribution requirements. Additionally, the competitive underwriting environment in recent years has yielded deterioration in terms of the middle market, including fewer/looser covenants and higher underlying leverage. Fitch believes a sustained slowdown in the economy, which could result from the coronavirus pandemic, is likely to translate to asset quality issues more quickly given the limited embedded financial cushion in most portfolio credits and weaker lender flexibility in credit documentation. Recently relaxed regulatory limits on leverage are an evolving sector headwind, which could contribute to increased risk profiles for individual BDCs.
Solar’s leverage ratio was 0.66x as of Dec. 31, 2019, which implied an asset coverage cushion of 40.6%. Solar’s cushion is above the peer average and within Fitch’s ‘a’ category leverage benchmark range of 33%-60% for BDCs. Fitch believes Solar is relatively well-positioned as its portfolio can sustain a valuation decline of more than 33% before its asset coverage cushion falls to the low end of Fitch’s ‘bbb’ category benchmark range of 11%-33%. While not currently anticipated, should Solar decide to opportunistically shift the portfolio into more junior debt investments, Fitch expects that Solar would maintain the covenant cushion at an appropriate level to account for potential valuation volatility in the portfolio and/or realized losses.
While Fitch believes Solar’s exposure to borrowers in the hardest hit corporate sectors – including travel, leisure, retail and energy – are manageable, social distancing guidelines have pushed the U.S. economy towards a recession, which will have credit implications for the entire portfolio. Solar’s credit performance has been strong in recent years and superior to peers, albeit in a very benign credit environment. The firm had only one investment on non-accrual status as of YE19, representing 0.5% of the portfolio at fair value and 1.6% of the portfolio at cost, both of which were better than the peer average. Fitch expects non-accrual and/or realized loss metrics to tick up in 2020, but the agency would view meaningful realized losses negatively, particularly if credit metrics underperform the peer group.
In addition to senior secured cash flow loans, Solar also provides asset-based loans and equipment financing solutions through its investments in Crystal Financial, LLC (Crystal) and Nations Equipment Finance, LLC (NEF). While the firm’s investments in Crystal and NEF are accounted for as equity holdings, which could yield greater valuation volatility, both are first-lien, short-duration lenders and are levered under 1.0x. If Solar’s investments in Crystal and NEF were consolidated, senior secured loans would have represented 98.6% of the portfolio (predominantly first-lien) as of YE19, which is well above the peer average. Fitch views the first-lien portfolio exposure favorably. Solar has not originated a second-lien cash flow investment since 4Q15.
Fitch believes Solar has sufficient liquidity to fund increased draws on revolver commitments and to work with underperforming portfolio companies in the coming months in an effort to maximize recoveries, if necessary. Solar notes it had approximately $650 million of cash and undrawn debt capacity as of March 27, 2020. As of this same date, the firm had $126 million in undrawn commitments to portfolio companies, of which less than $12 million were unfunded commitments currently available to be drawn based on contractual requirements in the underlying loan agreements. Fitch expects Solar’s liquidity position to remain sound given its borrowing capacity on secured credit facilities.
In December 2019, the firm issued $200 million in aggregate of senior unsecured notes in a private placement, comprising $125 million of five-year, 4.2% senior unsecured notes due in December 2024 and $75 million of seven-year, 4.375% senior unsecured notes due in December 2026. Proceeds from the issuances were used to reduce outstanding borrowings under the secured revolving credit facility.
As of Dec. 31, 2019, unsecured debt represented 75.1% of total debt, which was above the peer average and within Fitch’s ‘a’ category benchmark range of 50%-90% for BDCs. While that ratio is expected to decline with portfolio growth, Fitch expects Solar will continue to access the unsecured debt markets opportunistically, maintaining its unsecured debt component within Fitch’s ‘bbb’ category benchmark range of 35%-50% for BDCs.
Net investment income (NII) coverage of the dividend remained solid, amounting to 110.2% in 2019 and averaging 99.1% since 2007. Earnings and dividend coverage are expected to be weaker over the medium term as interest rates have declined (although the presence of LIBOR floors and declining funding costs will serve as partial mitigants), while non-accruals and paid-in-kind (PIK) interest are expected to increase for the sector. Still, Solar’s coverage metrics should provide some cushion to counter declining earnings.
The Stable Rating Outlook reflects Fitch’s expectations that Solar’s asset coverage cushion will be sufficient to absorb valuation marks and credit deterioration in coming quarters, while leverage will remain at the low end of the targeted range of 0.9x-1.25x. The Outlook also reflects an expectation that Solar will continue to focus primarily on senior secured debt investments and maintain sufficient liquidity and solid dividend coverage. The equalization of the secured and unsecured debt ratings with the long-term IDR reflects solid collateral coverage for all classes of debt given the firm’s senior lending focus, the increased proportion of senior unsecured funding in the capital structure and the firm’s expectation that it will be subject to a 150% regulatory asset coverage limitation.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
- A decline in the company’s asset coverage cushion to below 11%, a sustained increase in non-accrual levels, meaningful realized losses, weaker cash-based NII coverage of the dividend and/or an inability to continue accessing the unsecured debt markets resulting in unsecured debt remaining below 35% of total debt for an extended period of time.
- A more rapid-than-expected increase in leverage and, in the longer term, an increase in leverage above 1.25x or a material change in the firm’s risk profile represented by a material decline in first-lien positions or a shift in focus toward subordinated debt and/or equity investments without a commensurate decline in leverage.
Fitch also believes that higher leverage, the potential for reduced unsecured funding in the near to medium term and the challenging economic backdrop stemming from the coronavirus pandemic limit the likelihood of positive rating momentum over the medium term.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
- In the longer term, strong and differentiated asset quality performance of recent vintages, which would be evaluated in conjunction with the stability and consistency of the firm’s operating performance, asset quality, valuation and underlying portfolio metrics that include leverage and interest coverage, coupled with maintenance of solid funding flexibility, a strong liquidity profile and consistent core operating performance.
- In the longer term, although not envisioned, a material reduction in leverage not accompanied by an offsetting increase in the portfolio risk profile.
The secured and unsecured debt ratings are primarily linked to the long-term IDR and all are expected to move in tandem. However, a material reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.
Headquartered in New York, NY, Solar is an externally managed BDC founded in 2007. Solar completed its IPO in February 2010. As of Dec. 31, 2019, the company had an investment portfolio comprised of 108 portfolio companies across 28 industries, totaling $1.5 billion at fair value.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Financial Institutions issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years.
The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies). For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.
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