NON-RATING ACTION COMMENTARY
FITCH COMPLETES BDC PEER REVIEW; FIVE OUTLOOKS REVISED TO NEGATIVE
Fitch Ratings-New York-17 April 2020: Fitch Ratings has completed a review of nine business development companies (BDCs) in light of expectations for heightened credit challenges resulting from the coronavirus pandemic. The review was comprised of nine publicly rated firms.
The Rating Outlooks for the following five issuers were revised to Negative from Stable:
- Ares Capital Corporation’s Long-Term Issuer Default Rating (IDR) was affirmed at ‘BBB’; Rating Outlook revised to Negative from Stable.
- BlackRock TCP Capital Corporation’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook revised to Negative from Stable.
- FS KKR Capital Corp.’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook revised to Negative from Stable.
- Goldman Sachs BDC, Inc.’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook revised to Negative from Stable.
- Oaktree Specialty Lending Corporation’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook revised to Negative from Stable.
The Rating Outlooks for the following four issuers were maintained at Stable:
- Owl Rock Capital Corporation’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook Stable.
- Owl Rock Capital Corporation II’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook Stable.
- Solar Capital Ltd.’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook Stable.
- TPG Specialty Lending, Inc.’s Long-Term IDR was affirmed at ‘BBB-‘; Rating Outlook Stable.
Fitch has published press releases for each of the BDCs, which are available on www.fitchratings.com. Please refer to these releases for further information on the rationale for each rating action.
The ratings assigned to BlackRock Capital Investment Corporation (BB-/Rating Watch Negative) and New Mountain Finance Corporation (NMFC; BBB-/Rating Watch Negative) were not included in this review given actions taken on their ratings on April 6, 2020 and March 25, 2020, respectively. For more information on those actions, please refer to ‘Fitch Downgrades BlackRock Capital’s Ratings to ‘BB-‘; Ratings Remain on Negative Watch’ and ‘Fitch Places New Mountain Finance Corp’s ‘BBB-‘ Ratings on Negative Watch on Elevated Valuation Risk’ available on www.fitchratings.com.
Fitch’s sector outlook for BDCs remains negative, as asset coverage cushions will come under pressure, for some, relative to targeted levels, as the sector experiences negative portfolio valuation marks in the near term and elevated portfolio credit issues thereafter, resulting the coronavirus.
While Fitch believes BDC exposures 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.
Fitch regularly tests BDCs’ sensitivity to valuation declines and the resultant impact on asset coverage and related covenants. In a recent analysis, Fitch took rated BDC portfolios as of Dec. 31, 2019, and applied valuation stresses of 5%, 10%, 15%, and 20% to portfolio fair values, to assess the impact on asset coverage ratios, assuming no offsetting portfolio management measures were implemented. On average, investment-grade BDCs had capacity to withstand valuation declines of 18.8% before breaching the low-end of Fitch’s ‘bbb’ category asset coverage benchmark range of 11%-33% and valuation declines of 27.6% before falling below regulatory minimum asset coverage cushion requirements. However, cushions to valuation marks vary widely amongst rated BDCs. Furthermore, in some cases, cushions to minimum equity covenants are more constraining than asset coverage covenants. The average cushion to minimum equity covenants was about 24.5% of portfolio fair value at YE 2019, for investment-grade BDCs. Those issuers assigned a Negative Rating Outlook today typically exhibit smaller risk-adjusted asset coverage cushions or have smaller cushions to minimum equity covenants and thus greater potential for rating downgrades over the outlook horizon.
In addition to valuation movements and credit considerations, BDCs have also experienced increased revolver draws since year-end as underlying portfolio companies have looked to shore up liquidity. BDCs do not consistently break out unfunded commitments between revolver draws, delayed draw term loans, where borrowers must meet certain pre-conditions to fund, and other commitments, but unfunded commitments averaged 8.1% of portfolio balances at YE 2019 for the Fitch-rated group. Fitch believes BDCs have sufficient borrowing capacity on credit facilities to fund these revolver draws, should the need arise, but draws on facilities will result in higher leverage and lower asset coverage cushions.
New origination volume is expected to be limited near term, but Fitch believes BDCs will selectively deploy capital into supporting existing portfolio companies to seek to maximize recoveries, which, when combined with recent increases in revolver draws, will test BDCs’ ability to maintain leverage within targeted ranges in 2020. Liquidity availability also varies across the sector, so some firms will be better positioned to support existing portfolio companies.
Earnings and dividend coverage will be challenged in the coming quarters. Recent rate cuts, in response to the global spread of the coronavirus, will pressure portfolio yields, although the presence of LIBOR floors (generally around 1%) in a large portion of floating rate investments will mute that impact to some extent. More impactful, however, will be the emergence of portfolio credit issues. Non-accruals are expected to increase meaningfully for the sector in the coming months as portfolio companies struggle to make interest payments in the face of lower revenue, thus reducing BDCs’ interest income. Portfolio companies may increasingly use paid-in-kind (PIK) interest to preserve cash, however, this will not impact BDCs’ recognition of income, which must be distributed for tax purposes, leading to a mismatch between cash earnings and cash dividends. Net investment income coverage of dividends was solid, at 109%, on average, in 2019 for the rated peer group, but coverage will decline in 2020. As a result, firms have implemented or may consider dividend cuts.
BDC stocks have traded down significantly in recent weeks and were trading at a 34.7% average discount to net asset value on April 10, 2020, which compared to a 6.5% average discount on Feb. 28, 2020. That discount is expected to deter most BDCs from accessing the equity markets to raise capital, given the dilutive impact of a new offering.
On a positive note, Fitch-rated BDCs have no meaningful debt maturities until 2022, with only NMFC having debt coming due in 2021; a $90 million issuance in May 2021. The lack of near-term maturities is a function of increased unsecured debt issuance volume in the 14 months ended February 2020 ($6.3 billion issued) and the continuous extension of maturities on bank credit facilities, which often have a two-to-three year revolving period before a one-year amortization period.
On April 8, 2020, the SEC granted an exemption under the Investment Company Act of 1940, permitting BDCs the option to exclude valuation marks on portfolio companies that are not permanently impaired, if held on Dec. 31, 2019, in their calculation of the asset coverage ratio.
Fitch does not expect Fitch-rated BDCs to avail themselves of the option, given the size of their asset coverage cushions and the fact that lending facilities do not afford the same exclusion, absent an amendment. The SEC also granted an exemption that provides BDCs more flexibility to do co-investments with affiliates that have already invested alongside the BDC. This is not a meaningful change to current practice, but continues to give BDCs the ability to take advantage of dry powder elsewhere on the advisor’s platform to maximize recoveries in the portfolio.
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