Depressed share values relative to the net asset values (NAVs) of business development companies (BDCs) are adding to the headaches facing many management teams already dealing with competitive underwriting conditions, dividend coverage pressure and, more recently, energy price declines, says Fitch Ratings. Continued widening of BDC share prices from their NAVs could lead firms to consider asset sales or even force some consolidation, particularly if relative discounts result in competitive disadvantages.
BDCs are dependent on the equity markets for growth capital because they must distribute at least 90% of their taxable earnings on an annual basis to avoid corporate taxes. Material share discounts to NAVs effectively curb BDCs' equity market access, which is important for funding portfolio growth and managing leverage when repayment speeds begin to slow, as is widely expected following the lengthy period of low rates. Depressed share prices also can constrain BDCs' abilities to capitalize on investment opportunities during times of market dislocation.
As a result, Fitch believes that BDCs trading at or above NAV will be better positioned to capitalize on investment opportunities, whereas BDCs with constrained equity market access for an extended period may experience damage to their franchises and funding profiles, leaving them a target for acquisitions and/or forced asset sales to other BDCs or other market participants.
Several factors have combined to weigh on BDC share prices, in Fitch's view. These include the removal of BDCs from select equity indices in 2014, and more recently, market expectations for credit losses to increase from unsustainable lows, the potential for further dividend cuts to follow recent asset yield pressure, and potential valuation declines from portfolio energy exposures.
Depressed share prices are not currently pressuring BDCs to the point of imminent asset sales or mergers, but continued valuation declines would increase the chances for such activity, in our view. As of Jan.12, 2015, the eight Fitch-rated investment-grade BDCs were trading at a 10.7% discount to NAV, on average.
Acquisition opportunities could come in the form of selective asset sales, should a BDC need to generate cash proceeds for de-leveraging purposes, or an outright sale of the entire portfolio, as was the case when Ares Capital Corporation bought Allied Capital Corporation in April 2010. However, transactions following the financial crisis were motivated largely by covenant breaches and funding concerns as BDCs incurred significant write-downs in equity portfolios in fourth-quarter 2008 and had shorter-duration funding profiles.
Today, Fitch believes potential transactions could be motivated more by competitive pressures and relative franchise strengths, as some BDCs may become adversely selected against for deal flow, resulting in weaker asset quality performance down the road.
A hold-up to acquisition activity to date has likely been strong asset quality performance, which Fitch believes is somewhat bolstered by a strengthening economy and low absolute interest rates. When asset quality metrics begin to normalize, differentiation in underwriting capabilities is expected to emerge, which could yield more M&A. That said, target firms will likely have to accept meaningful valuation discounts, particularly if the acquirer is raising capital below NAV to complete the deal.
To the extent that BDCs' trading discounts are telegraphing true asset quality deterioration, a potential credit concern highlighted in Fitch's recent BDC Sector Outlook, negative rating actions could result.
Any rating action associated with an announced transaction would be dependent upon Fitch's view of the discount taken on the assets purchased relative to their fundamental value, in addition to an assessment of the funding strategy and impact on consolidated leverage, if any.
There are two positive by-products of constrained equity market access. First, growth is constrained at a time when competitive dynamics are heightened and repayment activity is contributing to increased portfolio concentrations in more recent vintage years. Second, arresting the growth of equity limits dividend burdens from increasing.
Additional information is available on www.fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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