Where Is All That Business Development Company Leverage?

Investment Management Update

Date: August 28, 2019

In March 2018, after more than a decade of seeking legislation that would permit business development companies (BDCs) to incur additional amounts of leverage, the Small Business Credit Availability Act (SBCAA) was finally signed into law. The SBCAA provided a mechanism for BDCs to obtain approval from their stockholders or their boards of directors to reduce their asset coverage ratios from 200% to 150%. A number of BDCs acted quickly in order to be able to take advantage of this provision. By December 31, 2018, 14 BDCs had obtained stockholder approval to immediately be eligible to reduce their asset coverage ratios to 150% and six other BDCs obtained approval from their boards of directors (but not stockholders) in order to be eligible to reduce their asset coverage ratios a year after such approval, as permitted by the SBCAA.

Nearly 18 months from the enactment of the SBCAA, perhaps the most surprising outcome is how small the impact of this provision has been. Of the approximately 50 BDCs that are listed on the NYSE or NASDAQ, only 22 are currently eligible to have asset coverage ratios of less than 200%. Two private BDCs have taken the necessary steps and are eligible to have reduced asset coverage ratios[1], and two additional listed BDCs have obtained approval from their boards of directors but are not yet eligible to incur additional borrowings. Taking into consideration that there are nearly 100 BDCs, the impact of this legislation has, to date, been underwhelming.

Further illustrating this, of the 22 BDCs that are currently able to incur additional leverage, most have not yet done so. As of June 30, 2019, of the 22 BDCS that are eligible to incur additional leverage, only 10 reported asset coverage ratios of less than 200%. While that number is an increase from March 31, 2019, when only six BDCs reported asset coverage ratios of less than 200%, the number is smaller than many would have anticipated 15 months after the enactment of the SBCAA.

The table below illustrates certain additional information regarding the asset coverage ratios of the BDCs eligible to have a reduced asset coverage ratio as of the dates noted. The data was obtained through a review of public filings with the SEC.

March 31,
2019

June 30,
2019

Number of BDCs eligible

17

22

Average asset coverage ratio

226%

221%

Median value

216%

204%

Number of BDCs with ratios under 200%

6

10

Number of BDCs with ratios under 200%
(2018 vintage)[2]

6

8

Number of BDCs with ratios under 200%
(2019 vintage)2

0

2

Highest asset coverage ratios

317%, 314%,
275%

353%, 320%,
312%

Lowest asset coverage ratios

161%, 180%,
182%

166%, 168%,
175%

 

The slow adoption rate can largely be attributed to a few factors that may have been underestimated by many when the legislation was enacted. First, just because a BDC is statutorily eligible to borrow additional amounts, it does not necessarily follow that a lender will automatically or quickly provide such financing. Further complicating this issue is that loan agreements in existence at the time of stockholder or board approval all had to be renegotiated in order to account for a lower asset coverage ratio. Once a loan agreement is re-opened, it is natural that lenders would take the opportunity to protect themselves if they are being asked to extend further credit. In some cases, this could result in changes to the criteria and composition of investments that are included in the borrowing base.

In addition, and related to the first point, while loan agreements have been amended to provide for a lower asset coverage ratio, the size of the facilities did not proportionally increase to correspond with the full amount that the BDCs can borrow pursuant to the SBCAA. In other words, lenders have been willing to upsize the facilities but, to date, only marginally so.

Finally, many BDCs hold large amounts of investments that do not meet the criteria required by the loan agreements to be included in the borrowing base. Loan agreements generally require that borrowing availability be secured by a diversified pool of senior secured first lien loans, which have lower yields but represent the highest position in the capital stack. For certain BDCs, increasing the portion of assets in senior secured first lien loans may not be consistent with their investment strategy. As a result, their borrowing availability may be lower than what is permitted by the loan agreement.

Where Do We Go from Here?

With additional time, it is likely that more BDCs will obtain approval to reduce their asset coverage ratios and more will take advantage of such approvals in order to increase borrowings beyond what was available prior to enactment of the SBCAA. In addition, new BDCs are able to have a reduced asset coverage ratio on day one and can craft investment strategies with these levels in mind. The lenders to BDCs will ultimately have the greatest say as to how quickly this happens and to what extent. Finally, a general weakening in the credit markets would materially impact the willingness of lenders to extend additional credit and make it more difficult for BDCs to hold a diversified pool of investments that meet the necessary criteria to increase borrowing availability under their loan agreements.

FOR MORE INFORMATION

For more information, please contact:

Owen Pinkerton
202.331.8330
Owen.Pinkerton@ThompsonHine.com

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[1] The SBCAA imposed onerous requirements on BDCs that do not have a class of equity securities listed on an exchange in order to be eligible to reduce their asset coverage ratios. Such entities are required to, over the course of four issuer tender offers, offer to repurchase all shares of common stock outstanding prior to becoming eligible to incur additional leverage. As a result, very few private, non-listed BDCs have sought to reduce their asset coverage ratios.

[2] “2018 vintage” refers to the 14 BDCs that were able to reduce their assert coverage ratios, effective during the year ended December 31, 2018. “2019 vintage” refers to the eight BDCs that were able to reduce their assert coverage ratios, effective prior to June 30, 2019.