NEW YORK, Feb 19 (Reuters) - Business development companies (BDCs) are extending losses in 2016 as slumping share prices restrict access to growth capital and the value of some loan investments fall in volatile markets as fears of defaults rise.
BDCs specialize in lending to privately-owned US middle market companies and are closed-end investment funds that raise equity capital from retail and institutional shareholders.
The sector is currently trading at a steep discount to Net Asset Value (NAV), which is making it difficult to raise fresh equity without diluting existing shareholders. With few exceptions, the funds are trading at 75-80% below NAV, which measures mutual funds’ price per share.
“It’s a big deficit to overcome. The sector is dependent on the equity markets for growth,” said Meghan Neenan, senior director and BDC analyst at Fitch Ratings.
The lack of fresh equity capital means that BDCs are less able to take advantage of the higher spreads and tighter leveraged loan structures that are now on offer, after years of investing in aggressively priced and structured deals.
BDCs have gained market share in the last two years alone with other alternative capital providers by investing heavily in borrower-friendly loans as banks pulled back from lending to small and mid-sized companies in the face of heightened regulatory scrutiny on leveraged loans.
Market volatility has pushed spreads on middle market institutional term loans higher to an average of 540bp in the first quarter, the widest level since 563bp in the third quarter of 2012. Spreads were 519bp in the fourth quarter of 2015 and 514bp a year earlier.
In addition to tumbling NAV, BDC analysts are also watching for signs of any deterioration in credit quality, including underperforming loans in a rising default environment.
“Industry wide asset quality metrics, most notably non-accrual levels, remain at unsustainably low levels,” Fitch Ratings analysts said in the rating agency’s 2016 BDC Outlook.
Loans are placed on non-accrual status when principal or interest payments are overdue by 30 days or more and - or if - there is reasonable doubt that the principal or interest will be collected.
In the current earnings round, Fifth Street Finance Corp (FSC) placed its investment in healthcare services company Ameritox on non-accrual, bringing the total number of non-accruing loans in its portfolio to five as of December 31, 2015.
Apollo Investment Corp (AINV) placed its first-lien investment in oil and natural gas exploration company Osage Exploration on non-accrual status, as well as its Debtor-In-Possession (DIP) loan in iron ore concentrate and pellet producer Magnetation, AINV said on its February 9 earnings call.
AINV also said two of its eight core oil and gas investments, Spotted Hawk and Venoco, would “need additional capital or go through restructuring.”
The asset quality of BDCs are likely to deteriorate in the near term, Fitch analysts said in the 2016 outlook, noting that the pace of deterioration will be “dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the quality of individual firms’ underwriting.”
While areas of stress outside the energy sector still appear idiosyncratic, Neenan said that Fitch had seen “a lot of mark downs” in the fourth quarter of 2015.
BDC managers are currently looking at a range of options to try to preserve shareholder value, including accretive stock buybacks and waiving some management fees to try to offset share price volatility, falling oil prices, aggressive underwriting conditions and the first signs of credit quality woes.
Share repurchase programs, however, have to be carefully balanced with repaying debt in order to maintain leverage ratios.
Some BDCs, such as Solar Capital Ltd and TPG Specialty Lending Inc, are better positioned with little to no direct energy exposure, less leverage and have more capital available to deploy in new investments. (Editing By Tessa Walsh and Jon Methven)