Two Business Development Companies (“BDCs”) announced equity offerings after the close of business yesterday. Market leader Ares Capital (ticker: ARCC) announced its intention to sell 10,000,000 shares and allot another 1,500,000 shares to the underwriter. At yesterday’s closing of $17 that would raise $195mn of new equity. Hercules Technology (ticker: HTGC) made a similar announcement for a total of 6,613,000 shares and a likely raise of nearly $70mn.
Both companies have, within the past few days, released third quarter earnings. For both results were favorable, with higher per share net investment income than the prior quarter, lower non-accruals (although HTGC did have a large write-off in the period), and substantial new business activity both booked and in the pipeline. Nonetheless, neither company can claim to desperately need the new equity money in the short term. In fact, Ares boasted on the conference call of having plenty of “dry powder’:
Subject to leverage and borrowing base restrictions, Ares Capital had approximately $495 million available for additional borrowings under its existing credit facilities as of September 30, 2010.
By contrast, the investment pipeline and backlog were $180mn and $310mn respectively in early November as the earnings report indicates, and much of the latter may never close and a portion of both numbers will be syndicated out. Moreover, in the weeks since quarter end repayments were outstripping new loans ($18mn net) , which generates more investing capacity. On the earnings conference call, management pointed out that ARCC was under-leveraged at 0.5:1 debt to equity versus its self imposed limit of 0.65:1.0 or more.
It’s a similar story at Hercules Technology. On the conference call, management made much of its under-leveraged balance sheet, and liquidity. The only debt on the balance sheet is long term SBIC financing and there’s $65mn more of that to tap at historically low rates. Plus, HTGC has $83mn in cash on the balance sheet, and $70mn under two completely unused Revolvers. According to the earnings report the company had $301mn in total capital to spend. By contrast the company had $103mn in signed term sheets, only a portion of which would need funding in the weeks ahead. Debt to equity at HTGC was an excellent 0.47:1.0 at September 30th, and when SBIC debt is excluded (as is allowed under the BDC rules) HTGC had zero in debt !
Why then the rush to raise equity? Management will probably point to the anticipation of a busy fourth quarter (although neither HTGC or ARCC is making the argument heard elsewhere that prospective changes in the capital gains treatment is about to cause a flood of deal making before year end). However, the big challenge most BDCs have had in recent quarters is just booking enough deals to keep up with the large number of their own portfolio companies getting refinanced. HTGC’s total assets at September, for example, are unchanged from the level at December 31 2009.
Our own view is that many BDCs remain traumatised by the events of the Great Recession, and have internally sworn off depending on Revolving debt financing on their balance sheets for investment asset growth. HTGC, for example, has made little use of its Revolvers with Wells Fargo and Union because the company is aware that in a pinch the lenders could fail to renew the facilities and cause a scramble to refinance at the worst possible time. That’s what happened during the recession with a different set of jumpy lenders and caused HTGC considerable hardship. ARCC, too, eagerly took on its recent $200mn 30 year Note to reduce reliance on its shorter term Revolving debt. The company has not paid off the relatively expensive Unsecured Notes inherited from the Allied acquisition in order to stagger its debt maturities as much as possible. Revolving debt accounts for only a third of outstanding debt capital at present and could go lower.
Moreover, equity is very inexpensive right now for many BDCs. ARCC is raising new capital which will presumably pay a 8.2% dividend yield, and HTGC 7.6% (although there’s talk of a Special Dividend at year-end). That’s competitive with medium term debt, and very attractive permanent capital.
What we are likely to see both from ARCC/HTGC and more widely in the industry is that many BDCs will maintain debt to equity ratios at around the 0.5:1 levels as a matter of policy, or half their pro-forma legal capacity. Before the Great recession most BDCs were not shy to have debt/equity consistently at or above 0.8:1.0. Moreover, Revolver financing (inexpensive but short term) will become an increasingly smaller portion of most BDCs capital structure.
This leaves us with a good news/bad news conclusion. The good news is that many BDCs will have stronger balance sheets than ever before in the medium term, with increased reliance on continuous equity raises and where possible-on medium term and long term debt financing with limited covenants. As long as equity is plentiful (and two-thirds of BDCs have been able to tap the markets in recent months) , and longer maturity debt is available, this must be seen as a positive factor for the industry. The bad news for investors is that the cost of capital will increase as a result, and companies are more likely to defend current dividend levels than seek to increase them. It’s a trade off the BDC Reporter is willing to make but investors hoping for regular dividend increases may be disappointed.
Disclosure: Author is long ARCC, HTGC