Business Development Companies' Changing Approach to Balance Sheet Risk

by: Nicholas Marshi

One of the themes of some of our recent posts is that the most important lesson learned by most Business Development Companies (“BDCs”) from the Great Recession is the necessity of maintaining a strong balance sheet at all times, capable of withstanding virtually any market condition. Two years ago BDCs discovered that even though they were relatively un-leveraged compared to banks and other finance companies (due to the BDC-specific regulatory limitation of 1:1 debt to equity), a sharp reduction in asset values could still result in financial difficulties, and require emergency actions to stay in business.

Thankfully no BDC went bankrupt, but two-thirds of the BDCs (13 of 20, to be precise) we track -- which were in business at December 31, 2007 and are still in operation today -- faced very real challenges in 2008 and 2009, when the value of their loan investments dropped sharply in value, as every quarter resulted in additional write-downs, both realized and unrealized.

Today we’re going to briefly remind you of how many BDCs were impacted by the Great Recession and discuss what specific strategies many of the companies in the industry are adopting to avoid history repeating itself the next time the economy goes into the tank. The focus will be mostly on equity; another article will be about new uses of debt.

All Hands on Deck

When the Great Recession began to bite, most BDCs were in fire-drill mode. Some BDCs were thrown over by their lenders running for the exits, such as Gladstone Capital (NASDAQ:GLAD) , Gladstone Investment (NASDAQ:GAIN), Hercules Technology (NASDAQ:HTGC) and TICC Capital (NASDAQ:TICC). With lenders not renewing credit lines due to their concern about asset quality, these BDCs had to sell off assets in a hurry, and not always at the best prices.

Gladstone Capital, for example, sold off virtually all its relatively liquid syndicated loan portfolio to pay off Deutsche Bank (NYSE:DB), but also had to cut its dividend by 50%. A similar scenario with the same absconding lender occurred at sister company Gladstone Investment. At December 31, 2007, GAIN had $356mn in investment assets at cost. As of September 30, 2010, assets had dropped to $187mn. Debt, which was at $150mn in 2007, is only $25mn as of September of last year. Here too the company had to cut its dividend in half.

Other BDCs defaulted under their loan or note agreements, usually because values had dropped below covenanted levels and despite the fact that incoming cash flow was more than sufficient to pay debt obligations. The most infamous default was American Capital (NASDAQ:ACAS), which went from paying an ever-increasing dividend all the way through to the third quarter of 2008 to suspending pay-outs and almost filing for bankruptcy, all within a matter of weeks. Ditto for Allied Capital, now part of Ares Capital (NASDAQ:ARCC); Patriot Capital, now part of Prospect Capital (NASDAQ:PSEC); GSC Investment, which was bought up by Saratoga Capital (NYSE:SAR); and Kohlberg Capital (NASDAQ:KCAP), which entered into a protracted argument with its lenders as to whether it was actually in default or not.

Even BDCs which did not lose their lenders (either out of loyalty or because credit lines were not up for renewal) had to work very hard to keep out of trouble and avoid defaults. Many of the bigger BDCs, such as the previously mentioned Ares Capital, Apollo Investment (NASDAQ:AINV) and Blackrock Kelso (NASDAQ:BKCC), shrunk their portfolios to remain in the good graces of their lenders.

Let us take BlackRock Kelso as an illustrative example that can serve for several other similarly challenged BDCs. At December 2007, the company had $1.154bn in total investment assets at cost. Now, nearly three years later, and despite a revival in lending and business confidence, total assets are 16% below the 2007 level and debt outstanding is down by one-third.

Many BDCs managed to hold on to their borrowing facilities but ending up paying fees and higher rates, and accepted tighter covenants and loan restrictions.The pain extended to shareholders as well. Besides seeing stock prices drop across the board, and dividends cut by 53% in aggregate, many BDCs raised capital through rights offerings or by selling stock at dilutive, below-Net Asset Value prices in order to stay the course. Several BDCs paid out dividends only in additional stock in order to conserve cash to pay down debt.

Happy Days Are Here Again

The BDC industry has managed a remarkable turnaround since the dark days of 2008-09. Today there is no BDC in default under its loan agreement, and only two BDCs are not paying cash dividends: American Capital and Saratoga Investment. Nonetheless, several BDCs are still recovering from the body blow that was the Great Recession. TICC Capital has never been able to replace its senior lenders and has operated without any borrowing capacity for over two years. MCG Capital (NASDAQ:MCGC) has a complex formula of repayments and limitations to follow with its debt arrangements. Saratoga Investment on its recent conference call admitted to be still working out several credits in its portfolio. Kohlberg Capital has come to terms with its lenders but has to pay off $127mn in borrowings by February 11 of this year. Whether that will be achieved by refinancing or asset sales is not known.

Sticking With Risk

We could go on, but the point of recounting the recent troubled history of the BDC industry is to underscore that there has been an almost universal reaction from the management of the companies in this sector to ensure that it shall not happen again. Interestingly, the economic slowdown has not caused a significant change in the target market of the BDC companies, which continue to be focused on the unsecured segment of leveraged financing. Only a few BDCs have changed their credit-underwriting strategies and sought to move up the risk ladder from subordinated debt to senior loans.

A few BDCs opportunistically added senior debt investments when the flight of competing lenders made them competitive, but most BDCs are sticking to their knitting. The economics of senior debt do not support the high costs and onerous management fees of BDCs. Notwithstanding the Great Recession, BDCs are continuing to make higher-yielding, higher-risk investments in the form of second lien, mezzanine and uni-tranche loans in buy-outs and recapitalizations.

Das Capital

There has been considerable change going on, though, and it’s in the way BDCs construct their balance sheets. We’re going to look at some of the main capital structuring strategies being employed, starting today with the increasing role of equity.

More Equity: Helped by the comeback of the stock markets in 2010, many BDCs are relying much more heavily than before on equity capital. We track 23 BDCs and 16 have sold new shares in the past 12 months, in some cases multiple times. Prospect Capital is the most extreme example of what we’re describing.

The company is on a program of continual equity raising which it dub its “at the market stock distribution program.” In sheer number of shares issued, Prospect has been highly successful. At December 31, 2009 (just after digesting Patriot Capital in return for issuing a boatload of new shares), PSEC had 63mn shares outstanding. By early November 2010 that number had jumped to 83mn, a 32% increase. In 3Q 2010, Prospect sold 9mn shares and raised $88mn, which was more than total new assets added to the balance sheet for the quarter net of repayments. In fact, until a few months ago, Prospect was finding it easier to raise equity on decent terms than new debt facilities.

Even financially-challenged companies like American Capital were able to raise equity, which has allowed the troubled giant (still the largest BDC in terms of fair market value of assets) to resume making a trickle of new loans. Likewise, TICC Capital, which has not been able to arrange a new debt facility on acceptable terms, did manage to raise new equity for the first time in years, despite being a smaller BDC in a sector which stills worries many investors.

Another specialty BDC, Hercules Technology, has also raised new equity in recent weeks with a value of $72mn.The bigger, more successful BDCs have been raising equity multiple times. Front runner Ares Capital issued new stock twice in 2010, and acquired Allied Capital with additional stock issuance. BlackRock Kelso went twice to the equity market in the space of six months, raising over $150mn.

The result so far has been far stronger balance sheets, with equity providing the bulk of the funding of BDCs' balance sheets. We looked at BDCs with GAAP equity in excess of $500mn. There are seven companies in this category, and if you eliminate American Capital (which is still de-leveraging) total equity was $7.4bn versus total net debt (that’s debt less cash) of $2.9bn. Or put the more traditional way: Debt to equity was just 0.39: 1.0. Apollo had the highest debt to equity by our calculation: 0.58:1.0, while two BDCs -- Prospect Capital and Fifth Street Finance (NYSE:FSC) -- had essentially no net debt whatsoever.

If you look at the entire 23 BDC company universe, we determined that only five companies have debt to equity ratios over 0.5: 1.0, and 18 are below that threshold. 10 BDCs have virtually no debt at all. We don’t have comparable data for the years just before the Great Recession, but there’s no doubt that the great majority of BDCs were financing themselves predominantly with debt rather than equity., sometimes all the way up to the 1:1 limit, on the flawed assumption that investment assets were stable and would not fall in value and sharply decrease equity values.

Even the few BDCs with debt to equity above 0.5:1.0 are hardly pushing the envelope of risk. American Capital , which is at 0.7:1.0, is seeking to improve its metrics and has publicly announced its intention to drive debt to equity down to 60%. Apollo is at a moderate 0.58: 1.0. Kohlberg Capital, as discussed above, is about to de-leverage in February and will see its debt to equity plummet. Medallion Financial (TAXI) has a different capital structure than most BDCs due to its ownership of a bank, so this leverage ratio does not really tell us anything. PennantPark (NASDAQ:PNNT) is at 0.61: 1.0 but has a very clean balance sheet, no non-accruing loans and a revolver which doesn’t mature till 2012 and is priced at an enticingly low cost of capital: LIBOR +1%.

Equity Is Here to Stay

Clearly there has been a sea change in the use of capital to fund the BDC industry. Going forward into 2011, we can’t imagine that debt to equity levels will remain as low as they are today, but comments made by managements on conference calls suggest debt will remain under 0.6:1.0 for virtually every BDC for the remainder of the year, at least.

For management, this increased reliance on equity capital is an important step in bulletproofing their balance sheets, and looks like it could be a permanent feature of the BDC scene. For investors, the flow of new equity into the industry has stemmed prospects for material dividend increases, but has also reduced the risk of major financial catastrophes when the next recession strikes. In the Great Recession, nine of the 21 BDCs in business at December 31 2007 either completely suspended their dividends or cut their pay-outs by 50%. It’s harder to imagine such a disastrous outcome today given the new equity driven approach to balance sheet construction.

Don't Write Debt Off

Debt is not dead by any means. However, many BDCs are finding new forms of debt capital to reduce balance sheet risk. More on that in a few days.

Disclosure: I am long ACAS, ARCC, FSC, BKCC, TICC, SAR, PNNT, KCAP, PSEC.