We are penning a series of articles about the major trends that will affect the Business Development Company (BDC) industry in the next 12 months. We’ll spell out which segments of this increasingly variegated industry will be most affected and how the companies involved may react in terms of business strategy, dividend policy etc.
We’re starting out with an industry trend that has been affecting the industry for several quarters and does not seem to be showing any signs of abatement: portfolio loan refinancing, and it’s impact on some of the largest Business Development Companies which service this corner of the leveraged finance market.
Ever since the capital markets realized the global financial system was not going to hell in a hand basket, and aided by the Fed’s lowering of interest rates, there has been a massive wave of loan refinancing going on in leveraged private companies. The phenomenon began in 2010 and has continued to date. Every sponsor group and/or management team (so it seems) with debt priced at above current market levels has been going to market or preparing to do so to realize significant interest savings.
Thanks to massive flows into the junk bond market and the public syndicated loan market (with every fund and his brother launching senior loan funds which invest in floating rate assets, anticipating higher rates in the months to come) the owners of very large leveraged companies and the upper middle market have been the primary beneficiaries.
The result for the BDC industry has been a notable and inescapable churn of portfolio loans amongst the 5 BDCs that lend in the upper middle market. Some portfolio companies have been snatched away by the junk bond market, hungry for product even at the low end of the typical size range. Also, syndicated loan groups, usually helmed by the big banks, have also been offering great deals to the bigger, performing companies previously financed by BDCs. The loans made are then sold off to the many public Closed End Funds and other willing buyers, grateful for the relatively high yields.
Of course the BDCs have not sat idly by while up to half of their assets or more have been refinanced away, and have been actively adding new assets themselves to keep their loan books from shrinking. (There is an exception to that rule which is American Capital, which we’ll discuss later when we get to specifics).
However, the upper middle market leveraged financing market (and the segment above which BDCs don’t participate in) has been hobbled by the relatively low level of new buyouts coming to market. On Conference Calls management has been saying that 75% of all financing activity is coming from refinancings and recapitalizations (which often includes a dividend for the sponsor group shareholders).
Why are there so few buyouts when capital is so freely available? First, there is still uncertainty about the economic and regulatory outlook and that affects the buyers. There is plenty of unspent firepower in the sponsor community and a real need to get their capital invested but there is a reluctance to make the outsized offers necessary to get deals done.
Which leads into our second point. Buyers continue to hold out for pre-recession level multiples where purchases are concerned. American Capital (ACAS), which has been selling off many control investments in recent quarters, mentioned on a recent conference call that all deals they’ve sold have gone for multiples equal or higher than what they originally paid for them, which was principally in the heyday of 2006-2007.
Finally, we’re guessing that many prospective companies for sale may have survived the Great Recession but have not yet reached earnings levels that would maximize the returns to their owners yet. So the owners sit and wait with little downside risk. After all, with the high multiples being paid when a deal does get done, even a modest increase in EBITDA translates into much higher returns for the sponsors and their long suffering limited partners.
IMPACT ON THE BDC PLAYERS IN THE UPPER MID MARKET
There are 5 BDCs that operate almost exclusively in the upper middle market financing segment. These companies are: American Capital: ACAS; Ares Capital: ARCC; Apollo Investment: AINV; BlackRock Kelso: BKCC; Solar Capital: SLRC. Over the first quarter they have been unable to put the large amounts of capital received from refinancings, equity issuances, convertible debt issues etc. to work.
In the case of all but ACAS, these BDCs have been booking new loans by the bushel and still seeing their loan books shrink. Of course, higher competition for assets has meant lower loan spreads (everything else being equal) and having to accept deal structures less favorable than the last two years when it was a lenders market.
Not surprisingly, interest income has stagnated or fallen at these BDCs and there’s no reason to expect that this won’t continue (after all this article is supposed to be about the future).
To date, the BDCs have been able to lessen the earnings blow thanks to the fees received both from departing borrowers and new borrowers. Over time, though, competition will lessen proceeds from the latter.
COST OF DEBT CAPITAL INCREASING
It does not help that the BDCs in this space have also been focused on preparing themselves to face the next recession with stronger balance sheets than was the case the last time round. Ironically these BDCs have been doing a lot of refinancing and restructuring of their own. Principally, besides raising equity capital, this has meant adding long term and medium term debt to their balance sheets with fixed interest rates, looser covenants and maturities way out into the unknown future. On the back burner are the Revolving Lines of Credit with their inexpensive financing tied to dirt cheap LIBOR. Those facilities are increasingly regarded as useful to top off a capital structure packed with long term capital.
The bottom line is higher interest costs just as investment income is coming down and when management fees are at full freight. Everything else being equal, this is a recipe for lower Net Investment Income Per Share with no obvious end in sight. No wonder most of these BDCs reported earnings in the last quarter below the analyst consensus and below their dividend (even Ares Capital which has made much of its conservative dividend policy).
IQ 2011 RESULTS TO DATE
BlackRock announced Net Investment Income Per Share of just $0.20 for the latest quarter, way off the previously announced dividend of $0.32, and one-third off the Net Investment Income Per Share recorded a year earlier. (The earnings were 16% off Consensus.) The Company used the opportunity to make it clear that it was giving up the attempt to have its earnings catch up with its pay-out and cut its dividend to $0.26 a quarter. This has been a disaster for the stock, which is down 25% from the high of the year.
Apollo has not yet reported earnings because March is their year-end, but the writing on the wall seems to be lower net investment income on an absolute and per share basis both for the year and the quarter. We are guessing that a dividend cut is also likely. In the quarter ended December 31 2010, Net Investment Income was $0.26 per share, down from $0.30 a year earlier.
Solar Capital saw Net Investment Income in the IQ 2011 drop 10% over a year earlier. However, the newest BDC in this group made up some of the drop-off in lower interest expense. (Unlike the other BDCs mentioned, Solar continues to rely principally on revolving lines of credit for its debt). Still, earnings were 1 cent off Consensus.
American Capital, burdened with very expensive debt from its extended renegotiation and restructuring with its lenders last year, does not even make an attempt to keep investment asset levels unchanged. The only new loans booked in the most recent quarter were to existing borrowers. Otherwise all proceeds from loan repayments and asset sales went to either paying down debt or building up cash. As a result the company’s portfolio is like a museum exhibition of the pre-recession lending period, with all but a handful of loans dating back to 2007 and before. Interest Income dropped 13% (adjusting for “non-recurring income related to the removal of investments from non-accrual status”).
Still, Net Operating Income (as ACAS defines earnings) was $0.23 per share, up 5 cents over Consensus. That’s almost exclusively due to the non-recurring income mentioned above.
Ares Capital reported adjusted Net Investment Income Per Share (which they call Core EPS) of $0.31, up from $0.28 a year ago, but down from $0.42 in the prior quarter. Like with BKCC, ARCC’s earnings were below Consensus. Total investment assets came down marginally. The weighted average yield on the portfolio dropped from 13.2% at weighted average cost to 12.8%.
LOOKING FORWARD: POSSIBLE
With 4 out of 5 BDCs in this segment reporting, it’s clear that Net Investment Income is stuck in neutral (although there’s plenty of activity in the Realized and Unrealized Gains which we won’t address here). Many smaller BDCs operating in the middle market and lower middle market have faced neither the refinancing tidal wave nor the pressure on margins, though pricing pressures are appearing across the spectrum. Several smaller BDCs are growing their total investment assets, increasing earnings per share and dividends.
Nonetheless, we are NOT suggesting that the refinancing phenomenon and the more competitive lending environment will NECESSARILY result in a permanent or even long term reduction in Net Investment Income at the larger BDCs. Looking at the Analyst Consensus: Ares, American Capital and Solar Capital are all expected to increase earnings this year over the annualized level of their last quarterly result. Apollo and BlackRock Kelso are expected to tread water. All five companies are expected to increase earnings over the 2011 level in 2012.
POTENTIAL UPSIDE OPPORTUNTIES
What could go right and get the bigger BDCs out of their earnings rut ?
First, the leveraged buy-out market could start to rev up. In their Conference call, Ares Capital suggested activity in April was picking up and pointed to net new loans booked since the quarter end, and half a billion dollars still in the hopper. If the LBO market heats up, and the refinancing market slows down we’ll probably see all the BDCs discussed (except ACAS) load up on net new investment assets, even if the average yields drop. At the BDC Reporter, we believe a more vigorous M&A market for buy-outs will return, but we don’t have enough evidence as yet.
Second, several of the BDCs have non-income producing assets (including equity investments, loans booked at low rates and non performing loans) that can be converted into high yielding loan assets. Both Ares Capital and American Capital have substantial non-income producing assets (over $400mn in the case of ARCC). That would boost interest income and act as a brake on lower portfolio yields.
Third, some of the BDCs may yet be able to cut their cost of debt capital and reduce interest expense further. The biggest candidate is American Capital, which has every incentive to pay off very expensive Notes, which are priced 4-6% higher than comparably sized BDCs. Ares Capital continues to tinker with its balance sheet and may be able to continue its policy of funding itself with long term debt, but at lower rates if the capital markets oblige.
Fourth, interest rates could increase and buoy earnings. Our review suggests all the BDCs we’ve discussed would benefit from higher interest rates. Most of the companies have already fixed their liabilities, while amassing an increasing proportion of floating rate investment assets. If LIBOR rates jump from 0.3% to, say, 3.0% interest income will jump, interest expense will barely change and most of the extra income will end up with the shareholders.
For the bigger BDCs, the pressure of refinancings and lower yields will continue for the forseable future. All else being equal that will continue to pressure recurring earnings from loan income. There are a number of variables that could yet allow the five BDCs we have discussed to boost earnings, but most of the opportunities are outside of their control (higher interest rates, higher LBO activity), or will take several quarters to play out (converting non-income producing assets to yield assets, reducing cost of debt capital).
If interest rates remain low, refinancing remains high, LBO activity tepid and asset conversion slow, these BDCs may be stuck at or below their current earnings run rate in the year ahead. However, we should also point out that all the companies discussed--should they be unable to grow--will boast rock solid balance sheets with debt to equity levels more than 50% below the BDC requirements, plenty of liquidity to spend when the market opportunity does return, and seasoned loan portfolios principally booked in the post-Recession period. Glass half full or half empty? You be the judge.
Disclosure: I am long ACAS, ARCC, AINV, BKCC, SLRC.