With apologies to Yogi Berra, this feels like deja vu all over again. Almost exactly a year ago we put pen to paper to discuss what might be the impact of a potential "double dip" recession on the Business Development Company (BDC) industry. One year on and we're facing a similar question mark brought on by the concerns raised by the Greek debt crisis (again). We've been listening to the same commentary on CNBC as everyone else, and reading the news articles and opinion pieces. We're a little frustrated at how glibly much of the analysis jumps from a potential Greek default on their sovereign debt to a global recession. Nonetheless, the point of this article is to once again to presume that such a dire scenario does come to pass. We would like to make crystal clear, as we did a year ago, that we don't believe that anything so dire is going to happen. As they say, this is just a test.
A SYNOPSIS FOR OUR BUSY READERS
We're going to detail what happened last time the BDC industry faced a recession, and what we expect will happen this time, should the worst come to pass. We'll ruin the suspense up front and let you know that we don't expect a new recession to have anywhere near as harmful an impact as the Great Recession of 2008-2009. Yes, we're actually going on the record to say that this time it will be different. Read on for all the arguments and supporting facts.
PAINTING A DARK PICTURE
Let's flesh out the details a little of our worst case scenario: we are going to assume the Greek default does occur, several other debt laden countries follow suit and the banking system worldwide goes into lock-down, worried about the financial viability of many of its members. Like in 2008-2009, business financing will likely become very hard to come by and asset values will drop. Moreover, in the fullness of time the recession that will follow will result in increasing defaults, bankruptcies and bad debts. (We don't foresee the complete collapse of industrialized societies or another Great Depression. If matters get that bad, all bets are off.)
WHAT HAPPENED LAST TIME THERE WAS A RECESSION
When the 2008-2009 Great Recession began with conditions very similar to those described above, the impact on the BDC industry was dire. The impact was felt in two distinct waves. The initial impact of the Recession came from the reduction in asset values as BDCs are required to revalue their assets to market prices every quarter. In many cases this caused, or threatened to cause, defaults on bank loan agreements and on CLO financings, which funded many of the larger BDCs. Of course, with lending agreements in default or in jeopardy, BDCs were forced to de-leverage in a hurry to bring debt levels are control.
In 2008-2009 the main problem was that the 21 BDCs in existence at December 31 2007 had been used to over 5 years of very stable asset values. As a result, to enhance earnings and to take advantage in the boom environment of 2006-2007, most BDCs had leveraged themselves up close to the maximum allowable of debt to equity of 1.0:1.0. When the Great Recession came along loan asset values were written down by as much as 40% in the space of a year or less.
That turned out to be disastrous for companies like American Capital (ACAS), Allied Capital, Patriot Capital, MCG Capital (MCGC) when their portfolio values dropped below BDC mandated thresholds. Debt covenants were breached as well, as borrowing base calculations precipitously fell. Even companies that nominally avoided breaching the minimum 200% assets to debt requirement that BDCs live by and did not default had to focus all their energies on reducing debt by selling off assets and forsaking new business. Companies in this category included BlackRockKelso (BKCC), Apollo Investment (AINV) and PennantPark Investment (PNNT).
Also hard hit were BDCs who faced lender defections, and were unable to replace debt financing in full. Most dramatic was the case of TICC Capital (TICC), which was forced to de-leverage completely. Other BDCs in this category were Hercules Technology (HTGC), Gladstone Capital (GLAD), Gladstone Investment (GAIN), GSC Investment (now Saratoga Investment) (SAR) and Kohlberg Capital (KCAP).
In a second wave came the actual bad debts, which began to materially affect earnings in the middle of 2008 and peaked in June 2009, but have continued to impact earnings in some of the BDCs to this day. Here the results varied dramatically by company. Leading the pack were American Capital and Allied Capital, with MCGC Capital and Apollo Investment not far behind. By our calculation, Realized and Unrealized Losses at 6 companies exceed 30% of equity at par. Another 6 ranged between 10%-30%. On the other hand a number of BDCs managed to largely dodge the bad debt bullet in the last recession, and managed to keep losses (calculated as Realized Losses to Equity At Cost) in single digits. Companies that achieved this feat include Triangle Capital (TCAP), Main Street Capital (MAIN), Fifth Street Finance (FSC) and Ares Capital (ARCC), although those numbers are helped by the astute purchase of Allied Capital.
As you might expect, BDCs that incurred major credit write-offs also had to cut or suspend dividend payments. BDCs that kept credit losses low were able to keep dividend cuts relatively mild (ARCC), or were able to maintain or even increase their pay-outs during and after the Great Recession (MAIN,TCAP, FSC).
WHAT MIGHT HAPPEN IN THE NEXT RECESSION
First of all we should note for the record that the number of companies in the industry has increased, despite the absorption of Allied Capital and Patriot Capital into existing BDCs. There are now 28 industry players we are tracking, up from 23 two and a half years ago.
Back to our possible next recession: what might happen to the BDC industry at it stands today should a recession come along in the weeks ahead ? We would expect the same double punch to occur of asset values dropping before bad debts increase. We're already experiencing a mini-crisis of confidence in the leveraged finance markets in recent days, with corporate and junk bond issuance slowing down to the lowest levels of the year, and loan spreads widening.
However, we're remarkably unworried about the impact that a sudden drop in asset values might have on BDC companies ability to continue "business as usual." Our sang froid is largely due to the much stronger capital structures that most BDCs have constructed in the post-Great Recession period. The easy fact to quantify is that debt to equity levels are far more conservative than they were at the onset of the last economic recession in December 2007.
Here are a few examples: American Capital's debt to equity was 0.75: 1.00 (and 1.4: 1.0 a year later). Today, American Capital's net debt to equity is 0.40: 1.00, and dropping. Ares Capital's was at 0.61 in 2007 and 0.83 in 2008, but is at 0.42 as of March 2011. Apollo Investment was 0.86 in 2007, but is at 0.53 now. We're still compiling all the numbers, but we estimate that aggregate debt to equity for the industry as a whole does not exceed 0.3: 1.0. Or put another way: BDCs have borrowed less than a third of the debt capital they are allowed to under the industry's special restrictions.
"WE WON'T GET FOOLED AGAIN"
Beyond the numbers, though, we are taking comfort from the knowledge that most every BDC has constructed a capital structure intended to be more resilient in turbulent economic environments, and capable of enduring most conceivable market crises. We've heard the same mantra from most every company on most every conference call or Investor presentation: we want to be prepared for the next recession. In practical terms this was accomplished by most of the BDCs reloading themselves with multiple rounds of equity offerings in the past 30 months. Beyond that, many BDCs have greatly reduced their reliance on short or medium term Revolver financing (which is liable to default, or not get renewed at a critical juncture). Instead, the BDCs have turned to medium or long term unsecured debt or convertible debt, with maturities equal or greater than the loan assets being financed. Even more important than the maturity structure of this debt are the looser covenants that are attached to them. This has increased interest expense but has positioned many BDCs to avoid having loan defaults triggered when market conditions deteriorate.
The bigger BDCs have tapped the private market for this type of financing and the smaller BDCs have mostly turned to the Small Business Investment Corporation (SBIC) for 10-year debt. A handful of BDCs which have been unable to locate appropriate medium term financing have either jettisoned their Revolvers entirely (TICC Capital comes to mind), or has maintained cash or other liquid assets in sufficient quantities to pay off any Revolver outstandings at will (Gladstone Investment Corporation, Kayne Anderson Energy, NGP Capital are examples). We'd be hard pressed to identify even one BDC that is currently even theoretically at risk from a fickle revolving debt lender.
Which is not to say that a sharp reduction in asset values and in market confidence would have no impact on the BDC industry. A number of the companies in the industry fund themselves partially through CLO structures that might be at risk in this theoretical new recession. The risk principally is that the BDCs, which have usually invested in the subordinated and equity portions of said CLOs, will have to wait to receive any current payments on their higher yielding tranches until the more senior tranches are paid off or market conditions improve. This is already the case with American Capital, which has about $1bn of CLO debt financing on its books. Other BDCs that might be affected include Golub Capital (GBDC), Kohlberg Capital and MCG Capital . However, due to the considerable amounts of liquidity sitting at most of these BDCs, the diversion of these interest payments could be absorbed without a major impact on the direction of the BDC's business.
Overall, our research suggests every BDC we track would be able to absorb a 30% drop in the fair market value of their assets without breaching the BDC 200% asset coverage rule and in virtually all cases without triggering a default under its debt agreements. (If we are hedging ourselves slightly here it's only because it is hard to know exactly what provisions of loan agreements might be affected by such a sharp drop in loan values as most BDCs provide very inadequate information about covenant compliance in their filings, so we're more in the dark in this area than we'd like to be).
BAD DEBTS REDUX
Bad debts don't happen right away when a new recession comes into town. It takes time for weakening economic conditions to show up in companies' earnings and for defaults to begin to pop up. For the benefit of this exercise, we'll assume a recession that would begin in the second or the third quarter of 2011 would result in a higher spate of bad debts from the fourth quarter of 2011 and into 2012. (In the first quarter of 2011 there were very few new non-accruing loans showing up on the BDCs financial reports).
Of course, bad debts are the bane of any lender, and BDCs are no exception. Again, though, we are reassured by where the industry sits today versus back at the outset of the last recession. This time the loan portfolios on most BDCs books (American Capital being a very notable exception) are mostly composed of investments made in companies in the post-Great Recession period. These loans were underwritten with far greater conservatism, and in a much narrower, more defensive universe of borrowers than the loans put on the books in 2006-2007. We've been reviewing the quarterly filings for several periods and found very few loans made in the past two and a half years going on non-accrual. We'd be very surprised, even if a new recession took hold, that bad debt levels of the mid-2008 to mid-2011 vintage periods would be anything like the losses realized from loans made in the 2006 to mid 2008 period.
WHAT WE WORRY ABOUT
The one area we worry most about where bad debts are concerned should a new recession occur are the remaining loans from the pre-Great Recession period. Data available from American Capital and other sources has clearly shown that loans made in the heady days of 2006-2007 have defaulted at a greater percentage than loans made before or since.
Many BDCs have virtually no loans from this period still on their books or like new BDC THL Credit (TCRD) came on the scene subsequently (IPO in April 2010). However, there is still a reasonable minority of loans still outstanding from 2006-2007 that are still in default. We have relatively good visibility on how many of these loans are on the books of BDCs. In the last 7 quarters the number and dollar volume of the loans has been reducing as companies are liquidated, restructured, bought out or return to performing status. Nonetheless, and despite a slew of refinancings across every sector of the BDC industry, the BDC industry continues to carry in portfolio many billions of dollars in loans dating from before June 2008. Our educated guess is that such loans still account for at least one-third of total industry investments at cost, or well over $7bn.
PERFORMING TO NON-PERFORMING AND BACK AGAIN
Harder to put our arms around are how many of these loans which have been performing might become non-performing with the onset of this new hypothetical Recession. We're most concerned about the many loans that were under-performing for one reason or another, and were restructured by their lenders (usually swapping out some debt for an equity stake) and re-entered into the Performing category. There is no explicit data in the filings about the dollar value outstanding of such loans, so you have to read all the reports carefully to determine each BDCs exposure to these born again performing loans. Some BDCs do not have any loans of this kind at all, while others have numerous examples of what we're talking about. Not to pick on anyone but Prospect Capital (PSEC), American Capital and Gladstone Investment have been active in such restructurings. Maybe this sub-category of loans in portfolio will behave no differently than all other pre-Great Recession loans, but common sense would suggest otherwise.
Again, we'll say we don't expect another recession, but should one occur we don't expect the way it will play out will mimic what happened in the 2008-2009 Great Recession. The lower leverage on BDCs books; the longer term capital in place and the substantial amounts of cash sloshing around will absorb even a very sharp drop in asset values should they occur. That will save the BDCs from fire sales of loan assets and from scrambling around for new lenders at the bottom of the market. It will probably allow more BDCs than three years ago to continue to book loans (presumably on excellent terms) even in the midst of the hypothetical crisis.
If there is a new recession, we believe bad debts will increase in most every case, but we expect most of the theoretical losses to be concentrated from amongst the loans booked prior to the Great Recession, and especially amongst companies that had problems last time round and got rescued by their sponsors and financiers through a restructuring. In absolute terms, though, credit losses should be significantly lower than the last time around. In many cases higher credit losses will be offset by higher income as BDCs get the opportunity to deploy the substantial amounts of unused capital sitting on their balance sheets. However, we would expect that within the ranks of the industry there will be a wide variance in performance given the very different mix of assets, unused capital, debt agreements etc. that each BDC has. As happened the last time around there will be winners and losers, but they're unlikely to be exactly the same players in each category.
Disclosure: I am long ACAS, BKCC, AINV, PNNT, TICC, HTGC, KCAP, TCAP, MAIN, FSC, ARCC, GBDC, PSEC.