Possible Impact of Double Dip Recession on BDC Industry

by: Nicholas Marshi

We’ll put our cards on the table up front. We don’t believe there is going to be a double dip recession in 2010-2011 (much after that and it’s just a new recession). If we’re right and the economy continues to expand, whether fast or slow, the Business Development Company (“BDC”) industry should continue to see fundamentals improve: continued equity raisings, higher asset formation, lower non accruals and by 2011 lower Realized Losses. This would be a continuation of the recovery process of the industry which has been underway for months.

However, this article isn’t about what might happen in a good economy, but what could occur to the BDC industry should there be a double dip recession after all. Let’s say that the economy starts to decelerate, unemployment starts to track up again, lenders begin tightening credit and you can imagine the rest. What happens to the 22 BDCs we track, which comprise the bulk of the public companies?

We’ve been analyzing the subject over the last few days as the “wall of worry” mounts, looking at each company’s balance sheet, available capital ( cash, debt, equity), earnings, bad debts etc. We’re fortunate that we have the experience of the Great Recession seared in our memories.

First, we looked at what impact a double dip might have on BDCs liquidity. In the Great Recession, a credit crunch was caused by bank lenders refusing to renew lines of credit, and from defaults under loan agreements, principally due to asset values being marked down to market values. Some BDCs had to sell assets off in a hurry to avoid defaults or to pay off lenders, others went into default which caused all their energies to become focused on survival. A few were unable to navigate the suddenly changed conditions: Patriot Capital- in default and with it’s lenders unsupportive-sold out to Prospect Capital (NASDAQ:PSEC). Likewise Allied Capital-deeply in default- sold to Ares Capital (NASDAQ:ARCC) for similar reasons. GSC Investment (GNV) has just agreed to a major equity infusion and recapitalization to escape it’s defaulted debt with Deutsche Bank (NYSE:DB).

We applied a Stress Test to the balance sheet of every BDC we track: reducing the fair market value of investment assets by 30% in one fell swoop, and seeking to determine if such a dramatic reduction would cause asset coverage of net debt to fall under the 200% BDC gold standard ( which is always a big problem because it triggers loan defaults and causes the companies to be unable to continue to pay dividends). We took into account the type of borrowing arrangements of each BDC and the maturity of the lending arrangements. The key question we asked ourselves: is this company likely to default or at least be forced to give up any business as usual and focus it’s managerial energies on maintaining adequate liquidity.

What may be surprising to some, we only identified 3 companies which might face a liquidity crisis if conditions sharply deteriorated: American Capital (NASDAQ:ACAS), Kohlberg Capital (NASDAQ:KCAP) and Medallion Financial (TAXI). The first two are in this category because they are still fixing their capital structures damaged by the Great Recession. ACAS has raised equity recently, continues to sell assets and is beginning to get over 200% coverage. A debt restructuring is underway. A sharp shock to the economic system might undo that good work. It’s unlikely but not impossible. Kohlberg is still battling on all fronts, trying to get it’s financial filings in order to avoid a stock market delisting, suing it’s lenders and ( presumably) renegotiating it’s debt agreement. A second recession won’t help. As for Medallion, the company has de-leveraged outside it’s bank subsidiary. We worry that worsening economic conditions might cause bank regulators to force Medallion Bank to retain earnings and forbid any distribution up to the parent. The impact might at the very least be lower or no dividend payments.

What ’s interesting is which BDCs we don’t think will be in trouble who were the last time. Take for example TICC Capital (TICC). This technology lender had to repay it’s lenders by selling off assets under pressure in the Great Recession. This time the Company has no debt whatsoever, a decent amount of cash sitting on the balance sheet and a relatively clean portfolio credit wise. Asset values may drop but TICC would be unaffected, having no lender to answer to. Likewise with Gladstone Capital (NASDAQ:GLAD) and Gladstone Investment (NASDAQ:GAIN). The sister companies, which both lend in the lower middle market, had to sell off syndicated loans at rock bottom prices to repay a defecting lender who wanted out at all costs during the Great Recession. Today both companies have recently renewed loan agreements (albeit for short periods, lower amounts and higher pricing). More importantly for our stress test, both companies still have very little debt outstanding so a default due to asset borrowing bases dropping too much in value is nit in the cards.

Another saving grace this time round is that several BDCs have built their debt capital principally or exclusively from the SBIC, which does not mark the supporting loan assets to FMV, and whose securities do not have to be repaid for many years yet. Companies in this category include Triangle Capital (NYSE:TCAP) and Hercules Technology (NASDAQ:HTGC). The latter, for example, may have two Revolvers but they are being used as back-up lines of credit so far. Investments are being funded with equity and SBIC monies.

To quantify a little more, we believe that 50% of BDCs ( or 11 companies) have either virtually no debt or have only SBIC debt outstanding. There are 8 BDCs with moderate amounts of debt outstanding, but none are likely to face a liquidity crisis under our Stress scenario. The reasons differ by company. Apollo Investment (NASDAQ:AINV) has recently raised substantial amounts of new equity and has seen many existing loans get repaid. Apollo has been deliberate in reinvesting the proceeds so the Company has one third if it’s investable assets in cash form. Moreover it’s Revolver has just been renegotiated and extended. A 30 % asset meltdown would probably slow new asset formation, but is unlikely to cause a default.

If a second recession should come on soon, the BDC industry would be much more resilient than in 2008-2009 because most of the companies have become far more conservative than previously, have tried to learn from the Great Recession and are still substantially de-leveraged. Whereas in the Great Recession about two-thirds of the BDCs faced credit crunch and liquidity issues, this time round we put the percentage at only 15%. Even the three companies we have some doubts about should be able to survive.

Of course, avoiding a liquidity crisis does not mean that a second recession would be be benign for the BDC industry. A recession would ultimately mean higher bad debts, higher borrowing costs from bankers (SBIC borrowing costs might drop,though, as they are tied to Treasuries; also LIBOR borrowing costs would likely stay low) and fewer transactions to finance. Some of that would be offset, as it was the last time around, by lower management fees and operating expenses. Here we find it much harder to quantify because we have no idea how severe or how long this pro-forma recession might be.

Nonetheless, here a few words of comfort about bad debts. Many BDCs have divested themselves of the bulk of the loans made during the pre- Great Recession expansion, which were under-priced and over leveraged. New deals done in the past year, especially in the lower middle market and middle market where most of the new deal activity has gene concentrated, have been underwritten on far more conservative standards. Most BDCs have gravitated to more “defensive” industries, just in case a second recession did come to pass. The number of bad debts have been trending downwards in most cases in the last quarter. A number of BDCs have cleansed their portfolios and there are little or no non accruing loans left. Solar Capital (NASDAQ:SLRC) is in this category, and so is Pennant Park (NASDAQ:PNNT).

Many BDCs have capital to spend. If deals can be found, the earnings will fully or partly offset the possible earnings erosion from higher bad debts which inevitably accompany a recession. We surmise that two thirds of the BDCs we track have a good chance of being able offset bad debt losses with earnings from new assets over the next 24 months.

A recession is like a hurricane, and nobody looks forward to the collateral damage that will inevitably ensue. However, we believe the BDC industry is in far better shape than it was two years ago to see out the possible storm brewing. There are only 3 companies out of 22 whose liquidity might be stressed and two-thirds have the capital and capital structures to take advantage of what opportunities might be thrown up.