Fed's new rules for business development companies bring opportunity
INSIGHT ARTICLE |
The following content was first presented at the 7th Annual Trends in Business Development Companies Event held at Nasdaq on June 12, 2018.
The details and impact: How BDCs will be affected by the omnibus spending bill
It was March madness for BDCs. Business development companies scored a surprise win on March 23, when Congress passed its omnibus spending bill, which included new rules that BDCs have been chasing for years.
In a last-minute change, lawmakers added language that will allow BDCs to borrow more money and increase their lending. The provision eliminates the cap that restricted leverage to a 1:1 ratio of debt to equity. The bill allows BDCs to borrow $2 for every $1 of assets they own.
This should boost the BDC sector, which has faced mounting challenges in an increasingly competitive middle-market lending environment, according to a panel moderated by RSM’s Kate Seitz at June’s Nasdaq Marketsite conference.
“This would be the biggest change this industry has seen,” Ryan Lynch, analyst at Keefe, Bruyette & Woods, told Bloomberg at the time. “’Game changer’ may be too strong, but this is definitely very significant.”
As with all change, though, uncertainty persists. For example, not all BDCs will qualify for access to the full 2:1 leverage—and some of those that do may have a hard time taking it.
“BDCs have options here,” said Harry Pangas, who represents BDCs in connection with transactional and regulatory matters for the corporate law firm Eversheds Sutherland.
“One option is to opt into the legislation, and you see a lot of BDCs doing that. Those that do can go three ways. The board can approve it, stockholders can approve it, or there’s a dual approach: You can have your board approve it, start the clock on the one-year waiting period, then go to stockholders.”
The new legislation is just that—new—and BDCs are still examining and interpreting it. The opt-in process is one area of their focus. Boards at some public BDCs are asking, what if we approve the opt-in and shareholders vote it down? Can we ignore them? Institutional Shareholder Services, whose policy encourages responsiveness to stockholders, would likely take a dim view of that approach.
Some boards have floated the idea of unilateral opt-in, bypassing shareholders altogether. And while boards often do take unilateral action, several analysts have recommended against it for BDCs pursuing the new 2:1 leverage.
Another area of energetic discussion is rating agencies and their assessment of BDCs that access increased leverage. S&P has said it will downgrade BDCs that expand their ability to take on new debt. The BDC industry’s take: That just ain’t fair.
“It seems ridiculous to me, because S&P applies an investment-grade rating to plenty of companies with the ability to go out and become very highly leveraged, at which point they’ll be downgraded,” said Aaron Peck, a partner at Chicago-based Monroe Capital, which manages a listed BDC with $500 million in assets. “S&P doesn’t say to them, ‘We’re going to downgrade you today because you can go out and take on that leverage.’ They’re rated according to what they do, not what they can do.”
There are BDCs with mezzanine-oriented portfolios and subdebt and a lot of equity that will access 2:1, Peck explained. And then there are those with portfolios that are more senior-secured, lower-leverage, and at less risk if they do increase debt.
“BDCs should be treated according to their situation, and I’m hoping someone at S&P wakes up and realizes they have a pretty unfair approach,” Peck said.
To that point, two BDCs recently announced that their boards had approved the new leverage. S&P came out a week or two later with its threat of downgrades. The two BDCs subsequently filed a retraction.
“Maybe some of the bigger BDCs will be able to access the leverage, maybe others won’t,” Pangas said. “Maybe smaller ones that don’t have credit facilities and don’t care about S&P will. It’ll be interesting to see how it all shakes out.”
It should also be noted that Fitch has said it will address BDCs pursuing new leverage on a case-by-case basis. And it should be further noted that many BDCs are ratings-agnostic. “S&P doesn’t rate smaller BDCs investment-grade anyway,” said David Spreng, founder and CEO of Runway Growth Capital, a BDC started in 2016 that makes $5 million to $30 million growth loans to sponsored and non-sponsored companies. “So for me, I don’t really care what S&P does,” he said. “Maybe someday I will.”
The new legislation also presents uncertainty for an increasingly popular vehicle: the private BDC. The structure offers several advantages, such as tax benefits when dealing with foreign investors and tax-exempt investors. “The vehicle we’re getting called on now is the private BDC, not so much the traded and not so much the non-traded,” Pangas said. “It’s the vehicle du jour.”
But the new legislation poses questions for private BDCs, specifically on the topic of stock buybacks. It requires private and nontraded BDCs to offer to repurchase stocks from shareholders, but it doesn’t say exactly how.
“It’s ambiguous at best,” said Jim Curtis of Dechert. “Do you do one offer? Do you do a series of four offers? The statute says repurchase 25 percent of those securities in each quarter following the date of the approval. But how do you do it?”
For nontraded BDCs in particular, this presents real issues. If it’s four individual offers at 25 percent each, that means the BDC has to be prepared for the worst-case scenario, where it’s fully subscribed. And that means having 25 percent of the portfolio liquid for a year. But switching from assets that are yielding 12 percent to assets that are yielding perhaps a point and a half is likely going to conflict with the BDC’s stated investment strategy and objectives.
“This will certainly have an immediate effect on all your shareholders,” Dechert said. “Maybe not quite as bad as if you do a single tender offer and you pay 25 percent. But then how many shares are you going to have to repurchase in one tender offer? You can plan for it… You can get 25 percent in cash at the tender offer and a promissory note for the balance. Does that work? We don’t know yet. But I think we’ll find out soon.”
Under the new legislation, there is a lot that BDCs still don’t know. But one thing they do know: They have a win. Full ramifications, they can figure out later.