The coronavirus pandemic has taken a severe toll on the American economy, with small and midsize businesses being hit especially hard. It’s not surprising, then, that the stock prices of business development companies, which invest in small and midsize companies along with distressed enterprises, have experienced the sharpest and fastest decline since the financial crisis of 2008-9.
Still, BDCs may ultimately have a better chance of weathering the storm without suffering the depression-level shocks that seem to have been priced into their stock prices.
This is because of regulatory relief from the Securities and Exchange Commission and financing aid from the Federal Reserve, which will help BDCs fund portfolio companies that are in dire need of liquidity.
Indeed, BDCs have recovered a bit from the lows reached in March as markets welcomed the news of the relief from the SEC and the Fed.
BDCs have underperformed equity indices …
SEC grants relief
The SEC issued an order on April 8 granting temporary exemptions from rules that would have limited BDCs’ ability to continue to provide credit support to portfolio companies under current financial conditions. The exemption period will last until December, and the SEC may extend the period and issue other relief if it deems it necessary.
The temporary relief will allow a BDC to issue senior securities by calculating its asset coverage ratio using the fair values of its portfolio company holdings as of December 31, 2019, instead of more recent values at the time of issuance.
The SEC’s regulatory change gave some relief to the way BDC’s must value their holdings.
This approach will yield a much more favorable asset coverage ratio because depressed valuations in the current market conditions will not significantly affect a BDC’s asset coverage ratio and the ability to take on more leverage.
The revised asset coverage ratio calculated using this temporary method will need to be adjusted by 25% of the difference between the revised asset coverage ratio and the asset coverage ratio calculated using the normal rules.
To take advantage of the relief, a BDC must receive board approval and make an election by filing a Form 8-K. In addition, before issuing senior securities, the board will need to determine that the issuance is in the best interest of the BDC and shareholders.
BDCs making the election to rely on the temporary relief will be subject to a restriction for 90 days from the date the election is made, which will prohibit any new initial investment in any portfolio company in which the BDC was not already invested at the time the order was issued.
Any new investments will be permissible only if at the time of investment the BDC’s asset coverage ratio complies with the regular asset coverage ratios applicable before the relief order.
The relief order also temporarily eased the rules for making follow-on investments alongside affiliated funds if a BDC has an existing order permitting co-investment transactions in portfolio companies.
Expanding TALF
On April 9, the Fed announced it would broaden the range of assets that are eligible collateral under the Term Asset-Backed Securities Loan Facility – a lending program designed to support the flow of credit to consumers and businesses — to include AAA-rated tranches of newly issued collateralized loan obligations.
A special purpose vehicle to be backstopped by $10 billion of equity from the Treasury will be created to facilitate TALF. The Fed will lend to this special purpose vehicle, which will in turn make up to $100 billion of three-year loans that are fully secured by eligible asset-backed securities.
The Fed expanded the types of securities allowed under TALF.
The list of eligible collateral was extended in the recent announcement to include asset-backed securities with credit exposures to leveraged loans and commercial mortgages. This will allow assets held by BDCs which can be packaged into collateralized loan obligations to be used as eligible collateral to secure funding under TALF. This is welcome relief following weeks of outcries from industry players to extend the eligibility to assets held by mortgage REITs and BDCs, which until recently had been left out of the Fed’s lending programs.
The TALF program is part of a broader $2.3 trillion liquidity commitment from the Fed that includes other funding programs. The most significant of these programs is the Main Street Lending Program which was designed to provide loans to small and midsize businesses. Portfolio companies of BDCs may be eligible for these loans if they have between 500 to 10,000 employees and revenue of less than $2.5 billion. BDCs should explore this program with their portfolio companies and their bankers.
In the event that a portfolio company is small enough to fall under the 500-employee threshold, the Paycheck Protection Program (PPP) through the Small Business Administration can be explored as an alternative option.
The Fed’s $2.3 trillion liquidity commitments also include support for the flow of credit via PPP through its Paycheck Protection Program Lending Facility, and Congress is currently exploring legislation to supplement the $349 billion earmarked for PPP under the CARES Act by up to an additional $250 billion.
BDCs have other options
In addition to taking advantage of the SEC relief and lending programs from the Fed or the Small Business Administration, BDCs can explore other alternatives to support their portfolio companies:
- Drawing on lines of credit: The passage of the Small Business Credit Availability Act in 2018 increased leverage limits for BDCs to a 2:1 debt-to-equity ratio from the previous 1:1 if a BDC took certain steps to receive the approval of its board or shareholders. BDCs that took advantage of this change also went on to extend their lines of credit with their lenders in line with the new limits.
- Not all BDCs tapped into this extended availability, though, and have kept leverage ratios well below 2:1. These BDCs will be well positioned to draw on their lines of credit to inject liquidity into portfolio companies that need it or to take advantage of the current market dislocation to make investments. BDCs that had unfunded commitments to their portfolio companies may have no choice but to tap into the available lines with their lenders to satisfy draw-down requests on unused revolvers which have ticked up in March and April as portfolio companies look to bolster liquidity.
- Rights offerings: With stock prices battered and well below net asset values the only option left to BDCs for tapping the public markets may be in the form of a rights offering. BDCs are prohibited from issuing new equity at an offering price below their net asset value unless they obtain shareholder approval. Through a rights offering, current shareholders can be offered the right to subscribe for new shares at a discounted price. This may be unpopular as shareholders that do not take up their rights will be diluted. But for BDCs close to their limits on leverage, even with the temporary relief from the SEC, a rights offering may be the only option to raise cash through public markets.
- Partnering with private equity sponsors or other lenders: BDCs typically co-invest with private equity sponsors or as part of syndicates with other lenders. Tapping into the pool of dry powder available to private equity sponsors to provide bridge financing or working with other lenders to arrange follow-on facilities can limit a BDC’s individual commitment and allow available capacity to stretch further.
- Selective funding of existing portfolios: BDC sponsors will need to enter triage mode to ensure that limited capital resources are allocated in the most effective way on a risk-reward basis. BDCs will need to sort through the portfolio and identify businesses that have limited prospects of surviving the current slump or low potential in the aftermath of the crisis. To avoid throwing more good money into such portfolio companies, these will need to be allowed to fail to conserve cash for businesses that can weather the storm or new investments that have more attractive return profiles in the short to long term.
- Payment-in-kind and other forbearance: To ease cash flow demands on portfolio companies, and to the extent that debt arrangements allow it, payment of interest in kind, or PIK, should be explored to offer temporary relief. Beyond contractually agreed means to defer cash payments, additional forbearance or debt modification may need to be arranged to temporarily modify or suspend payment terms over the next two to three quarters.
Tax considerations
As BDCs incur significant unrealized losses and try to weather this crisis, it will be important to weigh the impact on their qualification for treatment under Subchapter M of the Internal Revenue Code. Treatment under Subchapter M allows regulated investment companies like BDCs to deduct dividends paid to shareholders from taxable income if certain requirements are fulfilled.
One way to minimize the cash drain from dividend payments is the use of dividend reinvestment plans.
One of these requirements is that a BDC must distribute at least 90% of its taxable income as dividends. Most BDCs make these dividend distributions quarterly, and in the current environment this will be a drain of much-needed cash resources and worsen leverage ratios that are already hurt by depressed valuations of portfolio holdings.
Use of PIK and other debt modifications to alleviate liquidity stresses on portfolio companies will generate non-cash income, which will still be subject to the 90% distribution requirement. This will only transfer the liquidity pressures to the BDC, which will need to fund the dividend distribution to its shareholders without realizing any cash from the underlying income.
One way to minimize the cash drain from dividend payments is the use of dividend reinvestment plans, or DRIPs. These plans allow declared dividends to be settled by issuing the equivalent amount of additional shares in the BDC instead of cash payouts. The amount reinvested is treated as a deemed cash dividend and will satisfy the distribution requirement.
The takeaway
Despite the expectation for losses in BDC portfolios in the next two to three quarters, the recent market drops may be overdone. The current stock prices and discounts to NAV imply a level of loss in the order of magnitude last seen during 2008-9. While it is difficult to forecast the full extent of the economic damage that the coronavirus and resulting stay-in-shelter orders will cause, BDCs and their portfolio companies have a number of avenues to pursue to survive through the current crisis and minimize losses in the long run.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center
