Business development companies are facing one of their toughest challenges ever since Congress created them in 1980 as a way to encourage investment in small to midsize businesses.
Today, as they reel from the effects of the coronavirus outbreak, the valuations of their portfolio companies have dropped as the risk of default has grown amid a liquidity crunch. RSM recently hosted a virtual roundtable of BDC executives, who shared their insights into how they are coping with the downturn. There are steps, some of which were discussed at the roundtable, that BDCs can take to manage the significant shock to the economy.
BDC loan portfolio valuations have recovered from March lows…
Maintaining access to credit
BDCs will need to continue supporting their portfolio companies to ensure their survival even as their ability to do so may be hampered by the terms of the credit facilities with wholesale lenders. BDCs rely on lenders to extend revolving lines or credit or term loans to achieve the leverage that enables them to increase their returns.
These credit facilities often come with maintenance covenants on financial metrics such as minimum shareholder equity, asset coverage ratios and EBITDA, or fixed-charge coverage ratios. Many of these are under threat as the sudden financial shock that took hold in March has set in.
Many credit facilities are under threat as the sudden financial shock that took hold in March has set in.
Realized and unrealized losses from write-offs and significant valuation markdowns will be inevitable. This will test the resilience of most BDC portfolios and balance sheets, and potentially leave some of them out of compliance with certain covenants. This could have the effect of restricting further drawdowns on available lines of credit when they are needed the most and can trigger an acceleration of repayments, raise interest charges and activate cross-default provisions in other loan agreements.
To prevent these adverse outcomes and technical defaults, BDCs are working with their lenders to negotiate amendments to credit facilities or to secure temporary waivers for certain covenants. Risk management and minimizing credit exposure to distressed companies is top of mind for lenders in the current environment as they look to protect their own balances sheets.
Given this backdrop, BDC insiders have indicated that asking for such accommodations has been received with mixed reception. Some lenders have been constructive and shown a willingness to work with borrowers, while others have indicated that such requests would be viewed negatively and could result in a re-evaluation of the risk profile, which would result in an increase in pricing. The tone from lenders has also been noted to be fluid and constantly shifting as lenders assess conditions one day at a time in an ever-changing atmosphere.
Where lenders have been willing to make concessions, BDCs have mentioned being able to secure holidays for valuation adjustment events. This will cushion BDCs from the portfolio valuation drops that would have threatened their ability to meet certain covenants. Lenders have also shown flexibility on adjusting advance rates, which will allow BDCs to maintain borrowing capacity even as collateral values fall.
Accommodations have also extended to temporary waivers of unused facility fees and accepting interest payments in kind. To secure the amendments or temporary relief, some borrowers reported that they have had to pay down some of the outstanding debt and lenders seeking a rate increase is not off the table.
In a previous note, we wrote about how some BDCs had recently pursued rights offerings as a way to get around the fact that BDCs are prohibited from issuing new equity at an offering price below their net asset value, unless they obtain shareholder approval.
We may see more BDC shareholders approve stock offerings at a price below net asset value.
One BDC recently announced that its stockholders had approved a proposal at its annual stockholders meeting to authorize it to issue common stock at a price below net asset value.
With BDC stocks trading below net asset values, we may see more of these approvals in the coming months or other announcements of rights offering as BDCs seek to generate capital to support existing portfolio companies, to take advantage of market opportunities in the current dislocation or to bring leverage ratios within target ranges.
BDCs are trading below NAV, making equity offerings a challenge…
Making valuation assessments
BDCs will find the quarterly valuation process more challenging possibly for the remainder of this year as trailing inputs are rendered obsolete and forward inputs prove to be estimates founded in too many unknowns. These include when and how quickly the economy will reopen, whether a second wave of Covid-19 cases will surface, possible changes in consumer behaviors and preferences, and the state of the competitive landscape in the aftermath.
A number of BDCs and valuation agents have reported taking a three-tier approach:
- Tier 1 for performing positions that have minimal to no impact from Covid-19,.
- Tier 2 for portfolio companies that are moderately impacted.
- Tier 3 for those with direct exposure to Covid-19 and facing significant disruption.
These tiers are then used to calibrate accordingly relative to December 31, 2019, valuations.
It will be important to ensure that a good-faith valuation that takes into account information available to market participants as of the measurement date is performed. This will be particularly difficult given the wild swings in public or other observable markets. April ended up being one of the best months for U.S. stocks in more than 30 years as equities rebounded strongly from lows reached in March.
As appraisers develop valuation assumptions in the coming quarters, they will need to be conscious of the bias that may set it from anchoring on the high and low points observed in an extremely volatile market and be more attentive to market conditions as of the valuation date.
Meeting distribution requirements
BDCs will need to continue making distributions in order to meet the distribution requirement to qualify as a regulated investment company and for favorable treatment under Subchapter M of the Internal Revenue Code. Even though most BDCs have a healthy share of undistributed income to cover shortfalls in the interim months, we have observed some BDCs announce a change in their dividend payment schedule from monthly to quarterly to better match dividend distributions with timing of receipt of income by the BDC.
We believe such actions to be prudent moves that will help with liquidity management while still complying with the distribution requirements. The current extenuating conditions offer enough rationale for such actions to defray some of the shareholder backlash that would be expected from making such a change in normal times.
BDCs may have an opportunity to limit cash outflows from the fund through the use of formal or informal dividend reinvestment plans and part cash-part stock distributions. Most BDCs have observed a low participation in dividend reinvestment plans as most investors automatically opt out of receiving stock in favor of cash. A significant number of BDC stockholders hold their shares through brokerage firms and this can create opportunities for BDCs if the brokers opt in to their dividend reinvestment plan.
In cases where BDCs offer a discount from market prices to investors reinvesting in stock, this can be of benefit to clients of brokerage firms that take advantage of this instead of going into the open market to reinvest dividends received on behalf of clients that have not opted out of receiving stock. BDCs may benefit from greater participation in dividend reinvestment plans if these mechanics were more widely communicated to investors.
BDCs have generally seen limited pockets of opportunity for their portfolio companies to secure funding under the Paycheck Protection Program and these companies also seem set to miss out on the Main Street Lending Program unless further iterations to the term sheets are made. Given that BDCs often invest alongside private equity sponsors, the affiliation rules have been a stumbling block.
Even with the Main Street Priority Loan Facility, BDC portfolio companies may still face challenges.
Even with the April 30 announcement from the Fed of the Main Street Priority Loan Facility under its Main Street Lending Program, which increased the 4.0x debt to earnings before interest, taxes, depreciation and amortization (EBITDA) ratio to 6.0x, BDC portfolio companies may still face challenges.
Even if these companies have debt-to-EBITDA ratios below 6.0x, a difficult hurdle to overcome in and of itself, the lack of banking relationships or outstanding loans with institutions qualifying as eligible lenders under the Main Street Lending Program will prove to be a hindrance. This lack of existing banking relationships is the reason they turn to non-bank lenders such as BDCs in the first place.
The announcement by the Fed on April 9 to include asset-backed securities with credit exposures to leveraged loans as eligible collateral under the Term Asset-Backed Securities Loan Facility (TALF) was received positively by markets in the immediate aftermath as this meant collateralized loan obligations (CLOs), which some BDCs invest in, could be used to secure funding under TALF.
Since then, closer inspection of the term sheet has made it more apparent that TALF will not do much to alleviate BDCs’ funding pressures. The term sheet requires that the collateral be newly issued AAA-rated CLO tranches. Given that the CLO market was more or less closed throughout March and opened up again only with very limited activity in April, access to eligible CLO tranches is all but impossible. This is another one of the Fed’s term sheet that will need further revisions before it can be of practical benefit to BDCs.
On April 8, the Securities and Exchange Commission extended some temporary relief that would allow BDC to take on more leverage until December, beyond the limits set in the original Investment Company Act of 1940. This was also well received as markets applauded the additional latitude that BDCs had been afforded to enable them to continue supporting their portfolio companies. The temporary relief comes with a 90-day restriction from making new initial investments in any portfolio company in which the BDC was not already invested at the time the relief order was issued.
We believe this restriction to be a deterrent. This limitation, coupled with the difficulty in the current conditions to secure the additional borrowing capacity needed to increase leverage as intended by the relief order has resulted in this temporary relief going more or less unused. Since the announcement, we have observed only one BDC making the necessary filing to take advantage of this relief.
- BDCs are at risk of falling out of compliance with debt covenants, as expected portfolio losses mount and collateral values drop. To preserve credit lines, BDCs are working with lenders to amend credit facilities or obtain temporary relief. Although lenders many prefer to limit their exposure in a crisis, some are recognizing the need to work with BDCs to avoid a cascade of defaults that may ultimately be more costly for all parties.
- BDCs are exploring equity offerings even in the current difficult conditions. Rights offerings and plans for shareholder-approved equity offerings at a discount to net asset value have already surfaced and there may be more to come.
- Valuations will be difficult to determine in a volatile market and as economic uncertainty make forecasting challenging. A tiered approach that sorts subject companies based on the extent of Covid-19 exposure may help in calibrating valuation assumptions
- BDCs should weigh changing the frequency of dividend payouts to better align with cash inflows. Dividend reinvestment plans may also help to reduce cash burn, but these will be limited by low investor participation.
- BDCs will not benefit from government stimulus without further changes to current fiscal and monetary responses. Their portfolio companies are expected to miss out on the Paycheck Protection Program and Main Street Lending Program. In addition, BDCs are unlikely to get any relief from the Fed’s TALF program and SEC regulatory order announced in April.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.