Some specialist finance firms that lend to midsize businesses face the threat of a funding crunch just as the coronavirus pandemic increases defaults, a potential blow that could shrink their businesses.
In the past seven weeks, two leading companies that lend to middle market companies,
Golub Capital BDC Inc.,
both raised funds by making sales of shares at significant discounts to their net asset value. Such a sale is generally viewed as a sign of stress in the industry.
BCSF revealed in its latest earnings report that a March 31 amendment to one of its banking facilities made it an event of default if an offering of shares in the company was not in the works by the next month. end of June 22. BCSF declined to comment.
The company is also one of a handful of middle market lenders that have recently issued bonds at high interest rates. Others include Antares Holdings LP and
FS KKR Capital Corp.
The pressure on publicly traded business development companies, or BDCs, and the private debt funds that often invest alongside them comes after years of rapid growth that has been driven in large part by investors seeking returns at a low price. days of ultra low interest rates.
Total assets under management of private debt and direct loan funds stood at more than $ 740 billion at the end of September, up from about $ 125 billion in 2006, according to Preqin, a research firm.
Similar to certain other types of asset managers, middle market credit companies typically rely on bank lines of credit to finance their investments. Such debt carries low interest rates and can increase lenders’ returns during good times.
There is a flip side, however. In stressed environments like today’s, banks may lower borrowing limits and require additional collateral, or liquidity, if assets lose value. Lenders can also be in a hurry from both sides if their own holding companies rushing to draw lines of credit, which happened in March.
“These capital structures can only handle such a deterioration in loan values,” said Finian O’Shea, BDC analyst at Wells Fargo Securities. Lenders who have raised money may not have breached the terms of their credit facilities, but “the reason they’ve done these things is to relieve that potential pressure,” he said.
Lenders worried about their standing with banks are less likely to grant new loans to businesses ranging from regional restaurant chains to upstart software companies, analysts said. But efforts to fix the problem, such as stock sales, can reduce returns for investors.
BDCs that have raised funds recently have generally said they are cautious about the uncertainty generated by the coronavirus pandemic.
Golub Capital BDC “is neither under pressure nor has it ever been pressured by lenders to raise capital,” said Chief Executive Officer David Golub. GBDC and Golub Capital, its affiliate private debt fund manager, “are enviably positioned with more than $ 5 billion of dry powder available for new loans in the middle market,” he added.
Dan Pietrzak, Co-Chairman and Chief Investment Officer of FS KKR, said: “We were able to step into a difficult market at the start of the second quarter and further improve our strong liquidity with only a nominal increase in our overall cost of debt. “
Mid-market lenders don’t often face this kind of funding challenge. Taking on the role of banks, many grant most of their loans directly to businesses, often to finance equity buybacks. They then hold these loans for their entire term.
The lines of credit they get from banks may differ. A standard arrangement allows specialist lenders to assess the value of their loans, which are difficult to assess, for themselves. But when an event calls into question the financial health of a borrower, the power to assess the loan can be transferred to the bank. These so-called value adjustment events can range from a large increase in debt to earnings to a delayed earnings report.
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Value adjustment events have already started to accelerate and may accelerate in the coming months after borrowers report earnings for quarters that fully reflect the impact of the pandemic, insiders of the pandemic said. industry. Moody’s Investors Service has estimated that the 12-month default rate for speculative-grade corporate loans and bonds will rise to just over 12% by year-end, from 4.7% at the end of March.
Ironically, some lenders who take a conservative approach to lending may be more exposed to funding problems, analysts said.
The BDCs of Bain and Golub, for example, fill the vast majority of their portfolio with priority loans in the event of bankruptcy. These loans are viewed by banks as more valuable collateral than junior loans, but they also tend to earn less than lower-ranking debt. This provides an incentive to borrow more with cheaper debt backed by specific assets rather than unsecured bonds, which carry higher interest rates.
The downside to this strategy is that it leaves these lenders with fewer so-called unencumbered assets that could be added as collateral elsewhere if necessary.
As of March 31, unsecured borrowing was only 13% of GBDC’s outstanding debt and 1% of BCSF’s debt, although the BCSF subsequently increased its unsecured debt with a sale of bonds. of $ 115 million. Their other borrowings came in the form of lines of credit from banks and secured loan bonds, or CLOs, another type of secured debt.
Capital of Arès Corp.
—The largest BDC by net assets — had 56% of its debt in the form of unsecured and convertible bonds.
Bain’s BDC shares fell 44% this year on Wednesday, while Golub’s BDC shares slipped 35%, according to FactSet. Ares Capital shares are down 21%.
Jerry DeVito, managing director of private credit firm Owl Rock Capital Partners which helps lead the firm’s funding strategy, said he expects private debt managers to try to hone the facilities banks in the future so that they can better withstand pandemic-type shocks.
“Borrowers are going to say I’ve learned another lesson about what can go wrong – we need to review some aspects of how these structures work,” he said.
Owl Rock Capital Partners manages the second largest BDC in terms of net assets, Owl Rock Capital Corp., which had 40% of its debt in unsecured instruments as of March 31.
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