Decimated stock valuations and heavy balance-sheet stress have the publicly-traded business development companies, or BDCs, pulling back on new loans but perhaps more open to selling portfolio companies.
New lending is scant, especially by the bigger players, because the growing disparity between share prices and book values has rendered the companies virtually unable to issue new stock to fund deals. Instead, dividend cuts and layoffs are the order of the day as the firms look to weather the credit crisis by conserving capital and cutting costs.
“While we continue to be one of the leading investors in the risk capital of middle-market companies and continue to produce substantial net operating income, we are not investing at the rates we have in the past and therefore need to size our operations to our current volume of business,” said Malon Wilkus, the company’s chairman and chief executive officer, in a statement.
The story is similar at
American Capital’s new investments totaled $443 million for the three months ended Sept. 30, a drop of 52 percent from its activity in the second quarter and 68 percent from the same period a year earlier. Of that $443 million total, $348 million represented financing for private equity buyouts, mostly in the form of subordinated debt. Funds deployed for American Capital-sponsored buyouts were nil, compared to $586 million in the same period a year earlier. Allied Capital made a total of $433.8 million in new investments in the third quarter but the majority of that, $319 million, was spent to purchase senior lender positions for portfolio company Ciena Capital LLC, which filed for bankruptcy protection on Sept. 30.
BDCs are required to maintain a debt-to-equity ratio of no more than 1:1 and to pay out at least 90 percent of their net operating income to shareholders through dividends. The firms typically finance investments by issuing new equity and thus are hamstrung in the current market, as their stocks across the board are trading well below book value.
American Capital finished the third quarter with a net asset value, or NAV, per share of $24.43 but its shares closed at $7.87 on Nov. 10, when it reported its third-quarter results. Allied Capital’s NAV per share was $13.51 as of Sept. 30 but its shares finished Nov. 10, when it also issued its report, at $4.11.
Shareholder approval is needed to sell new stock in such instances but that isn’t even really an issue at the moment, according to one observer. “No management team is even thinking about issuing stock at these levels,” Troy Ward, an analyst with Stifel Nicolaus, told Buyouts.
The weakness in leveraged loan pricing, in particular, has become a serious problem for these companies, weighing down near-term results, forcing substantial markdowns and putting certain financial covenants of credit facilities in jeopardy. Of late, these loans have been trading as low as 60 percent of par, according to a recent reading of the S&P/LSTA U.S. Leveraged Loan 100 index, which references the 100 largest institutional leveraged loans.
A BDC must ‘mark-to-market’ its assets each quarter. At current levels, the leveraged loan market is priced as if 80 percent of all loans will default. Having to reflect that doomsday scenario on their balance sheets has been devastating for BDCs as the unrealized depreciation of the underlying assets flows directly to their income statements, hurting shareholders’ equity, which often must be maintained to a certain minimum level in order to stay in compliance with the covenants of credit facilities.
In a recent research note on the BDCs, Stifel Nicolaus attributed poor third-quarter results for the group mainly to the deterioration in leveraged loan prices and said it expects to see a similar impact in the fourth quarter.
“We would argue that the current pricing is caused more by technical dislocations in the market place rather than actual default expectations of 80 percent,” the firm said. “Unfortunately, we think this dislocation will remain in effect until the banking system heals.” In response, the BDCs are buckling down. The focus now is on stockpiling cash and shoring up the balance sheet, not ramping up new investments.
From here, BDCs will undoubtedly be hoping for some measure of recovery in the leveraged loan market, a development that would enhance liquidity and loosen the vice they are currently in with regard to mark-to-market. To ward off potential covenant violations, the companies may look to negotiate amendments with their own creditors that provide a greater cushion for minimum shareholder equity. Another option is, of course, actively seeking exits in order to boost liquidity and pay down debt.
The middle market was fairly active, despite the credit crunch, through the end of the third quarter in September. American Capital was able to make about six deals, realizing total net portfolio gains of $73 million for the latest quarter, not bad, considering the circumstances.
The BDCs as a whole could look to become much more active sellers in the months ahead if current conditions continue to prevail although it’s difficult to see where the buyers will come from if the economy continues to suffer.
Ward, the Stifel Nicolaus analyst, believes the BDCs are trapped at the moment, as the weakness in the leveraged loan market is really a reflection of its stagnancy. “No one is actually selling any loans at 60 cents on the dollar. It’s going to take some serious de-levering for things to loosen up,” he said.