Talking Deal Prices: Higher BDC leverage may not juice valuations

Business development companies — engines of middle-market dealmaking — finally got Congress to approve higher leverage limits of 2:1, up from 1:1, capping a multiyear effort by the industry.

Congress included the Small Business Credit Availability Act in an omnibus spending package signed by President Donald Trump, and supporters say it will help smaller businesses access more capital and hire more people.

Whether the extra leverage also leads to richer buyout multiples for BDC portfolios remains to be seen.

The law requires BDC boards to approve higher leverage limits, as well as a year-long cooling-off period before implementation. If a BDC wants to accelerate use of higher leverage, it needs to get shareholder approval.

Since then, several BDCs including Ares Capital, Corporate Capital Trust, TCG BDC, Stellus Capital Management and TriplePoint Venture Growth have all moved to adopt the higher leverage limits.

At first blush, doubling the amount of leverage available to BDCs seems as if it could effectively lead to higher buyout prices and shakier debt terms since competition for deals across the M&A universe remains intense.

Feeding this view, S&P in April issued a negative outlook on several BDCs and a CreditWatch rating on others because “in terms of credit risk, the legislature has narrowed the gap between BDCs and other nonbank finance companies.”

The action amounted to a warning shot for the asset class, with the prospect of debt downgrades raising the cost of capital.

Ares implementation

Possibly with an eye on its bondholders or even concern from its shareholders, the largest BDC, Ares Capital, on June 25 presented its strategy for implementing the SBCAA in a way that may help calm fears about overleverage and overpaying.

Ares vowed to maintain the quality of its investment portfolio, “patiently” deploy its capital on buyouts and other deals, and increase its leverage target only to a range of 0.9x to 1.25x, not 2x. It also vowed to keep its investment-grade credit rating.

To sweeten the deal for shareholders, Ares said it would reduce its base management fee to 1 percent from 1.5 percent on assets financed with leverage of more than 1x debt-to-equity.

“We don’t expect to see any change in our investment strategy at all,” Mitchell Goldstein, Ares Capital co-president, said Aug. 1 on the company’s second-quarter analyst call.

“There are other BDCs that have said … we’re going to orient ourselves more toward senior loans or increase our financial leverage. … We really don’t intend to do anything differently.”

Given Ares Capital’s market-leading position, it may effectively set the bar for leverage limits well below the 2:1 limit for the industry.

S&P on June 25 downgraded Ares Capital to BBB-/stable from BBB. The move maintained the BDC’s investment-grade rating.

In a June research note, Wells Fargo analyst Jonathan Bock praised Ares for avoiding a more severe debt downgrade and welcomed the firm’s move to adopt the SBCAA as a win-win for shareholders and the BDC. (Bock left Wells Fargo in July to become CFO of Barings BDC Inc.)

“Shareholder returns are set to improve via stable spreads, lower fees and higher leverage and it will lead to an improved risk profile via more senior secured assets and a relaxed regulatory leverage 2:1 covenant,” Bock said.

At the upper 1.25x end of Ares’s new target, the BDC’s leverage range is well below that of banks, which operate with debt-to-equity leverage of almost 10x; broadly syndicated CLOs, at just above 9x, and SBICs at 3x, Bock noted.

Risk-reward

Meanwhile, industry insiders are quick to point out other advantages offered by the new 2:1 leverage limit.

For one, it may better protect BDCs against economic downturns. If assets get marked down while debt loads remain the same, the new leverage limit will provide a cushion.

The higher leverage limit may also allow BDCs to purchase more companies and therefore diversify the risk in their portfolios.

With the risk BDCs would be taking if leverage ratios increase comes the possibility of better returns, at least for now.

In terms of deal prices, BDCs will remain motivated to avoid overpaying just to maintain their IRR performance and dividend payments.

Another counterbalancing force against excessive BDC leverage comes from banks that lend to BDCs. Some banks have covenants that may prevent BDCs from getting too close to the 2:1 limit, industry players said.

“BDCs must still focus on delivering a return to their investors,” said Paul Forrester, a partner at Mayer Brown who follows the BDC space.

“This discipline may keep acquisition prices in check. The new leverage limits may help BDCs be more competitive, but not overly aggressive.”

While purchase-price multiples remain lofty across the space, BDCs also have a couple of advantages to win deals, as well.

BDCs enjoy a lower cost of credit stemming from their tax-exempt status. They also benefit from potentially longer hold periods for portfolio companies than traditional PE firms.

The BDCs also fill an M&A niche by providing capital to companies that may not qualify for bank loans because they’re too risky or not large enough to attract interest from Wall Street lenders.

Still, at least one firm, Main Street Capital Corp, has opted not to adopt the new leverage limits.

S&P on May 4 rewarded the BDC with a revised outlook to stable from negative because the company will maintain low leverage relative to its peers.

For the most part, BDCs appear to have enough checks and balances in place to avoid paying reckless prices, even with the higher allowed leverage ratio.

But they may be a bit more competitive while the M&A-price cycle remains elevated and better insulated against any upcoming economic shocks that could cause deal prices to cool off.