BDC Mergers Reduce Portfolio Risk Amid Tough Economic Backdrop

The growing trend of mergers among rated business development companies (BDCs) has generally improved portfolio diversification, increased first-lien exposures, built asset coverage cushions through lower leverage and should broaden funding profiles, all of which are supportive of credit, Fitch Ratings says. However, these combinations have not had an immediate impact on ratings, as any potential benefits are not expected to materially offset the continued risks and overhang of the economic fallout of the pandemic and the downside risk to overall portfolios.

Increased scale through consolidation is expected to allow BDCs the ability to issue index-eligible tranches of unsecured debt, which will expand their investor base and the liquidity of their bonds. Demonstrated access to the unsecured bond markets over time enhances a BDC’s funding flexibility, particularly in times of stress, and is viewed positively from a ratings perspective. Fitch’s ‘bbb’ category benchmark looks for unsecured debt to represent 35%-50% of a BDC’s total debt.

While recent BDC mergers have reduced unsecured funding percentages below 35% on a proforma basis, improved access to the market is expected to make debt issuance more attractive after the transaction closes. Failure to expand unsecured funding toward Fitch's investment-grade benchmark range over the Rating Outlook horizon could result in negative rating action.

Asset coverage cushions have been pressured in the wake of the pandemic as market volatility and credit deterioration contributed to meaningful unrealized portfolio depreciation in 1Q20. While a portion of the valuation declines reversed course in 2Q20 and 3Q20, some BDCs continue to operate at or near the low-end of Fitch’s ‘bbb’ category asset coverage cushion benchmark range of 11%-33%.

BDC mergers have typically been de-leveraging events, which has been beneficial for the asset coverage cushion, particularly as Fitch believes realized credit losses will tick upward in 2021 as COVID-19 cases rise and additional lockdown measures are implemented. Realized and unrealized portfolio losses reduce the headroom on asset coverage cushions relative to targeted ranges for ratings and could result in negative rating action if sustained at lower levels.

Exemptive order relief from the SEC allows affiliate funds to co-invest in transactions, which means there is meaningful overlap of portfolio company exposures across commonly managed BDCs. Still, the overlap is less than 100%, which results in improved portfolio diversification for the merged vehicle. Lower average investment sizes also reduce the risk that an individual portfolio company’s underperformance has an outsized impact on the BDC’s credit profile.

The mergers, while potentially supportive of credit, are not expected to result in significant changes in investment strategy or management of leverage. Recent examples include FS KKR Capital Corp.’s (BBB-/Negative) announced merger with FS KKR Capital Corp II, an unrated affiliated BDC also managed by FS/KKR Advisor, LLC, and Oaktree Specialty Lending Corporation's (OCSL, BBB-/Stable) announced merger with Oaktree Strategic Income Corporation, an unrated affiliated BDC also managed by Oaktree Fund Advisors. Goldman Sachs BDC (BBB-/Negative) completed its merger with Goldman Sachs Middle Market Lending Corp. last month, which it announced in 2019, while Golub Capital BDC (BBB-/Stable) closed a merger last year with Golub Capital Investment Corporation.

Contacts:

Chelsea Richardson

Director, Non-Bank Financial Institutions
+1 212 612-7899
Fitch Ratings, Inc.
300 West 57th Street
New York, NY 10019

Meghan Neenan, CFA
Managing Director, Non-Bank Financial Institutions
+1 212 908-9121
Fitch Ratings, Inc.

Laura Kaster, CFA
Senior Director, Fitch Wire
Financials, North and South America
+1 646 582 4497

Media Relations: Jessica Torchia, New York, Tel: +1 212 908 0653, Email: jessica.torchia@thefitchgroup.com

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.