As underwriting conditions remain relatively competitive, the slowdown in growth is positive, yet is also a result of multiple challenges to the industry. As leverage levels have trended higher in recent years, BDCs have grown, but with little improvement in portfolio yields. The high growth has raised our concern regarding eventual deterioration in asset quality metrics, which contributes to Fitch's negative outlook on the sector.

An important factor behind the recent loan slowdown is BDCs' constrained access to equity markets, a key source of capital to fund balance sheet growth. Such access is hampered when BDCs' share prices trade at discounts to net asset values (NAVs), as has been the case in recent quarters. Equity price discounts have been driven by a combination of concerns about the sustainability of current dividend levels, energy exposures, asset quality, off-balance sheet leverage, external manager conflicts, and share illiquidity following index removals in first-half 2014. At May 28, 2015, six of eight Fitch-rated BDCs that are publicly traded were trading at a discount to NAV, with an average discount for the eight BDCs of 4.9%. Fitch rates a ninth BDC, although it is not publicly traded.

Over the near-term, another factor that will continue to hamper BDC loan growth in our view is leverage, which has risen to the high end of management targets and have reduced cushions against the 1.0x debt/equity limit under the 40 Act for some BDCs. Average leverage for the peer group was 0.63x at March 31, 2015, down 1 bp in the quarter, but up from 0.57x at year-end 2012.

The very high growth rates of BDCs over the past four years have been driven by the availability of low cost debt funding, rising equity markets (which had helped BDC share prices, until last year), a market pullback by banks, the exit of many hedge funds and a rebuild of the CLO market. These factors contributed to the 2013 and 2014 vintage years being somewhat overheated, and will likely introduce asset quality issues for BDCs down the road, in our view.

A chart of loan origination and repayment changes for Fitch-rated BDCs back to 2012 can be found here. The bars show that first quarter 2015 loan originations dropped 47% versus first-quarter 2014 across nine Fitch-rated BDCs. It was the lowest level since first-quarter 2012 and the first net negative quarter since at least 2011. This quarter's drop is on the heels of the same group's combined loan originations growing 14% in 2014, and 21% compounded annual growth over the last three-year period.

Fitch expects incremental portfolio contraction at some BDCs seeking to reduce leverage or fund stock repurchases to appease shareholders, given depressed valuations.

One counterweight to the current conditions in our view is the relatively positive macroeconomic picture in the US that likely limits the risk of rapid deterioration of asset quality across the portfolio. The implementation of leveraged lending guidance on the banks and the uncertain future of GE Capital's sponsored finance business are two examples of potential market opportunities for BDCs.

Fitch believes that strong equity and debt market access may provide competitive advantages to those BDCs with such access, while those constrained may be more focused on optimizing earnings to close NAV discounts, which could potentially bring higher risk.