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Fitch: US BDC Valuations Improve in 1Q But Big Challenges Remain

May 23, 2016, 08:01 AM
Filed Under: Industry News

First-quarter business development company (BDC) earnings reports showed some improvement in portfolio valuations but also underscored the broader challenges facing the sector, says Fitch Ratings. Capital constraints, low market volumes and risks of asset quality deterioration continue to point to mounting dividend pressures for some BDCs, especially those with above-average leverage and outsized exposure to energy. Fitch has a Negative Ratings Outlook and sector outlook for BDCs in 2016.

Despite improved valuations, Fitch expects core earnings pressures to remain for BDCs in the short term. Rated BDC portfolios contracted about 0.45% on average on a sequential quarter basis in 1Q16 as $2.1 billion of sales and repayments more than offset $1.4 billion of aggregate originations. Origination volume declined 31.1% year over year in 1Q16 as middle-market issuance fell 24.8%, according to Thomson Reuters LPC, and BDCs remained capital-constrained. The fall in portfolio activity hurt fee generation in the quarter, which generally resulted in annual declines in net investment income.

Energy exposures continue to be a key issue, with portfolio valuation marks and non-accruals for investments in the sector growing, according to latest data. However, not all BDCs have the same level of energy exposure. According to a Fitch stress test, BDCs are generally well positioned to withstand an energy-related stress scenario from a leverage perspective. That said; lost revenue from non-accruing energy positions is hurting core earnings and, thus, dividend coverage.

Non-accrual ratios ticked up 109 bps in 1Q16 sequentially, amounting to 3.1% of average debt portfolios at fair value. Continued weakness in energy contributed to the deterioration, but several firms added non-energy investments to non-accrual status during the quarter. While Fitch does not believe these additions signal widespread issues in BDC portfolios, they do likely point to the beginning of some normalization in non-energy credit performance.

BDC share prices have improved in recent months, with the rated peer group trading at a 16.1% average discount to net asset value as of May 18, up from a 24.5% discount as of 5 February, but Fitch maintains that equity issuance is likely to be limited to this year. Only one BDC raised equity capital in 1Q16.

Instead, BDCs continue to focus on repurchasing shares, which contributed to a lack of improvement in leverage ratios in 1Q16. Average leverage for the rated peer group was 0.69x, flat with the prior quarter, and several firms remained at or above the upper end of their targeted range.

Leverage remains a more significant issue for BDCs with outsized energy exposures given the greater risks to asset quality and portfolio valuations. Fitch believes that leverage of 0.8x or more could result in elevated risks for those BDCs with above-average energy exposure. As a result, Fitch continues to expect some BDCs to divert portfolio repayment proceeds into debt repayment to reduce leverage in the coming quarters. This should push sector leverage ratios modestly lower over the remainder of the year.

The ongoing challenges to valuations, earnings and asset quality will all contribute to constraints on maintaining dividends. The earnings reports from 1Q16 indicate that these mounting dividend pressures have not eased. In Fitch's opinion, dividend coverage ratios had been bolstered partly in recent quarters by fee waivers or cuts to the fee rates, but this will not be sustainable in the medium term.

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