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Fitch: BDCs Face Continued Rating Pressure in 2017

October 25, 2016, 08:07 AM
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The Sector and Rating Outlooks for business development companies (BDCs) remain Negative for 2017, according to Fitch Ratings' 2017 BDC outlook report. Fitch has maintained Negative BDC Sector and Rating Outlooks for more than two years and the environment is unlikely to improve materially in 2017. Competitive underwriting conditions, earnings pressure, unsustainable asset quality metrics, reduced liquidity, limited growth capital and continued concerns about management team alignment dampen BDC prospects in 2017.

"Headwinds heading into 2017 include reduced economic growth expectations, refinancing burnout and continued unfavorable supply/demand dynamics in the middle market," said Meghan Neenan, Senior Director, Fitch Ratings.

Portfolio yields have resumed their decline after a brief reprieve in the first quarter of 2016 (1Q016) as middle-market issuance is down and the supply of capital has increased as low interest rates persist. Fitch does not see a catalyst for meaningful portfolio deterioration over the near tear-term as portfolio issues to date have been idiosyncratic or energy-related. However, Fitch notes that BDC portfolios are relatively concentrated in 2014-2016 vintages which exhibit higher underlying leverage levels.

BDCs remain under dividend coverage pressure and have sought to offset potential shortfalls by moving down the capital structure into higher yielding second-lien positions, creating more highly levered off-balance sheet vehicles, introducing incentive fee waivers or cutting management fees. However, these strategies have not always served to stave off dividend reductions and Fitch observed a number of cuts in 2016. Going into 2017, Fitch believes further dividend reductions are likely, particularly for BDCs reliant on non-recurring fee income or meaningful fee waivers to cover dividends.

Even after a recent rebound in BDC share prices, most BDCs continue to trade below net asset value (NAV), which inhibits their ability to access the equity markets for growth. To boost NAV some BDCs have redirected portfolio repayment proceeds into share repurchases, but this can inflate leverage ratios, which are already running high. Leverage was 0.72x for Fitch rated BDCs at 2Q16, up 14 basis points (bps) from a year ago.

"The challenges we saw in 2016 are unlikely to go away anytime soon, and even while energy prices are stabilizing, the softening retail sector could be an increasing performance concern for BDCs in 2017," added Neenan.

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