What Does BDC Modernization Mean for Investors?

When Congress passed and President Trump signed the $1.3 trillion omnibus spending package last week, “BDC modernization” became reality. The Small Business Credit Availability Act, which was a part of the spending bill, had existed as a legislative proposal for several years and enjoyed wide bi-partisan support through passage. The Act comprises a mere 11 pages of the 2,232-page spending bill, and generally touches on only two aspects of a business development company’s operations—the amount of leverage a BDC may take on, and its public filing requirements. However, these changes may have profound effects on future BDC investors, although perhaps not on investors in current BDC programs that had been subject to the prior rules.

Upping leverage limits to increase capital flow

Most importantly, the new law allows BDCs to incur debt up to a 2:1 ratio to equity, doubling the amount that BDCs had previously been allowed to leverage relative to equity. In other words, issuers will be able to take on twice the amount of leverage without raising any new equity. BDC industry proponents say that as a result, more capital will flow to small and midsized businesses, which are key to job creation in the U.S. economy. (It should also be noted: management fees to the BDC’s advisor that are typically calculated off of gross assets will, in turn, increase along with the debt.)

 Increased borrowing capacity also figures to make BDCs into more viable lenders in the small and middle market space. While a 2:1 leverage ratio is still relatively conservative compared to other vehicles, the increased debt capacity will allow BDCs to better compete with private loan funds that have not been subject to the same regulatory constraints. Of course, not every BDC that wants additional debt capital will be able to get it at beneficial terms. The raised leverage limits will mean different things to different programs, depending on the quality of the existing portfolio, position in portfolio companies’ capital stacks, current leverage ratios, and other factors (including whether the BDC is traded or non-traded, as we’ll discuss below). On the whole, the non-traded BDCs that FactRight tracks have already been increasing leverage over the past year, with average total debt/total equity ratio of 0.51x as of yearend 2017 (up from 0.40x at yearend 2016).  

S&P Global

How will more capital affect the credit quality of BDC portfolios?

 Modernization will allow BDCs to increase borrowing capacity to build larger asset portfolios and the potential for increased investor returns. Of course, increasing leverage can make performance more volatile, and higher returns come with the presence of higher risk.  A sudden market downtown would be more catastrophic to the leveraged fund than the non-leveraged.

 But some analysts expect that with increased leverage, BDCs will be able to pursue investments with higher credit quality. Generally, the higher levered return will enable managers to accept the lower yield from more secured investments and still cover distributions. One could predict, however, that as more money flows into the small and middle market through BDCs with enhanced borrowing capacities or through banking channels, competition for deals will increase, having an adverse effect on pricing, covenants, and/or position in the capital stack. (We’ve already noted on this blog the re-emergence of covenant lite.) In this scenario, small and middle market companies will receive a boost, but investors may have to accept lower (or more uncertain) yields.

 Currently, few BDCs are even testing the prior 1:1 debt-to-equity limit. A quick review of data supplied by S&P Global shows an average of approximately 0.55x for all traded and non-traded BDCs. To date, given the ability to use more leverage, most managers have chosen not to approach the previously capped level. It will be interesting to see how these managers adjust their portfolios given the new flexibility.  

But will new leverage limits affect current non-traded programs?

 Maybe not in practice. Under the Act, any current non-traded BDC seeking to increase its leverage to 2:1 would have to provide its shareholders the opportunity to sell all of their shares held as of the date the BDC approved the change in leverage (25% of shares in each of the following four quarters). According to the law firm Eversheds Sutherland, which has prepared a helpful legal alert that parses the impact of the Act (which you can access here), this means that the BDC itself must either repurchase the shares or else facilitate a reasonable third party tender offer. It’s hard to imagine too many non-listed programs willing to undertake such associated costs, or provide potential full liquidity for all shareholders, just to take on more debt. (Note that there are also board and/or shareholder approval requirements, which apply for all BDC programs, both traded and non-traded.) Instead, if raising the debt limit is the boon to BDCs proponents say it will be, we may see new programs launched to take advantage of it, even in the face of lackadaisical fundraising for current programs. If we don’t see new filings, debt limitation changes will have muted impact on the non-traded species of BDCs.

Changes to disclosure

 For a BDC wishing to take on more than the previously allowed leverage, it must make new and regular disclosures about items such as the amount of senior securities outstanding and associated risk. However, in other ways, disclosure requirements have been streamlined. Within one year of passage, the SEC must allow BDCs to use the same securities offering and proxy rules available to other reporting companies, and enable BDCs to file automatic shelf extensions. BDCs will also be allowed to incorporate by reference certain items in Form N-2, which will shorten the length of registration statements and prospectuses. Other filing requirements for BDCs will be synchronized with those of operating companies. Overall, BDCs expect compliance and filing costs to come down, but investors will have to get by with streamlined, and in some cases less, disclosure to what they have been accustomed.

Final takeaways

 The BDC industry was no doubt the winner with this new legislation and it can be argued that small and midsized businesses will benefit from increased access to capital and competition amongst lenders. However, it has yet to be determined whether changes, especially those regarding leverage, will actually translate into a materially better risk/return profile for BDC investors.