BDCs step closer to new legislation, more leverage

By Lynn Adler

NEW YORK (Reuters) - Business Development Companies (BDCs) are one step closer to being able to lend more to small businesses, after the US House Financial Services Committee passed a bill modernizing BDC regulation.

BDCs, an alternative source of funds for borrowers, have been pushing for more capacity to lend to and invest in small to mid-sized US companies as banks pull back from lending amid regulatory constraints.

The bill, HR 3868, which was passed by a 53 to 4 bipartisan vote on Nov 4, will make several changes to BDC funds, including allowing the use of more leverage.

Full House and Senate votes are still ahead, which could pull the process into 2016, analysts and BDC fund executives said.

A push last year lost momentum after clearing an initial legislative hurdle in late 2013.

BDCs are specialized closed-end investment funds that were created by Congress in 1980 to enhance capital access for U.S. middle market businesses, and offer the general public private equity and venture capital-like returns.

The new legislation will increase the leverage limit of a 1:1 debt-to-equity ratio, or asset coverage ratio, to 2:1 for BDCs. This increase will expand lending opportunities, while keeping leverage at lower levels than banks and other financial vehicles, BDC participants said.

“This modest increase in leverage still holds BDCs to a very low conservative use of leverage relative to other lenders in the capital markets but would permit BDCs to better meet the demand of middle market firms,” said Michael Gerber, executive vice president at Philadelphia-based Franklin Square Capital Partners.

Franklin Square, with almost US$18bn of BDC assets under management, expects significant growth in middle market lending as traditional capital sources dry up due to regulatory constraints and consolidation.

The legislation also allows BDCs to “build safer portfolios for investors by investing higher in the capital stack or in lower risk profiled portfolio companies while maintaining or improving returns,” Gerber said.

SEEKING STIMULUS

The main limitation of the BDC model is an inability often to raise capital when investment opportunities are most attractive, Fitch Ratings wrote in a 2016 outlook.

“Those with capital to invest, given lower absolute leverage ratios and fewer asset quality issues, are well positioned to outperform should underwriting conditions improve,” Fitch analysts wrote.

BDCs rated by Fitch traded at a 19.5% discount to net asset value at the end of October. BDCs trading below net asset values are generally unable to access the equity market for growth capital without shareholder approval, Fitch said.

With limited access to the equity markets, BDCs are unable to add debt to their capital structures without potentially breaching leverage targets.

Fitch-rated BDCs issued US$675m in public debt and US$322m in equity this year until Oct 15, which showed a sharp drop compared to more than US$2bn of debt and US$1.5bn of equity issued in 2014.

CONTAINING RISKS

As regulators crack down on highly leveraged financings, BDC participants note that the new legislation contains restraints.

Provisions include a one-year waiting period before accessing higher leverage following a vote by a BDC’s Board of Directors, and added shareholder protections.

“It is likely that the market, including the rating agencies, would regulate BDCs and that 2:1 leverage limits would not pose widespread risk,” Wells Fargo analysts wrote in a report.

The overall proposal would lead to “solid improvement in both strengthening BDCs’ regulatory framework and improving the industry’s prospects.”

Wells Fargo has an overweight rating on the BDC sector, saying that although passage of the bill is far from certain, the new legislative momentum is encouraging.

“This is a whole package of adjustments that will make the industry more streamlined so that it functions more efficiently,” another BDC executive said.

Small and mid-sized US businesses will be able to access to less expensive senior debt as a result, which stimulates their businesses and the economy.

“Streamlining would allow the BDCs to offer capital at a lower cost, and therefore charge lower interest rates, allowing businesses to lower their costs of borrowing so they can use that money to invest more in their businesses and hire more people,” the BDC executive said.

(Editing By Tessa Walsh and Jon Methven)

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