November 22, 2019 / 2:05 PM / 14 days ago

Cracks appear in the private debt market

NEW YORK, Nov 22 (LPC) - A large number of business development companies (BDC) reporting earnings on the third quarter of the year saw their net asset value (NAV) per share drop as a declining Libor rate and underperforming credits take their toll on middle market lenders.

The NAV of 83% of BDCs in the US deteriorated in the third quarter, according to BDC Collateral, continuing a similar downward trend from the second quarter.

Driving the decline is the US Federal Reserve’s decision to cut rates three times this year, a dramatic pivot from the rising interest-rate policy in effect this time last year. In October, the base rate was cut to 1.5%-1.75%.

Because the loans BDCs provide to middle market companies are floating rate, the cut in the base rate has put pressure on yields. Libor, for instance, is 1.9% today, down from 2.8% in December.

As rates climbed in 2018 spreads in the middle market tightened, but even as rates came down this year, spreads have not widened to compensate. As a result, many BDCs reported lower yields for the quarter.

“Libor is non-discriminatory, so it’s fall will have an impact on BDCs across the board,” said Michael Ewald, chief executive officer at Bain Capital Specialty Finance.

LEVERAGE SPIKE

To absorb the declining yields and meet return targets, BDCs have boosted leverage as they focused their investments on first-lien assets – the least risky part of the capital structure for debt investors.

On average leverage levels have gone up the past two quarters after legislation passed last year enabled BDCs to take on more debt.

BDCs’ leverage levels were 0.98 times on average, according to data from BDC Collateral, ticking up from 0.94 times recorded in the second quarter. In the first quarter and third quarter of 2018, leveraged was 0.86 times and 0.8 times, respectively.

Market analysts, however, are not too concerned with the spike in leverage, but are bothered by the growing trend of leverage facilities used to meet yield targets, rather than boosting distributions to shareholders.

“If a BDC is generating the same earnings with higher leverage then there is more risk to that entity,” said Ryan Lynch, an equity analyst at KBW. “But if this happened three years ago then BDCs wouldn’t have had the capacity and we would have seen dividend cuts. We haven’t seen that yet.”

SOFTENING

Continued declines in NAV per share highlight that the US middle market is not immune to softening across the US economy. While few expect a downturn anytime soon, many are seeing credits underperform.

Non-accruals, which are essentially defaulted loans within the BDC, for the third quarter continued to tick up. In the past three months, non-accruals were 4.08% of portfolio costs, up from 4% in the second quarter and 3.63% in the first quarter, according to BDC Collateral.

While underperforming credits put pressure on BDC portfolios, many are attributing the NAV decline to unique challenges faced by the borrowers, rather than any sector-wide trends.

“It depends on the BDC. Some BDCs have seen non-accruals jump up and it’s not surprising NAV came down. But most of our NAV decline can be attributed to idiosyncratic issues,” Ewald said. “There are some pockets of cost increases – for instance wage pressure – but it’s not something felt across the entire portfolio.”

BDCs funding aggressive private equity buy and build strategies have seen their loans underperform as add-on acquisitions fail to perform to expected levels. For analysts this is one sign that a broader slowdown in the US economy is being felt in the middle market and adversely impacting non-bank lenders.

“We’re seeing slower revenue and Ebitda growth, and broader economic data has shown some issues,” Lynch said. On average, this means certain borrowers are going to have stable growth, but other borrowers are going to have weaker or negative growth, which could increase credit issues across the space.” (Reporting by David Brooke. Editing by Michelle Sierra and Kristen Haunss)

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