December 13, 2013 / 3:06 PM / 4 years ago

BDC leverage cap reform clears hurdle; debate persists

NEW YORK (Reuters) - Proposed legislation that would effectively double the leverage cap for business development companies, which lend to small and mid-sized U.S. businesses, has cleared an initial legislative hurdle, seen by some as an early victory for supporters of the change.

However, even proponents of the bill said further revisions are necessary for the U.S. Senate to greenlight the bill, while some critics caution that raising the leverage limit would create unnecessary risk.

Members of the U.S. House Financial Services Committee voted 31 to 26 to adopt an amended version of the “Small Business Credit Availability Act,” which proposes to raise the leverage limit to 2:1 from 1:1. Discussions are ongoing to make additional tweaks that address investor protection concerns raised by Democrats.

“If a deal is struck with Democrats that accommodates demands for investor protections, the bill will get broad bipartisan support in the House and greatly increase the chances for passage in the Senate,” said Brett Palmer, president of the Small Business Investor Alliance.

BDCs are a specialized type of closed-end investment fund. The BDC industry has expanded steadily since the credit crisis, taking an increased share of the middle market lending pie, and is widely seen as playing a key role in fueling economic growth for small businesses.

As traditional lenders face increased capital constraints and tighter lending guidelines under new regulatory requirements, BDCs have stepped in as alternative capital providers.

For investors, the model is compelling: steady, robust returns at relatively low leverage levels.

Heated debate

While there is much consensus within the BDC community that the framework governing BDCs needs to be revised and modernized to ease capital formation, there is significant debate as to the merits of raising the leverage threshold.

The debate centers on how best to enable the industry to grow in order to expand borrower access to needed financing, while also managing credit risk and shareholder returns.

Critics from within the industry caution that increasing leverage under the current proposal adds more risk without differentiating between BDC models. Increased defaults could hamstring the ability to attract capital in the public equity markets or in the unsecured debt markets.

“The BDC structure is a way for retail investors to access the asset class, while enjoying the safety of the 1:1 model. All it will take is one blow up to result in the retail bid bowing out,” said Alex Frank, CFO of Fifth Street Management, an alternative asset manager and the SEC-registered investment adviser to two public BDCs, Fifth Street Finance FSC.O and Fifth Street Senior Floating Rate Corp FSFR.O. “The sector is still in the relatively early stages and still growing. I don’t see the need to change the leverage cap at all, but if so, differentiation based on risk is needed.”

There are other possible implications, as well, namely how the rating agencies would treat additional leverage. The leverage cap, which is low relative to other lending entities, is seen as one of the major underpinnings of investment grade BDC ratings.

“Fitch likes the 1:1 leverage cap, but a change won’t trigger any automatic downgrades. We would have to assess BDC by BDC and how each would use the excess capacity” said Meghan Neenan, senior director at Fitch. “Would they take advantage or not, if so what would it be used for?”

Of course, BDCs would not be required to bump up leverage to 2:1 and market participants said prudent BDCs would likely maintain a cushion as they do today under the current limit, but others would take on more capacity.

“Some BDCs would certainly increase leverage, and others may need to follow suit in order to compete,” said Frank.

The increase would be good for BDCs, but bad for the market, said a lender at another BDC shop. It would incent more BDCs to pop up, but it could make for more aggressive, sloppy lending.

Editing By Jon Methven

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