Business development companies are increasingly using off-balance sheet investment vehicles known as senior secured loan programs to increase their effective portfolio leverage without running afoul of regulatory limits on balance sheet leverage, but that trend can be risky, according to research from Fitch Ratings.
Fitch noted that the senior secured loan programs, or SSLPs, are receiving greater interest from business development companies (BDCs) seeking ways to combat portfolio yield pressure in the currently tight credit spread environment.
Fitch said the incremental risks of SSLPs, which include increased effective leverage and the potential for increased net asset value (NAV) volatility, warrant attention given current competitive underwriting conditions and the increased use of SSLPs by BDCs. These concerns are balanced against the additional portfolio diversification provided, the fact that, to date, BDCs have partnered with established market participants with track records of underwriting middle-market loans, and the fact that the magnitude of leverage employed is modest (typically two- to three-fold) relative to other potential yield-enhancing investments such as subordinated debt or CLO equity.
The largest SSLP program is a partnership between Ares Capital Corporation and GE Capital, which had about $9.4 billion of committed capital at June 30, 2014. Fifth Street Finance recently announced a $305 million partnership with investors through Natixis and a $210 million partnership with Kemper, while Solar Capital recently announced a $600 million partnership with PIMCO.
SSLPs typically invest in first lien senior secured loans of middle-market companies, with the financing of such investment activity shared by a BDC (in a subordinated position) and a large institutional partner (in a senior position). Given the joint financing, a BDC can use the SSLP to invest in larger deals or underwrite bigger positions in traditional deals. In accordance with the BDC’s subordinated investment position, the SSLP can also be used to invest in lower yielding investments that would not otherwise meet the BDC’s expected economic returns without the application of additional leverage at the SSLP level. BDCs are also subject to a leverage cap of 1.0x, as measured by balance sheet debt/equity, imposed by the Investment Company Act of 1940.
The primary risk associated with a BDC's use of an SSLP is that it raises the BDC's effective leverage, taking into account not only the leverage on the BDC's balance sheet, but also leverage embedded within the BDC's investment. Fitch said it evaluates a BDC's effective leverage by considering what impact consolidating the fund would have on total leverage. Depending on the size of the fund and the amount of leverage employed, the consolidation could bring effective leverage above the regulatory limit of 1.0x, which weakens the credit risk profile of the firm, all else equal.
Another risk to consider is the NAV volatility of the BDC's investment in an SSLP. The BDC is typically the majority equity holder of the off balance sheet SSLP, with the equity investment held on balance sheet and marked to fair value each quarter. The increased valuation volatility associated with equity investments relative to traditional debt investments means that regulatory leverage levels could be more susceptible in the event of meaningful write-downs.
BDC investments in SSLPs are generally constrained by a regulatory requirement that no more than 30 percent of the BDC's assets fall into a "nonqualifying" bucket. While the SEC has not specifically ruled that SSLP investments are deemed to be nonqualifying, BDCs, to date, have conservatively assumed that nonqualifying is the appropriate classification, Fitch noted. Still, the nonqualifying constraint is an incurrence-based test, meaning a BDC could commit capital well beyond the 30 percent limit, and then could not invest in another nonqualifying asset until the bucket was reduced back below 30 percent. This activity would further increase the gap between regulatory leverage levels and effective leverage levels.
Fitch said it also believes that the source of the SSLP's debt funding can contribute to the risk profile of the vehicle, given the potential for a duration mismatch between the assets and liabilities. An SSLP with bank revolver funding could face refinancing risks, while an SSLP with funding provided directly by a partnering investor may be preferential as the investors' motivations are aligned.
