BDCs borrowed to lend to indebted firms – and it's going badly

Renowned as risk takers, they raised cash by selling stock, multiplied the haul with borrowed money, then used it to lend to some of the country's most indebted companies. If all went well, they would profit handsomely.

But right now, the strategy is going badly for many business development companies — key players in the $812 billion private credit market.

Analysts and ratings companies are sounding alarms as a number of the firms — often just called BDCs — rush to shore up their finances or throw lifelines to their borrowers. One of the largest, Golub Capital BDC Inc., is among those raising funds at a time that may significantly dilute existing shareholders. And while the Federal Reserve and federal government announced programs to prop up struggling companies, BDCs may not benefit much. Many companies they finance, owned in part by private equity firms, don't qualify under current rules.

It's a bruising time for the aggressive investment vehicles that swelled in recent years to command $110 billion in assets and just a few months ago were vying to snap up more high-yield credits. BDCs offer another glimpse into what happens when investors juice returns with leverage only to find themselves wrong-footed with the deadly coronavirus pandemic upending commerce and straining the global financial system.

"The BDC sector is among those most affected by this credit shock," analysts at Moody's Investors Service wrote in a report last week, downgrading their outlook for the sector to negative from stable. "BDCs' loan portfolios will decline in value, weakening BDCs' capital positions and increasing their risk of bank covenant non-compliance," potentially leading to defaults on their debt.

In a harbinger of what's to come, Portman Ridge Finance Corp. just watched a company that it's helped finance since 2015 collapse in a matter of weeks.

The borrower, Ravn Air Group, filed for Chapter 11 bankruptcy protection on April 5, citing an eye-popping 80% to 90% drop in passenger revenue. Owned by private equity firms JF Lehman & Co. and W Capital Partners, the operator of flights for three Alaska air carriers said it had sought state and federal aid, and tried to work with lenders, but ran out of cash by the end of March, forcing it to suspend operations and lay off employees. It said it hopes to work out a solution and restart operations.

Portman Ridge had valued its $1.8 million piece of a loan to Ravn Air at almost 100 cents on the dollar at the end of December, SEC filings show.

Though BDCs are big lenders to business services and technology sectors that may be more resistant to the downturn, some players are more exposed to industries like leisure, entertainment, retail or travel, which have been walloped by the repercussions of the coronavirus.One problem for BDCs is that they often provide financing to highly indebted corporations owned by private equity firms — characteristics that may prevent those companies from tapping federal rescue programs. Many businesses controlled by private equity groups are excluded from billions of dollars in potentially forgivable Small Business Administration loans. A Fed lending program announced last week also deems borrowers with high leverage levels ineligible.

Another problem is that BDCs sometimes offer credit lines. Many companies are now drawing them down en masse, siphoning away available cash. At the end of last year, untapped credit facilities amounted to roughly 8% of the portfolios at a group of BDCs tracked by Fitch Ratings, which has had a negative outlook on the sector for years.

At least two BDCs are looking to shore up their liquidity with rights offerings.

Golub Capital BDC, a private lender with $4.6 billion in assets, announced early this month that it might raise as much as $375.3 million in a rights offering that started on April 9. In SEC filings, the firm said it will use proceeds to repay outstanding debt, support its borrowers and potentially "play offense" if attractive investment opportunities arise.

"It is concerning to us that GBDC felt it necessary to do a dilutive equity raise this early in the economic downturn," KBW analysts Ryan Lynch and Paul Johnson wrote in a report on April 1, referring to the company by its stock ticker. The analysts called the move "surprising" and said it may be particularly painful for existing shareholders because the firm, along with peers, already was trading at a significant discount to book value.

Meanwhile, Bain Capital Specialty Finance Inc., a BDC with $2.6 billion in assets, indicated March 30 that it also may raise additional equity while contending with a flood of requests to draw down revolvers.

Representatives for Portman Ridge, Golub and Bain declined to comment.

Fitch cut its rating on BlackRock Capital Investment Corp. deeper into junk last week, following a covenant waiver it views as a only a "temporary solution" to a longer-term financing problem. S&P Global Ratings signaled it may lower ratings on Prospect Capital Corp. in the next three months if the BDC's assets deteriorate significantly or if it raises the cap on its debt-to-equity ratio, a measure of leverage.

Representatives for those investment firms didn't immediately respond to messages seeking comment.

Despite the difficulties, some BDCs don't seem worried. A raft of the largest have written letters to shareholders, expressing interest in taking advantage of the credit-market disruption. And even with its negative view on the sector, Fitch acknowledged the turbulence may shift terms in lenders' favor in the future and that better-rated BDCs have no near-term maturities.

Last week, the Securities and Exchange Commission offered some relief, temporarily loosening the rules for BDCs to help them and companies in their portfolios weather the pandemic. Among the changes, BDCs can use the value of their holdings as of Dec. 31 — essentially ignoring the impact of the pandemic on their investments — when selling new senior bonds so that they don't exceed the typical 2-to-1 regulatory cap on debt to equity.

In other words, they can lever up even further.