Credit Quality, Leverage in Focus for Private Debt, Fitch Says
Credit Quality, Leverage in Focus for Private Debt, Fitch Says
(Bloomberg) -- A competitive underwriting environment, falling credit quality and low interest rates will pressure a $100 billion corner of the private debt market in the coming year, according to a new Fitch Ratings report.
Business development companies will continue to face challenges heading into 2020 as execution risk is elevated for those looking to boost leverage at a time when deal structure and terms are softer, analysts led by Chelsea Richardson said in the report.
“Terms continue to weaken in the middle market and that is really driving the negative sector outlook,” Richardson said in a phone interview.
The credit vehicles are seeing more covenant-lite deals, weaker investor protections and inflated earnings -- all causes for concern, Richardson said.
“The key for BDC is just holding the line when it comes to documents when they’re structuring these deals,” she said. “It’s important for BDCs to maintain access to sufficient deals to allow them to be selective in originations.”
There are some bright spots for BDCs, though.
After the passage of the Small Business Credit Availability Act, the private debt vehicles won the ability to increase their leverage levels -- essentially allowing a BDC to have twice as much debt as equity after gaining shareholder or board approval, compared with the earlier limit of one times as much. Many BDCs have taken advantage of the change.
Public leverage targets for BDCs that have capitalized on the act’s passage range from 0.9-1.4 times, up from 0.65-0.85 times previously, the report said.
“All else equal, of course increased leverage levels are a negative, but we are seeing an improvement to cushions,” Richardson said. Though BDC leverage will continue to rise as most vehicles are still below their target levels and cushions will decline as a result, they should remain sufficient to account for market volatility and credit losses, she said. Many BDCs are also increasing their investments in first-lien debt, rather than riskier, subordinated tranches.
An uptick in unsecured debt issuance for BDCs is also a positive for the industry, according to Fitch. Sales of that type of debt for Fitch’s nine rated BDCs have totaled nearly $3 billion year-to-date, nearly three times the issuance for all of 2018, according to the report.
More BDCs are likely to tap the unsecured market if rates remain low -- and as investors become more comfortable with the industry. Richardson said Fitch likes to see the vehicles with about a third of their funding in unsecured debt as it gives them more financial flexibility by upping their unencumbered assets.
“Improved capital markets conditions and investor appetite, relative to 2018 and early 2019, should continue to support unsecured debt issuances in 2020 as more BDCs may seek to lock in relatively attractive financing costs,” the report said.
To contact the reporter on this story: Kelsey Butler in New York at kbutler55@bloomberg.net
To contact the editors responsible for this story: Natalie Harrison at nharrison73@bloomberg.net, Allan Lopez, Sally Bakewell
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