IFR 03.7.2020

72 International Financing Review March 7 2020

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3USTAINALYTICS

Plunging Libor to dampen private credit

fund returns

„ US MIDDLE MARKET Fall could affect the financial health of BDCs

A drop in a key interest rate that business

development companies use when lending to

small to mid-sized companies is expected to

diminish earnings in the private credit market.

BDCs have reported lower portfolio yields as

a result of the continued decline of Libor, the

interest rate on which most BDC investments

are based.

For BDCs, which are investment companies

that use their capital to make loans to or buy

ownership in private companies, a lower Libor

means decreased earnings power.

This, in turn, means lower returns.

Libor, which has trended downward since

the end of 2018, fell sharply in recent days.

Following an emergency move on Tuesday by

the Federal Reserve to cut interest rates by 50bp

to blunt the impact of the growing threat from

the coronavirus outbreak, three-month Libor fell

to 100bp on Wednesday. The benchmark started

the year at 190bp.

“The Fed not only acknowledged that there is a

real risk to the economy but also endorsed the fear

and uncertainty around the magnitude and duration

of the impact,” one industry source said referring

to Tuesday’s cut. “What was designed to calm the

markets, therefore, really did the opposite.”

The rate cut and choreographed central bank

responses around the globe would likely keep

Libor trending downward, said Ryan Lynch, a

KBW analyst.

LIBOR FLOORS

The absence of Libor floors, which require a

minimum interest rate to be paid on the loan,

could constitute an additional challenge as the

benchmark drops.

Introduced during the credit crisis as an antidote

to a plunging rate, participants in the leveraged

loan market began to push for the removal of floors

when Libor started to bounce back and inch closer

to 1%, the level of many floors.

Although investors pushed to add Libor floors

back into loan credit agreements as the decline

began, it might take time for BDCs to benefit

from the protection since older loans were issued

without them.

“When you think of an average BDC position,

it is generally in the portfolio for three to four

years, so it will take a while for legacy assets,

which may not have floors, to rotate out,” said

Meghan Neenan, an analyst at Fitch Ratings.

Widening credit spreads could offset the

negative effect of a plunging Libor on earnings.

In recent years, the deluge of capital into the

direct lending market has kept effective interest

rates on middle market loans low. But BDC

leadership teams have expressed mixed views

on recent earnings calls about whether this will

happen, Neenan said.

GOOD PLACE

One key metric of a BDC’s financial health is

whether it can consistently cover its quarterly

dividend. The funds do this via their net

investment income, which is the return from the

investment portfolio minus fees and expenses.

For now, most BDCs are in a good place to

cover this distribution, as they have earned

spillover income, or income above their dividend,

partially due to the additional leverage capacity

signed into law in March 2018, according to

Chelsea Richardson, a Fitch analyst. The Small

Business Credit Availability Act allowed BDCs to

increase their leverage profile to a 2:1 debt-to-

equity ratio, up from 1:1.

“Dividend coverage has been strong; some firms

have built up spillover income,” she said. “Dividend

levels are at a level where most BDCs can afford NII

to fall before they can’t cover the dividend.”

The fall in Libor could additionally affect

the financial health of BDCs and the way they

finance themselves.

The vehicles have historically financed

themselves with revolving credit facilities pegged

to floating-rate Libor. But a recent increase in

BDCs issuing unsecured debt, which has a fixed

interest rate, could make the industry’s cost of

capital more expensive.

Owl Rock Capital Corp, one of the largest

BDCs, has issued a number of unsecured notes,

with the most recent offering in January for

US$500m with a 3.75% interest rate.

“We continue to see improved financing

costs as the public credit markets become more

familiar with our story and expect to continue to

tap these markets over time at attractive rates,”

Craig Packer, president and chief executive

officer of Owl Rock Capital Corp, said on the

BDC’s year-end earnings call last month.

An Owl Rock spokesperson declined to

comment.

“In 2019, we saw a ramp in unsecured debt

issuance,” Fitch’s Neenan said. “BDCs wouldn’t

benefit from the decrease (in Libor) as much on

the right side of the balance sheet over the near-

term. They are relying less on their revolver.” A

balance sheet has two sides. On the left there

are assets; on the right there are liabilities.

The 19 largest BDCs tracked by Fitch issued

US$2.8bn of unsecured notes in 2017 and

US$1.7bn of unsecured notes in 2018, the

ratings firm said. Last year, that number spiked

to US$5.5bn. Year-to-date, US$2bn has been

issued, already surpassing 2018’s total.

While private credit may remain attractive to

many investors, decreased earnings power will

still hamper the BDC industry if Libor continues

to fall, as many expect it will.

Andrew Hedlund

9 IFR Loans 2323 p 63 - 76 .indd 72 06 / 03 / 2020 19 : 19 : 51