IBDs sold more than $22
billion of the high-commission product over the past decade
March 17, 2020 By Bruce Kelly
Due to
the far reaching impact of COVID-19, business development companies — one of the most popular
alternative investments sold by independent broker-dealers over
the past decade — will feel increased stress due to levels of debt and loan
covenants, according to a note issued by Fitch Ratings on Tuesday morning.
The
credit rating agency “expects (BDCs) requirement to mark their portfolios to
fair market value on a quarterly basis to be an increasing pressure point, in
light of falling asset prices resulting from the global coronavirus pandemic,”
according to the note.
The
very wide spreads on high-yield bonds are one reason for driving down the net
asset values of BDCs right now, said one industry executive, who asked not to
be named.
“Most
of these BDC funds are levered up, perhaps forcing them to break covenants,”
the executive said, citing loan covenants, a promise in a bond issuance that
requires borrowers to meet certain criteria. “And when loan covenants are
broken, BDCs become forced sellers of assets. This is not a great market to be
selling into. Can you imagine holding the debt of restaurants or energy
companies now? That’s not a great outlook.”
Broker-dealers
have sold more than $22 billion of nontraded BDCs since 2010, according to
Robert A. Stanger & Co. Inc. One product sponsor and manager, FS
Investments, accounts for roughly half
of that total.
BDCs
are essentially banks, raising capital from
investors and making loans to private companies. The closed-end
companies invest primarily in debt and equity of private firms. Yields can be
attractive because of the BDCs’ exposure to high credit risks amplified by
leverage.
“Portfolio
marks, on their own, are not necessarily indicative of the ultimate credit
performance of individual loans, but unrealized write-downs can pressure credit
facility covenants, including asset coverage requirements and minimum equity
levels, all of which can have negative rating implications,” according to
Fitch.
While
Fitch’s note focused on traded BDCs, illiquid, nontraded BDCs were a popular
alternative investment product sold by advisers after the credit crisis at independent
broker-dealers, which sold billions of dollars of various BDC funds.
Like
nontraded real estate investment trusts, many of the nontraded BDCs charged
high commissions of 6% to 7%. The goal for some of the products was to
eventually list them on an exchange or merge with a listed company, thus giving
investors an eventual exit from the company.
Fitch
noted that one FS Investments BDC, the listed FS KKR Capital Corp., had the
highest exposure to unfunded loan commitments, or contractual obligations for
future funds, among the 11 BDCs it examined, but that exposure drops
considerably for the company when joint ventures and unfunded equities are
excluded.
“As the
largest BDC complex in the market, FS KKR Capital is actively engaged with its
portfolio companies to provide support during these challenging times,” wrote a
company spokesperson in an email.
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