January 05, 2024 (MLN): The rapid growth of U.S. perpetual non-traded business development companies (BDCs) will experience heightened credit performance pressures as increased market competition leads to further spread compression and looser deal terms, says Fitch Ratings.
Strong fundraising across perpetual vehicles has led to more dry powder chasing deals in a muted M&A environment, while the eventual return of the broadly syndicated loan market could further pressure pricing and covenants in the upper middle market.
Perpetual non-traded BDCs will also have to manage structural weaknesses, unlike publicly traded BDCs and other commercial lenders, including managing quarterly redemption requests and accessing debt markets more frequently.
Given the pace of fundraising on the equity side, perpetual non-traded BDCs have had to raise material debt financing to maintain leverage targets, funding flexibility and return hurdles.
At September 30, 2023, 12.7% of perpetual non-traded BDCs’ debt was unsecured, which is well below Fitch’s 35% unsecured debt-to-total debt threshold for investment-grade BDCs.
Perpetual non-traded BDCs could be challenged to maintain unsecured funding ratios relative to publicly traded peers, depending on their rate of growth, absolute size and investor appetite related to total platform exposures.
The redemption structure of perpetual non-traded BDCs (typically up to 5% quarterly) can result in incremental capital leakage, weakening asset coverage levels.
Although redemptions are capped and subject to manager/board discretion, they can distract from core portfolio management duties; an inability to honor them can also create reputational risks.
Through-the-cycle redemption activity remains unclear given the short track record of the structure, but two firms experienced redemptions above their 5% limits in 2023.
