KBRA Releases Research – Second-Quarter 2024 Business Development Company (BDC) Ratings Compendium
10 Sep 2024 | New York
KBRA releases its Business Development Company Ratings Compendium, which looks at results for the quarter ended June 30, 2024. In this quarter’s Compendium, KBRA reviews the financial performance of KBRA-rated BDCs in a landscape marked by increased competition, tighter spreads, and the prospect of lower base interest rates. In 2Q24, competition intensified amid excess investor capital and weak loan demand, reflecting low transaction volume in mergers and acquisitions (M&A) and leveraged buyouts (LBO). Increased competition, especially in the upper middle market, has pressured loan pricing and increased the use of payment-in-kind (PIK) components at origination.
As expected, non-accruals increased at a manageable pace from a modest base. While non-accruals as a percentage of total investments at fair value (FV) and cost, respectively, increased quarter-over-quarter (QoQ) to a median of 0.9%/1.2% from 0.4%/0.9% for KBRA’s rated universe, it is within the range of expectations in a high interest rate environment. Going forward, portfolio companies may see some relief given the prospect that the Federal Reserve will begin a series of interest rate cuts, likely commencing on September 18.
Overall, the performance of KBRA-rated BDCs remained stable in 2Q24 with solid credit metrics, including comfortable liquidity coverage of near-term maturities, well contained non-accruals, and appropriate leverage. KBRA continues to monitor BDCs’ non-accrual rates and other signs of portfolio stress. KBRA’s Outlooks for our portfolio of rated BDCs remain mostly Stable, reflecting our view that BDCs in our rated universe can successfully manage through an uncertain environment—marked by a high proportion of investments composed of senior secured first lien loans, moderate leverage, and solid liquidity—as well as our expectation for manageable growth in non-accruals.
Key Takeaways
- Spreads over base rates continue to compress due to increased competition, which is most pronounced with upper middle market originations along with increased PIK at originations.
- Adding to the potential for lower investment income from spread compression is the prospect of reduced interest income stemming from the expected rate-cutting cycle in the coming months. Therefore, assets will reprice with the vast majority of loans floating rate—while on the liability side, very low-cost fixed rate debt that was issued in 2020 and 2021 will need to be refinanced at higher interest rates.
- To create operating efficiencies, several BDCs YTD have merged with affiliate credit vehicles, including affiliate BDCs.
- Generally, leverage remains conservative due to low deal flow in 2Q24 and limited investment opportunities. The sector continues to be cautious in its originations by maintaining relatively high credit quality standards in transactions focused primarily on less cyclical businesses.
- Industry participants report that transaction volume improved in 3Q24, with continued momentum likely as the Fed begins cutting rates over the next several quarters.
- Although non-accruals remain low as a percentage of total investments, most BDCs added a few portfolio companies to non-accrual status, including two highly visible portfolio companies with sizable private debt outstanding: Pluralsight and Khoros. However, Pluralsight was restructured after quarter-end with the lenders taking control and restructuring the outstanding debt. The portfolio company will exit non-accrual status in 3Q24.
- To get ahead of upcoming maturities, BDCs issued a solid amount of unsecured senior debt to an expanding investor base. KBRA-rated BDCs have issued about $6 billion of senior unsecured debt YTD, improving liquidity, increasing financial flexibility, and lowering asset encumbrance for the benefit of unsecured noteholders.
- KBRA reviewed PIK as a percentage of interest income and has found immaterial increases year-over-year (YoY). However, KBRA plans to take an in-depth look into the use of PIK in an upcoming private credit research report.
Click here to view the report.