With the economic outlook darkening and credit conditions tightening, business development companies (BDCs) are at risk of declines in the fair value of their investments. In a recession, BDCs--which typically focus on lending to highly leveraged middle-market companies--could face borrower stress, falling asset prices, and widening credit spreads.

A sharp decline in the value of BDC investments would not only weigh on their earnings but also could jeopardize their compliance with a key regulatory requirement to maintain certain asset levels relative to debt (the asset coverage requirement). In a severe scenario, a failure to comply, or even the risk of that, could cause business and financial disruption, force asset sales, or even threaten a tax advantage BDCs enjoy as investment companies.

Positively, S&P Global Ratings thinks most BDCs we rate are positioned to absorb a meaningful drop in the value of their investments. In our base case, which factors in the expectation of a shallow recession in 2023, we expect the 12 BDCs we publicly rate to maintain compliance with their asset coverage requirements, as reflected in stable outlooks on the ratings. Still, if conditions worsen, particularly if there is more than a shallow recession, the probability of asset coverage breaches will rise. We could take negative rating actions on BDCs that fail to maintain at least a 10% cushion over their requirements.

Most BDCs Have Good Asset Coverage Cushions, But We Could Take Negative Rating Actions If Those Cushions Narrow

At the median for the 12 BDCs we rate, it would take a 17% decline in the asset coverage ratio, most likely caused by an increase in unrealized losses, to cause a breach of the regulatory minimum, as of June 30, 2022. That implies it would take a significant worsening in conditions before many rated BDCs were in jeopardy of a breach.

However, if a BDC's cushion over its asset coverage requirement narrows to less than 10%, we typically limit its group stand-alone credit profile (which normally aligns with the rating) to 'bb+'. (A cushion narrowing to less than 10% would mean an asset coverage ratio of less than 220% or 165% when the requirement is 200% or 150%, respectively.) Given that we currently rate 11 of 12 BDCs at 'BBB-', a reduction in cushion to less than 10% could cause downgrades.

If a BDC's cushion falls below 10%, we could consider the likelihood of breach and its remediation plan for rebuilding the cushion and maintaining compliance with the asset coverage requirement before taking a rating action.

Failure To Comply With The Asset Coverage Requirement Can Cause Stress

Regulation also requires BDCs to mark their investments, mostly leveraged loans and securities, at fair value each quarter. Changes in fair value, therefore, affect the asset coverage ratio positively or negatively.

If a drop in fair value causes a BDC to breach its required asset coverage, the BDC could be unable to issue new debt or make new investments and, under certain circumstances, pay distributions to its shareholders. In a dire scenario, a failure to make distributions could ultimately jeopardize its RIC status--meaning, it would be taxed like an ordinary corporation. However, a loss of RIC status would not happen immediately, and BDCs would have certain avenues to avoid that.

To avoid or remedy a breach, a BDC may be forced to sell assets and cease new investments, disrupting its business. If it fails to avoid a breach, a BDC would very likely see a sharp drop in its stock price, pressure from investors, and potentially funding issues. BDCs often have revolving facilities that contain covenants requiring them to meet the asset coverage requirement. The BDCs dependent on such facilities, in contrast to those that use a higher proportion of publicly issued debt, could be most stressed from an asset coverage breach.

Unrealized Losses On BDC Balance Sheets Could Continue Climbing In The Coming Quarters

In the second quarter, most BDCs we rate reported increases in unrealized losses on their investments. These unrealized losses generally equated to a low-single-digit percentage of investments. Some BDCs said tougher market conditions, including widening credit spreads and increased market volatility, were the main reason for the increase in unrealized losses. They indicated negative portfolio company developments had much less of an impact. Valuations, which may be performed by an external valuation firm or the BDC itself, relate to such factors.

High-yield corporate credit spreads widened sharply in June 2022, probably contributing to those unrealized losses. After tightening over the summer, those spreads widened again in September but still appeared somewhat tighter than on June 30, 2022. That implies that changing spreads may not result in incremental unrealized losses for BDCs as of Sept. 30, 2022.

However, even if spreads do not widen again, a deterioration in the performance of the companies that BDCs lend to--due to a macroeconomic downturn, rising interest rates, or inflationary pressures--could, over time, lead to weakening valuations. Payments-in-kind interest payments (rather than cash interest payments) have only modestly increased among BDC borrowers, and nonaccrual loans have remained low. Still, a recession could result in material rises. BDCs generally lend on a floating-rate basis, and it could get tougher for borrowers to meet rising interest expenses, contributing to asset quality deterioration.

In their base case, S&P Global economists expect the U.S. economy to enter a shallow recession in the first half of 2023 and to grow 0.2% for the full year. Our economists anticipate the Fed will raise rates to 400 basis points-425 basis points by early 2023 and unemployment will peak at 5.7% in early 2025. They also see a potential downside scenario where more persistent inflation forces the Fed to act more aggressively, causing a bigger downturn. In that scenario, GDP contracts 0.3% for full-year 2023 and unemployment climbs to about 6% in 2024.

BDCs typically lend to middle-market companies, which can have relatively high leverage and experience financial stress amid economic downturns. In fact, we view BDCs as one of the most likely types of commercial lenders likely to see portfolio deterioration in a downturn.

We believe the BDCs most likely to experience increasing unrealized losses will likely have borrowers in industries that are unable to pass higher inflationary and interest rate pressure to end users, a concentration of large investments relative to equity, or material exposure to unitranche, second-lien, or mezzanine investments.