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Business development companies hopeful Congress allows jump in leverage

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Business development companies hopeful Congress allows jump in leverage

Business development companies are keeping a close eye on Capitol Hill as lawmakers appear to be nearing a deal on regulatory reform.

On March 14, the U.S. Senate passed legislation that would roll back parts of the Dodd-Frank Act, a law that beefed up financial regulation in the wake of the 2008 financial crisis. The newly passed bill would alter several regulations, such as increasing to $250 billion from $50 billion the asset threshold at which banks are subject to more stringent supervision. But Republican leadership in the House of Representatives would like to see the bill go further. Jeb Hensarling, R-Texas, said the House would not "rubber stamp" the Senate bill. As chairman of the House Financial Services Committee, Hensarling has promoted several pieces of legislation related to regulatory reform.

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"I look forward to combining them with our helpful House bipartisan banking bills and getting that combined bill to the President's desk. We must provide much needed regulatory relief to our community financial institutions so they can help finance homes, cars, small businesses, and our constituents' American dreams," Hensarling said in a statement regarding the Senate's legislation.House Republicans could change the legislation by requesting specific amendments or while in conference with the Senate. There is a chance that one change could benefit business development companies.

Hensarling's mention of encouraging small business credit could be a reference to including H.R. 4267, a House bill known as the Small Business Credit Availability Act. The legislation features Democratic co-sponsors and sailed through committee on a 58-2 vote. The bill would increase the leverage cap on business development companies, or BDCs, which are entities that invest in small and medium-sized companies in early stages of development. Currently, BDCs must maintain a debt-to-equity ratio of less than 1x, and H.R. 4267 would increase the ratio to 2x. Even if House Republicans do not include the legislation in Dodd-Frank reform, there is a chance the legislation could pass on its own, said John Hecht, an analyst who covers BDCs for Jefferies Group.

"It could be part of the Dodd-Frank reform bill, but the positive is that it could happen on its own. It has been attached to the bill one day, and the next day it's unattached, and then it's attached," Hecht said. "It's very fluid, but you're coming from a position of where nothing was happening and now things are happening."

Isaac Boltansky, an analyst for Compass Point Research & Trading, put odds at 40% that the BDC legislation would pass as part of the Senate reform bill.

If the leverage cap is raised, the largest BDC by market capitalization, Ares Capital Corp., would have a significant amount of space to take on more debt. The company reported a debt-to-equity ratio of 0.68x at 2017 year-end. Among the 20 largest BDCs by market cap, Hercules Capital Inc. reported the most leverage at 2017 year-end with a debt-to-equity ratio of 0.94x. Importantly, the data includes all types of debt, and a loan from the Small Business Administration does not count toward the leverage cap. BDCs do not uniformly report debt from the SBA, but Hercules Capital did report $190.2 million of gross debentures from the SBA as of 2017 year-end.

BDCs have struggled to find attractive assets in recent years, in part due to persistently low rates, said Hecht at Jefferies Group. With rates finally on the rise, an increase in the leverage cap could allow BDCs to deploy capital in a way that significantly boosts their returns on equity. At the same time, Hecht said there should not be a crush of capital chasing assets due to a legislation change. BDCs would likely need approval from shareholders to increase their leverage as well as from creditors to ensure that the companies do not violate any debt covenants.

"You won't have a step change where you have a massive inflow of capital all bidding for yield," Hecht said. "It'll be a change over time, which should make it a more logical process."

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