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Business development companies step into spotlight with moves on leverage, fees

When Goldman Sachs BDC Inc. announced that it would seek shareholder approval in June to increase leverage to 2:1 from 1:1, a result of recently passed legislation, it also said it would cut its base management fees to 1.5% from 2%. The move marks a big win for shareholders and could potentially signal a shift in the level of business development company, or BDC, participation in the U.S. syndicated loan market, lenders say.

Other BDCs have already followed suit, including Solar Capital Ltd., which recently announced a reduction in its base management fee from 2% to 1.75%.

New Mountain Finance Corp., like Goldman, is seeking shareholder approval on 2:1 leverage and has expressed interest in more senior debt. New Mountain management has explained that the unit's investment in senior debt would go hand-in-hand with effectively lower fees.

"Incremental assets added through increased leverage will be predominately senior," Robert Hamwee, managing director at New Mountain, said on a recent earnings call. "The management fee burden on these assets will be significantly less than our headline 1.75%. Specifically, as discussed many times over the years, on senior assets we charge a management fee only on the implied equity utilized to purchase those assets, which in most cases range from 30% to 50%. Therefore, we would expect management fees on the vast majority of these incremental assets to generally range from 60 to 80 basis points."

BDCs with lower management fees may have lower expenses and increased operating income. This can make it easier to maintain dividend coverage, or reduce the required return on assets to meet return on equity. Effectively, this can allow a BDC to invest in safer, lower-yielding assets, such as senior syndicated loans, with no change to dividends.

"If a BDC plans to invest in more liquid assets, like syndicated debt, then lower fees could make sense generally," said John Mahon, a partner at Schulte Roth & Zabel. This may cause BDC portfolio concentrations of senior loans to continue to rise.

For Goldman, the lower base management fee is expected to increase net operating income.

"By scaling the business with more debt, it makes sense to actually reduce the fees, and make more income flow through the bottom line for shareholders," said Christopher Testa, managing director and head of research at National Securities. "An increase in earnings made possible by the reduced fee and increased leverage could potentially result in a pretty substantial increase for net operating income per share potential for the company."

"We are increasing our 2018 and 2019 [net operating income]/share estimates [on Goldman Sachs BDC] from $1.83 and $1.82 to $1.89 and $1.91, respectively, and are becoming much more constructive on the shares at this valuation," Wells Fargo said in a recent equity research report.

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Solar Capital's net operating income will be supported by the reduction in fees as well, but the company has not expressed interest in operating with higher leverage.

"We are being extremely deliberate in our analysis, and have not yet reached a conclusion regarding our course of action [concerning a leverage increase]," Solar Capital CEO Michael Gross said in the company's most recent earnings call. Solar Capital has a current leverage ratio of 0.58x net debt to equity, an average leverage ratio of 0.23x and a target leverage ratio of 0.75x.

Part of a pattern

While now in the spotlight, these reductions have not come out of the blue.

Over the past few years, the BDC world has seen fees whittled down to the benefit of shareholders. These reductions came in the form of waived fees, "high water mark" fee structures and reduced management fees.

In 2015, Gladstone Capital Corp. and Medley Capital Corp. reduced their base management fees, while in 2016, Apollo Investment Corp. temporarily reduced its base management fee to 1.5% from 2% due to incurred losses. Fifth Street Finance, now Oaktree Specialty Lending Corp., reduced its base management fee from 2% to 1.75%, and that fee remains in place today.

The question now is, will the trend of lower management fees begin to spread faster through the BDC world in light of the new leverage rule and fee reductions by Goldman Sachs and Solar Capital?

Schulte's Mahon said: "If a manager believes it can make more money on the income incentive fee side by increasing its leverage, it may be willing to 'trade' a portion of its potential base management fees in order to induce stockholders to approve an increase in leverage — or at least appease market participants that may be unhappy with higher leverage ratios. The fact that Goldman's BDC has already done so may cause others to consider following suit if they plan to seek approval for a higher leverage ratio. That may also have the side effect of discouraging some BDCs from getting blanket approval for increased leverage if they have no current plans to use that leverage in the near term."

Looking down on leverage?

Initially, the new leverage rule for BDCs spurred negative reactions from rating agencies. S&P Global Ratings revised outlooks to negative for Corporate Capital Trust Inc., Goldman Sachs BDC, Hercules Capital Inc., Main Street Capital Corp., Oaktree Specialty Lending, Solar Capital, TCP Capital Corp. and TPG Specialty Lending Inc. due to the potential for increased leverage in the BDC industry.

However, this budding trend of reduced management fees may mitigate some of the danger that higher leverage provides through increased net operating income and financial flexibility.

"Although there are no direct implications to ratings, lower management fees are positive from a creditor perspective," Trevor Martin, associate director at S&P Ratings, said. "If leverage increases, the cost of debt of the revolving credit facilities could increase."

Naturally, lower fees would offset increased expenses.

But Martin counters the claim that additional leverage will significantly increase investment in lower-yielding, safer assets.

"The BDCs are claiming that with additional leverage they will invest in less risky assets, but we don't think they will meaningfully be able to shift the risk position of their portfolios. There's only so far you can go down the yield spectrum," he said.