NEW YORK, June 17 (LPC) - FS KKR Capital Corp is the latest Business Development Company (BDC) to issue a middle market Collateralized Loan Obligation (CLO) fund as the sector seeks to diversify funding sources and drive portfolio growth.
Access to a range of capital sources enhances liquidity, expands a BDC’s investor base beyond traditional debt investors and bank facility providers, and affords the middle market lenders more flexibility in deploying capital to borrowers. Specifically, the CLO market offers cost-effective funding given the longer maturity profile and a low weighted average cost of debt.
“We believe the CLO product provides an attractive funding cost, less mark-to-market exposure and a longer-term liability,” said Daniel Pietrzak, Chief Investment Officer of FS KKR Capital Corp. “These are all attractive features for a permanent capital vehicle, and our recent CLO deal prices tighter than several of our existing financing lines, providing a direct benefit to our investors from a lower liability cost.”
FS KKR’s US$507m FS KKR MM CLO 1 printed in late May. The AAA tranche priced at a spread of 170bp over Libor, LPC reported.
A determination by the U.S. Securities and Exchange Commission (SEC) last September that BDCs can issue balance sheet CLOs without violating Dodd-Frank era risk-retention rules has prompted more BDCs to tap the cost-effective funding as a source of capital.
Balance sheet CLOs are backed by a portfolio of middle market loans directly originated by a BDC. The decision was delivered in the form of a no-action letter in response to an inquiry by Golub Capital to the SEC.
“Following the no-action letter received last fall by Golub, we expected to see more balance sheet CLOs and believe this will be a trend going forward,” said Chelsea Richardson, associate director at Fitch Ratings.
FS KKR’s debut middle market CLO follows first-time offerings from Owl Rock Capital Corp and Barings BDC in May and April, respectively. Owl Rock raised a US$597.1m CLO, upsized from US$400m, the firm said in a Q1 2019 update on June 13. The AAA piece priced at a spread of 180bp over Libor. Barings BDC printed the US$449.25m Barings BDC Static CLO Ltd 2019-1 with the AAA slice priced at 102bp over Libor.
“This static CLO allows us to more closely match-fund our broadly-syndicated loan portfolio at an attractive all-in cost,” said Erick Lloyd, chief executive officer of Barings BDC, in a release. “This debt securitization also creates additional diversity in our capital structure.”
Late last September following the no-action letter, Bain Capital Specialty Finance Inc, the BDC affiliated with Bain Capital Credit, issued the US$451.2m BCC Middle Market CLO 2018-1, the platform’s inaugural middle market CLO. The AAA tranche priced at 155bp over Libor, according to a September 28, 2018 SEC filing.
BDCs typically fund the loans they make to US private small and mid-sized companies using a combination of debt and equity capital.
However, a BDC’s ability to raise growth capital is restricted if its share price falls below Net Asset Value (NAV). When a BDC’s stock is trading at a discount to NAV, issuing public equity is dilutive to shareholders.
BDCs average share price to NAV was at a .89x discount in June, compared to .78x at the end of last year.
As of the first week of June, only four public BDCs had executed follow-on equity offerings in 2019 amounting to just US$172m in new equity, according to LPC data.
For first-time issuers, Owl Rock (ORCC) looks to be the next to test the waters. The BDC filed preliminary documents on June 4 for an initial public offering of its common stock, indicating plans to shift to a public ownership structure with a listing of its shares on the NYSE. Bain Capital Specialty Finance in November was the last BDC to price a first-time offering.
Limited access to the public equity markets to raise growth capital makes access to a range of liquidity sources important in terms of funding assets and managing liabilities.
“We are still looking for BDCs to access the unsecured debt market,” Fitch’s Richardson said. “A CLO is different from a fully secured bank facility, but a pool of assets are still pledged to the CLO. We appreciate the unencumbered nature of assets resulting from unsecured debt and prefer to see the enhanced funding flexibility in times of stress.”
While BDCs are likely to increasingly tap the CLO market, the ability to do so is not expected to replace unsecured debt issuance, which is seen as particularly favorable by ratings agencies.
“In terms of substitutes, we do not expect CLOs to replace our desire to be a large, consistent issuer of unsecured debt,” FS KKR’s Pietrzak said. “The CLOs are more likely to be a substitute for our bilateral financing facilities. We are seeking to strike the right balance across the various liability options to enable us to optimize our portfolio construction and expense base for our investors.”
Owl Rock, prior to executing the CLO, in April completed an inaugural investment grade senior note issuance that was upsized to US$400m from US$300m, the firm said in the same quarterly update.
Moody’s Investors Service said in a note that the unsecured debt issuance, “will improve the company’s debt laddering and reduce its reliance on credit facilities, a credit positive.”
Of Owl Rock, Fitch’s Richardson said the BDC has been largely funded with secured bank funding, but also did an index-eligible unsecured debt issuance earlier in 2019 and a small private placement earlier on.
“The CLO is a natural progression in the continued diversification of its funding sources,” Richardson said.
Reporting by Leela Parker Deo. Editing by Michelle Sierra and Jon Methven