Plunging Libor to dampen private credit funds’ returns

NEW YORK, March 5 (LPC) - A drop in a key interest rate that business development companies (BDCs) use when lending to small to mid-sized companies is expected to diminish earnings in the private credit market.

BDCs have reported lower portfolio yields as a result of the continued decline of the London interbank offered rate (Libor), the interest rate on which most BDC investments are based.

For BDCs, which are investment companies that use their capital to make loans to or buy ownership in private companies, a lower Libor means decreased earnings power.

This, in turn, means lower returns.

Libor, which has trended downward since the end of 2018, fell sharply in recent days. Following an emergency move on Tuesday by the Federal Reserve (Fed) to cut interest rates by 50bp to blunt the impact of the growing threat from the coronavirus outbreak, three-month Libor fell to 100bp Wednesday. The benchmark started the year at 190bp.

“The Fed not only acknowledged that there is a real risk to the economy but also endorsed the fear and uncertainty around the magnitude and duration of the impact,” one industry source said referring to Tuesday’s cut. “What was designed to calm the markets, therefore, really did the opposite.”

The rate cut and choreographed central bank response around the globe will likely keep Libor trending downward, said Ryan Lynch, a KBW analyst.


The absence of Libor floors, which require a minimum interest rate to be paid on the loan, could constitute an additional challenge as the benchmark drops.

Introduced during the credit crisis as an antidote to a plunging rate, participants in the leveraged loan market began to push for the removal of floors when Libor started to bounce back and inch closer to 1%, the level of many floors.

Although investors pushed to add Libor floors back into loan credit agreements as the decline began, it might take time for BDCs to benefit from the protection since older loans were issued without them.

“When you think of an average BDC position, it is generally in the portfolio for three to four years, so it will take a while for legacy assets, which may not have floors, to rotate out,” said Meghan Neenan, an analyst at Fitch Ratings.

Widening credit spreads, the amount over Libor a borrower must pay, could offset the negative effect of a plunging Libor on earnings.

In recent years, the deluge of capital into the direct lending market has kept effective interest rates on middle market loans low. But BDC leadership teams have expressed mixed views on recent earnings calls about whether this will happen, Neenan said.


One key metric of a BDC’s financial health is whether it can consistently cover its quarterly dividend. The funds do this via their net investment income (NII), which is the return from the investment portfolio minus fees and expenses.

For now, most BDCs are in a good place to cover this distribution, as they have earned spillover income, or income above their dividend, partially due to the additional leverage capacity signed into law in March 2018, according to Chelsea Richardson, a Fitch analyst. The Small Business Credit Availability Act allowed BDCs to increase their leverage profile to a 2:1 debt-to-equity ratio, up from 1:1.

“Dividend coverage has been strong; some firms have built up spillover income,” she said. “Dividend levels are at a level where most BDCs can afford NII to fall before they can’t cover the dividend.”

The fall in Libor could additionally affect the financial health of BDCs and the way they finance themselves.

The vehicles have historically financed themselves with revolving credit facilities pegged to floating-rate Libor. But a recent increase in BDCs issuing unsecured debt, which has a fixed interest rate, could make the industry’s cost of capital more expensive.

Owl Rock Capital Corp, one of the largest BDCs, has issued a number of unsecured notes, with the most recent offering in January for US$500m with a 3.75% interest rate.

“We continue to see improved financing costs as the public credit markets become more familiar with our story and expect to continue to tap these markets over time at attractive rates,” Craig Packer, president and chief executive officer of Owl Rock Capital Corp, said on the BDC’s year-end earnings call last month.

An Owl Rock spokesperson declined to comment.

“In 2019, we saw a ramp in unsecured debt issuance,” Fitch’s Neenan said. “BDCs wouldn’t benefit from the decrease (in Libor) as much on the right side of the balance sheet over the near-term. They are relying less on their revolver.” A balance sheet has two sides. On the left there are assets; on the right there are liabilities.

The 19 largest BDCs tracked by Fitch issued US$2.8bn of unsecured notes in 2017 and US$1.7bn of unsecured notes in 2018, the ratings firm said. Last year, that number spiked to US$5.5bn. Year-to-date, US$2bn has been issued, already surpassing 2018’s total.

While private credit may remain attractive to many investors, decreased earnings power will still hamper the BDC industry if Libor continues to fall, as many expect. (Reporting by Andrew Hedlund; Editing by Michelle Sierra and Kristen Haunss)