Fitch: BDCs Tapping Venture Lending for Additional Growth
CHICAGO -- November 18, 2013
Increasingly, lenders to middle-market firms, also known as business
development companies (BDCs), are turning to venture lending for additional
investment opportunities and enhanced yields, as declining yields on
traditional middle-market investments continue to squeeze net investment
income. Fitch Ratings expects execution and underwriting risk to rise as BDCs
continue to reach for yield in a low-rate environment.
Venture lending, typically characterized by loans to fast-growing start-up
companies, has the potential to generate appropriate risk-adjusted returns.
But venture firms often lack positive cash flow, the hallmark of traditional
middle-market underwriting. Still, amortization schedules are generally more
favorable for lenders in these deals, and venture lending often comes with
equity warrants that can provide meaningful earnings upside for the BDC.
Hercules Technology Growth Capital, an internally managed BDC formed in 2003,
has a long track record in venture lending. However, more recently Ares
Capital Corporation (Ares) and Fifth Street Finance Corp (FSC) announced their
intentions to enter the business as well.
In March 2012, Ares hired a team of venture investors from BluCrest Capital
Finance GP. Ares is focusing on senior secured debt financings in sectors such
as communications, information technology, semiconductors and alternative
energy. Its first venture investment was made in August 2012 in a $6 million
secured credit facility to a medical device company. The investment has an 11%
yield, matures in July 2015, and comes with preferred-stock warrants.
FSC's manager announced on Aug. 6 that it too was entering venture lending
through the creation of Fifth Street Technology Partners (FSTP). The group
will be led by the former co-head and managing director of ORIX Venture
Finance LLC. FSTP plans to make structured and secured debt investments
ranging in size between $5 million and $50 million in venture-type deals.
While venture lending is expected to account for a relatively small portion of
Ares' and FSC's balance sheets, the fact that many venture deals come with
equity warrants could introduce increased leverage volatility if initial
equity gains are levered, and equity valuations decline in subsequent
quarters. Fitch believes that an increase in equity exposure should be met
with a corresponding reduction in overall leverage.
Venture lending is also highly competitive, with significant advantages
afforded to other players with longer track records and broader industry
contacts. This could be a headwind for new entrants, but Fitch views Ares' and
FSC's respective decisions to bring in experienced industry veterans as an
appropriate first step.
Given the typically small portfolio sizes of companies that receive BDC
investment under a venture strategy, BDCs are generally able to obtain Small
Business Administration (SBA) funding. FSC currently has two SBA licenses,
with $225 million of total funding capacity, and Fitch believes Ares may also
pursue an SBA license for its venture business. We view the SBA facilities as
an attractive and relatively cheap form of funding, with debt maturities that
extend for 10 years, but we also consider them as part of the BDC's overall
debt profile when calculating leverage.
The above article originally appeared as a post on the Fitch Wire credit
market commentary page. The original article can be accessed at
www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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