Since interest rates collapsed in the mid-2000s, American investors squeezed by low Treasury, muni and corporate bond yields pumped more than $50 billion into Business Development Companies (BDCs), investment funds which typically specialize in lending to U.S. middle-market companies, seeking higher returns in spreading the risk among higher-yielding assets. (Revised)
Sold by brokers, BDCs are associated with high returns, high initial fees and closed-end status, which means owners are often locked into them for long periods, though some BDC sponsors also sell public funds and more modest fees. Among the most successful BDC sponsors is Franklin Square Investment Corp. and its affiliates, founded by Philadelphia lawyer Michael Forman and dorm-and-hotel mogul David Adelman, which employs more than 300 people investing $17 billion in client money, mostly from its new offices at the former Navy Yard in South Philadelphia.
The recent slowdown in the energy and high-risk credit markets have hurt BDC valuations, driving Franklin Square's main fund below $9 a share for the first time since its public offering two years ago. In a conference call in early March, cofounder Forman told investors FSIC has slightly reduced its exposure to the battered oil and gas sector, to around 9% of their total. He called the volatile market "an opportunity" to buy good assets cheap. "We will be opportunistic," Forman added. "We will look at everything in the market." He said Franklin Square sub-advisors at GSO Blackstone (corrected) see "deceleration" but not "decline" in the U.S. economy.
Franklin Square has enjoyed an investment-grade BBB credit rating from Standard & Poor's, among the highest of any BDC group. But on Tuesday, S&P analysts Trevor Martin and Sebnem Caglayan threatened to cut the credit ratings of Franklin Square and three other BDCs, citing continued exposure to energy-company debt and the general increase in bad-debt fears as the economy slows. Franklin Square "suffered approximately $245 million of realized and unrealized losses" in the last nine months of 2015, reducing its debt-to-equity ratio to where "we could lower the rating on the firm" if it fails to build back its equity assets, the analysts wrote in a report to clients.
Franklin Square still has plenty of capital, but its "history only extends back to 2009, and therefore it has operated in a relatively benign credit environment," the analysts noted. While the firms whose debt Franklin Square owns hadn't defaulted on interest payments as of Dec. 31, several had been marked down below the price Franklin Square paid. S&P is particularly worried about Franklin Square's remaining exposure to energy investments in companies including Ascent Resources, FourPoint and Plains Offshore.
In a follow-up call with reporters, S&P analyst Mathew Albrecht said 7 of the 14 BDCs his firm rates face downgrades, due mostly to "sustained pressure on energy prices" and the volatility of the junk-bond market. (Some of the others are already rated below investment grade.)
Albrecht said his firm doesn't expect energy prospects to improve this year; production remains high or rising in the U.S., Canada, Russia and Iran, so oil prices should remain below $50 a barrel through 2018 and later -- as long as there's no recession, which could drive prices lower.
"Our expectation is that loan losses will continue to remain elevated," with "deteriorating asset quality," analyst Caglayan added in the call. Worst-case scenario: continued credit problems will lead to "forced failures" and "rapid deleveraging" that could force BDCs to sell assets at discounts that could hurt investment values.