BDCs in Distress: Tips for Managing Stress and Distress in a Volatile Market
In today’s marketplace, what does it mean for a BDC to be distressed? How do outside parties respond to BDCs in distress? How are dividend distributions complicated in distress situations and what are some other practical effects of distress? What preventative steps can BDCs take today? At Dechert's recent Permanent Capital Summit, panelists addressed these questions and offered the following key takeaways.
Early signs of distress may include:
- Difficulty in complying with financial covenants in credit facilities.
- Dislocation of stock price and NAV.
- Activist shareholders becoming more prevalent and vocal.
- Increased pressure from analysts.
Outside parties focus on a couple of key indicators, such as:
- Senior lenders: poor financial metrics, including low asset coverage ratios, volatile or concentrated asset compositions, concentrated maturity profiles and high borrowing bases.
- SEC: suspicious trends in reporting, including delayed write downs, overvaluing of assets and inconsistent income recognition.
The likelihood of resolutions like refinancing, amendment or restructuring depends in part on:
- The BDC’s relationship with its lenders.
- The amount of protection provided to lenders by the available collateral pool.
- The complexity of the BDC’s balance sheet, including the number of other interested parties.
- The willingness of lenders to allow BDCs to continue making dividend distributions.
- The nature and anticipated permanence of the source(s) of distress.
Specific issues to consider in connection with dividend distributions:
- BDCs generally elect RIC tax status in order to avoid corporate-level taxation.
- As a RIC, the BDC needs to distribute all of its income and gains to avoid being subject to tax.
- In certain instances the BDC may need to continue recognizing income on troubled or defaulted securities for tax purposes, even though the BDC has ceased accruing such income on its books.
- Dividend distribution requirements could be impacted by the potential need to consider amounts in taxable income where the BDC receives no corresponding cash payments.
- Failure to timely pay dividends can lead to loss of RIC tax status, among other penalties.
- Paying a portion of dividends in stock allows a BDC to retain cash while generally resulting in the same tax treatment for the BDC and its shareholders.
- Potential alternatives to cash dividends include delaying the payment through methods like excise taxes and distributing from other sources (e.g., undistributed capital gains).
Other practical effects of distress include:
- Increased likelihood of both private and public solicitations from activist shareholders.
- More serious consideration of significant buyback opportunities.
Preventative steps for BDCs:
- Look ahead to satisfy cash distributions and periodically true up the tax situation.
- Carefully consider financial and tax impact of investment restructurings (e.g., mitigate risk of advanced gain or loss recognition, or creation of phantom income).
- Make sure to have adequate valuation policies and procedures in place and plan for both downturns and upcycles.
- Regularly perform internal reviews of capital allocation, leverage, stock buyback options, management fees and sustainable dividends.
- Preserve financial flexibility and develop trust across all interested constituencies.