BDCs use off-balance sheet loans as work-around for leverage cap

Known as senior secured loan programs (SSLPs), these joint ventures between BDCs and another capital provider, usually an insurance company, are drawing more attention. The SSLPs often help boost returns for BDCs at a time when most continue to trade below their net asset value.

Here’s how an SSLP typically works: BDCs may invest up to 30 percent of their capital in non-qualifying assets that fall outside their regulatory structure. BDCs make investments in SSLPs from that 30 percent bucket and list them on the balance sheet as an equity investment in a joint venture or other vehicle. If the BDC doesn’t have sole operating control of the joint venture, then the leverage in the SSLP won’t fall under the one-to-one asset coverage ratio required by regulators.

SSLPs usually invest in first lien, senior secured loans of middle-market companies, with the financing shared between the BDC in a subordinated role and the joint venture partner, according to a research note from Fitch Ratings last year. This structure allows the BDC to invest in larger deals, according to Fitch. 

BDC executives said using more leverage through SSLPs gives them more leeway to loan money to solid companies, often considered safer than many other asset classes.

“It’s a tool,” said David Golub, president of Golub Capital, which runs an SSLP with an investment from RGA Reinsurance Co. “It’s not a good tool or a bad tool. It can be used well or it can be used badly.”

Todd Owens, CEO of Fifth Street Finance Corp and president of Fifth Street Floating Rate Corp, said the extra leverage in the SSLP, “allows us to invest in safe assets that can carry high levels of leverage but still get the returns we need in our BDCs.”

Owens said the vehicles have been around for a while, but, like others, he said the use of SSLPs has accelerated in the last year or two.

Fifth Street has two SSLPs, both added recently. Its Fifth Street Finance BDC teamed up last year with Trinity Universal Insurance Co, a unit of Kemper Corp, with a combined $200 million for an SSLP. In addition, Fifth Street Senior Floating Rate Corp formed an SSLP with the Glick Family investment arm, GF Funding.

The biggest and oldest SSLP is the senior secured loan fund run by GE Capital and Ares Capital Corp, the largest BDC by market cap, which is operated by Ares Management, according to Fitch. The fund was formed in 2007 by GE and Allied Capital, then two years later Ares bought Allied’s stake for $165 million in cash. At the time, the fund held $900 million in loans to middle-market companies. The program now tips the scale at $11 billion.

Just a few months ago, Solar Capital Ltd teamed up with PIMCO to form a $600 million SSLP with targeted leverage of 1.5x.

BDC executives said they worked with the Securities and Exchange Commission prior to launching SSLPs. Since BDCs trade publicly with many retail stock market investors as shareholders, the SEC continues to keep watch.

A spokeswoman for the SEC declined to comment.

SEC Chairwoman Mary Jo White hasn’t commented specifically on SSLPs. But she said BDCs concentrating investments in hedge and “other private funds” could raise potential investor protection concerns “because of the riskier strategies” associated with some of these funds, according to a 2013 letter to Congress.

Meghan Neenan, an analyst at Fitch Ratings, said SSLPs come with risks. “The primary risk associated with a BDC’s use of an SSLP is that it raises the BDC’s effective leverage, taking into account not only the leverage on the BDC’s balance sheet, but also leverage embedded within the BDC’s investment,” Neenan said in the research note.

To help mitigate risk, BDCs have partnered with established players with track records of underwriting middle-market loans, she said. The typical SSLP’s leverage of 2x to 3x is modest compared to other potential yield-enhancing investments such as subordinated debt or equity in collateralized loan obligations, Neenan said in the note.

Meanwhile, other players in the sponsored lending business continue to consider SSLPs. “We’re studying it,” said Aaron Peck, CFO and CIO of Monroe Capital Corp. 

Correction: Due to a reporting error, this story has been updated to fix an inaccuracy about one of Fifth Street’s senior secured loan programs, which included a combined $200 million from Fifth Street and a unit of Kemper Corp. The two firms did not each put in $200 million.