NEW YORK–(BUSINESS WIRE)–Fitch Ratings has affirmed the long-term Issuer Default Rating (IDR) and secured debt rating of Corporate Capital Trust (CCT) at ‘BB+’. The Rating Outlook is Stable. Today’s rating actions have been taken as part of Fitch’s periodic peer review of Business Development Companies (BDCs), which comprises 10 publicly rated firms.
BDC INDUSTRY OUTLOOK
Fitch’s outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.
BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at an 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.
The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch’s opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms’ underwriting.
Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of approximately 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy if and when underwriting conditions improve, thus weakening earnings upside.
KEY RATING DRIVERS
IDRs AND SENIOR DEBT
The rating affirmations reflect the strength of CCT’s relationship with CNL Fund Advisors Company (CNL) and KKR Credit Advisors (US) LLC (KKR Credit), low leverage, relatively low portfolio concentrations, and strong asset quality to date. CNL has demonstrated its ability to raise and administer capital in the retail market over a long period of time, while KKR Credit has a strong and established track record underwriting credit and has strong access to deal flow, given its affiliation with KKR & Co. L.P. (KKR, rated ‘A’ by Fitch).
Rating constraints include a limited operating history as a business development company (BDC), weaker-than-peer earnings yields, a fully secured funding profile, higher-than-average non-cash income, weaker relative earnings coverage of the dividend, and the potential that CCT will be unable to access the equity markets for capital following the completion of its current issuing authority in 2016, barring a liquidity event.
Leverage, as measured by debt to equity, amounted to 0.55 times (x) at Sept. 30, 2015, which is below the peer average of 0.64x and the firm’s long-term target of 0.67x. At third quarter 2015 (3Q15), effective borrowing capacity would have allowed the company to lever to 0.71x (assuming 40% collateral is held against the total return swap [TRS], although this requirement declined to 33% in the fourth quarter). Fitch believes the firm will look to increase debt capacity over time to add funding flexibility. However, leverage could move above that level with the recognition of additional portfolio depreciation, which Fitch believes is likely over the near-term given the volatile market environment. CCT’s leverage must be carefully managed, particularly as the firm’s access to the equity markets will decline in 2016 with the termination of their continuous offering.
CCT remains heavily focused on secured debt, which accounted for 74.2% of its portfolio at Sept. 30, 2015; modestly above the peer average. Still, exposure to equity investments, which can experience meaningful valuation volatility, has increased over the last year, from 4.8% of the portfolio at year-end 2014 to 9% at 3Q15, with an additional 2.7% in structured products. Fitch would view a meaningful increase in equities and structured products as a proportion of the portfolio negatively.
The investment portfolio is more diverse than peers, with the top 10 investments accounting for 22.6% of assets and 36.4% of equity, including the TRS, at Sept. 30, 2015. Still, Fitch expects portfolio concentrations to increase modestly over time, as CCT transitions the portfolio into more directly originated transactions. That said; CCT is likely to maintain a greater exposure to liquid credit than the peer group, as the firm has the option to co-invest alongside other KKR credit vehicles, including CLOs, in addition to its less liquid direct senior lending and mezzanine funds.
Asset quality trends have been strong since inception, supported, in part, by relatively benign market conditions. CCT had three investments on non-accrual status at 3Q15, accounting for 1.63% and 0.58% of the portfolio at cost and value, respectively. CCT’s subordinated investment in Hilding Anders (SE) has been on non-accrual since 4Q14 and remains one of the firm’s largest investments (second largest at cost). Two tranches of the firm’s subordinated debt are on paid-in-kind (PIK) non-accrual, while the largest tranche continues to accrue PIK.
Through the first three quarters of 2015, CCT recognized $28.8 million of net realized losses on portfolio company investments, relating largely to the restructuring of debt investments in Towergate Finance PLC. This is the largest investment loss in CCT’s history.
At Sept. 30, 2015, according to Fitch’s calculations, energy investments represented approximately 5.1% of the portfolio, at fair value, while oil & gas investments, more specifically accounted for 3.4% of the portfolio, excluding the TRS, both of which are below the peer average. Nearly 97% of oil & gas investments were in first lien securities and 3% were in equity. The fair value of the portfolio represented 77.1% of the cost basis, due largely to fair value marks taken on OAG Holdings, LLC and Wilbros Group, Inc.
According to a recent stress test conducted by Fitch, it was estimated that the impact on CCT’s leverage from an oil & gas stress to be negligible, with an energy stress resulting in a one bps increase in leverage, and a complete write-off of oil & gas exposure resulting in a two bps increase in leverage, based on Sept. 30, 2015 data; all of which is deemed manageable and compares favorably to the peer group average.
CCT’s operating earnings continued to increase in 2015 as equity proceeds were deployed into portfolio growth; however, this trend is expected to level off in 2016 as equity access will be more limited following the launch of Corporate Capital Trust II (another BDC managed by CNL and KKR Credit), leading to the ultimate closing of the offering no later than October 16, 2016. Additionally, tough market conditions and the underperformance of certain portfolio investments are likely to hurt overall returns in 2016.
CCT’s funding profile is fully secured, consisting of two special purpose vehicles (SPVs), a corporate revolver, and a secured term loan. Borrowing capacity is about $1.5 billion, and $1.2 billion was outstanding at Sept. 30, 2015. The firm also has a $500 million TRS, which is used opportunistically to fund investments in the liquid markets. The revolving period on CCT’s corporate credit facility expires in September 2016, but Fitch believes the firm will look to extend the maturity of the facility over the near-term. Fitch believes CCT will look to opportunistically access the unsecured markets to improve funding flexibility.
CCT’s liquidity profile is considered sound with $48.2 million of balance sheet cash, and $335 million of availability on various secured funding facilities, subject to borrowing base requirements, at Sept. 30, 2015. Additionally, cash flows from investment repayments and exits remain significant, amounting to $637.3 million in the first nine months of 2015. Additionally, a meaningful portion of the portfolio could be considered liquid, as 44.4% of fixed interest rate debt investments had prices generally available from third-party pricing services at Sept. 30, 2015.
Net investment income (NII) dividend coverage, which adjusts for non-cash incentive payment accruals and realized gains, was sound, amounting to 118.9% through 3Q15. However, coverage ratios fall if non-cash income is removed from NII, as CCT has a meaningful amount of PIK income. Realizations of non-cash income, to date, have been limited, given the relatively short operating history of the BDC. Fitch would view a reduction in non-cash income and an improvement in NII coverage of the dividend, excluding realized gains, favorably.
The Stable Outlook reflects Fitch’s expectations for continued operating consistency, improved earnings yields, given the gradual shift into less-liquid direct originations, the maintenance of good asset quality, modest leverage, and improved dividend coverage.
IDRs AND SENIOR DEBT
Negative rating actions for CCT could be driven by an extended increase in leverage above the targeted range of approximately 0.67x (asset coverage of 250%), resulting from increased borrowings or material realized or unrealized depreciation, and/or a meaningful increase in the proportion of equity holdings without a commensurate decline in leverage. A spike in non-accrual levels, a continued increase in non-cash income, an inability to refinance near-term debt maturities, and weaker cash income dividend coverage would also be viewed unfavorably from a ratings perspective.
Positive rating momentum for CCT is viewed as limited over the near term, particularly given the challenging market backdrop, but could develop over time with increased funding flexibility, including an extension of the debt maturity profile, access to the public unsecured debt markets, and the ability to issue public equity for growth capital. Other positive rating factors could include an improvement in net investment income yields, a continuation of solid asset quality performance, particularly given the competitive market environment, reduced non-cash income, and stronger cash earnings dividend coverage.
CCT is an externally managed business development company, organized in June 2010 and commencing investment operations in July 2011. As of Sept. 30, 2015, the company had investments in 120 portfolio companies amounting to approximately $3.5 billion.
Fitch has affirmed the following ratings:
Corporate Capital Trust
–Long-term Issuer Default Rating at ‘BB+’;
–Secured debt rating at ‘BB+’.
The Rating Outlook is Stable.
Additional information is available at ‘www’.fitchratings.com’
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
Dodd-Frank Rating Information Disclosure Form
Meghan Neenan, CFA
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
Hannah James, +1 646-582-4947
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