OREANDA-NEWS. With many business development companies (BDCs) trading below their net asset values (NAVs), there is a greater potential for BDC share buybacks over the near term, says Fitch Ratings.

Fitch views share repurchases as generally shareholder friendly and a contributor to higher leverage ratios, to the detriment of creditors. Share repurchases can pressure a BDC's ratings if the impact from higher leverage is beyond levels commensurate with portfolio risk or previously articulated target leverage ratios.

However, given the requirements on BDCs to distribute 90% of taxable earnings on an annual basis, repurchases can help manage a BDC's dividend burdens, particularly when market conditions are competitive. If, for example, the earnings per share accretion achievable through a buyback is greater than any accretion otherwise achievable through investments in new loan assets, then the BDC's creditors benefit from the buyback primarily through a reduction in share count, lowering cash outflows to support dividends.

A significant number of BDCs and their shareholders have been grappling with their share prices trading at discounts to NAV for over a year. Merger and acquisition volume in the middle market was relatively light in first-half 2015 and refinancing volume has eased. As a result, demand from BDCs for new loans has been outstripping the market's supply, pressuring loan pricing and terms, making share repurchases a more likely alternative.

Fitch believes that BDCs must carefully manage share repurchases in order to maintain regulatory asset coverage limitations, which effectively restrict a BDC's debt/equity ratio to a maximum of 1.0x. Maintaining a cushion typically means that the BDC has established an appropriate leverage target that takes into account the relative risk of the portfolio and the potential for valuation volatility in the assets.

The severity of the share price discounts can be ascribed to a variety of factors, including market expectations for credit losses to increase from current lows, the potential for dividend cuts given more competitive asset yields, reduced fees on lower origination volume, and valuation declines from portfolio energy exposures. Fitch-rated BDCs were trading at a 12.3% discount to their June 30, 2015 NAVs, as of Aug. 17, 2015.

A material share discount to NAV is challenging for BDCs because it curbs their equity market access as structural limitations prohibit equity raises below NAV without shareholder approval. Equity access is important for funding portfolio growth and managing leverage when repayment speeds begin to slow, as is widely expected following the lengthy period of low rates. Depressed share prices also can constrain a BDC's ability to capitalize on investment opportunities during times of market dislocation, which could materialize if asset quality issues start to emerge.

Fitch believes BDCs trading at or above NAV will be better positioned to capitalize on investment opportunities, whereas BDCs with constrained equity market access for an extended period may see their franchises and funding profiles degrade, leaving them a target for acquisitions and/or forced-asset sales.

Fitch has maintained a negative sector outlook on BDCs since November 2014, and in March 2014, we downgraded one BDC while assigning or maintaining Negative Rating Outlooks on four others.