Depressed oil prices have led to lower valuations on energy-related investments within the portfolios of 10 Fitch-rated business development companies (BDCs), says Fitch Ratings. Oil, gas and other energy exposures, while pressured based on fourth-quarter loan marks, remain manageable relative to Fitch’s ratings expectations for BDCs. However, heavy exposure to energy-related investments did contribute to one BDC’s Outlook being revised downward last month.For the group of 10 rated BDCs, oil and gas investments were, on average, marked at a 7.3% discount to cost at Dec. 31, 2014, compared to a 1.6% discount to cost at Sept. 30, 2014. More broadly, energy portfolios were marked at a 6.2% discount to cost at year-end 2014, compared to a 1.3% discount in the prior quarter.PennantPark Investment Corporation (Pennant, BBB-, Rating Outlook Stable) and Apollo Investment Corporation (Apollo, BBB, Rating Outlook Negative) remained the most exposed to the energy sector with investments accounting for 21.4% and 20.6%, respectively, of portfolios at Dec. 31, 2014, based on Fitch’s industry definitions. Pennant and Apollo also recognized unrealized depreciation of $53.2 million and $74.7 million, respectively, in the fourth quarter largely due to marks on energy investments, which yielded book value erosion of 3.8% and 3.6%, respectively, in the quarter.On March 13, Fitch revised Apollo’s Rating Outlook to Negative from Stable reflecting the firm’s higher than average leverage and increased portfolio risk given the company’s outsized exposure to energy, aviation finance and several highly levered structured investments.Fitch believes expected depreciation on energy investments has contributed to BDC share prices dropping below net asset value in recent months, which generally precludes BDCs from accessing the equity markets for growth capital.Average leverage for the rated peer group increased to 0.61x at Dec. 31, 2014 from 0.54x at Sept. 30, 2014 due, in part, to portfolio valuation hits. Fifth Street Finance Corp. (FSC, BB+, Rating Outlook Negative) and Pennant experienced the most significant increase in leverage quarter over quarter, up 21 bps and 13 bps, respectively. Given current share prices, an inability to raise equity will make it more difficult for firms to manage leverage ratios, particularly if unrealized portfolio depreciation continues to rise.While valuation marks have been meaningful, BDC energy investments continue to be heavily weighted toward first lien exposures, which accounted for 62.2% of total energy investments at year-end 2014. This was followed by 15.6% in second lien debt, 13.2% in subordinated debt, with only about 9% of energy investments as equity exposures. All else equal, additional senior investment positions should provide stronger recovery prospects in the event of default or restructuring.Fitch identified 13 oil and gas investments that are common across more than one BDC. For the same investment, there was relatively good consistency in terms of marks on energy investments in the fourth quarter, but there were some exceptions. For example, the first lien investment in Prince Mineral Holding Corp. (with an 11.5% coupon and a December 2019 maturity) was held at 103% of cost by Pennant and 94% of cost by Franklin Square Energy Partners (not rated by Fitch) at year-end 2014.
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