News Column

Fitch Affirms BlackRock Kelso at 'BBB-'; Outlook Revised to Negative

April 28, 2014

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has affirmed the long-term Issuer Default Rating (IDR), secured debt rating, and unsecured debt rating of BlackRock Kelso Capital Corporations (BKCC) at 'BBB-'. The Rating Outlook has been revised to Negative from Stable. These actions are being taken in conjunction with a broader industry review, which includes seven business development companies (BDCs), and coincides with the publication of an industry report titled 'Business Development Companies - A Comparative Analysis: 2014', which is available on Fitch's website.

KEY RATING DRIVERS

The rating affirmation reflects BKCC's experienced management team, demonstrated ability to operate through a cycle, strong asset quality, improved funding flexibility, and the strength of the company's historic relationships with BlackRock, Inc. and the principals of Kelso & Company.

Rating constraints include the capital markets impact on leverage, given the need to fair value the portfolio each quarter, dependence on the capital markets to fund portfolio growth, and a limited ability to retain capital due to dividend distribution requirements.

The Rating Outlook revision for BKCC reflects the weaker dividend coverage on a cash earnings basis, increased portfolio equity exposure combined with an increase in leverage, and increase in unsecured debt investments, which could be signaling a higher risk appetite.

BKCC's dividend coverage declined to 88% in 2013, from 103.4% in 2012, due to a decrease in net investment income generation. Fitch believes dividend coverage could improve if proceeds from the sale of equity investments are redeployed into income-producing securities, but given the competitive market environment, it could take some time for that to occur. If BKCC cannot cover the dividend with net investment income in the medium term, Fitch would view a dividend cut as prudent. Absent that, negative rating action could result, reflecting the use of principal proceeds to cover dividend shortfalls.

BKCC's total equity exposure, including preferred stock, was 21.9% of the portfolio at year-end 2013, compared to 13.5% at year-end 2012, due largely to the appreciation of several portfolio positions, some of which represent restructured debt investments. At the same time, leverage rose to 0.67 times (x) at Dec. 31, 2013 compared to 0.50x a year ago. While equity exposure is not necessarily viewed negatively by Fitch, it is evaluated in the context of the firm's leverage position given the potential for valuation volatility. Fitch believes a meaningful increase in equity exposure should be met with a commensurate decrease in balance sheet leverage.

Fitch believes BKCC's equity exposure could decline in the near term, as a large investment could potentially be sold. The company sold its investment in portfolio company, Arclin US Holdings (Arclin) during the first quarter of 2014 (1Q'14), which, on a pro forma basis reduced equity investments to 19.2% of the portfolio, all else equal; which is still above the firm's long-term target and historical range of 5%-10%.

Historically, BKCC has focused on senior secured debt investments, but during 2013 these investments declined, and represented 61.9% of the total portfolio at Dec. 31, 2013, compared to 70.7% a year ago, as unsecured debt and equity investments increased. Fitch believes the increase in unsecured debt as a percentage of the total portfolio could potentially alter the risk profile of the portfolio. While the shift could potentially offer similar risk-adjusted returns, Fitch would need to observe the performance of the investments over time.

Core operating performance, adjusted for the non-cash incentive payment accruals, declined in 2013 due to lower investment income and increased operating expenses. Interest income declined 7.6% from 2012, due to lower average cash-yielding portfolio investments and a lower weighted average yield during the period. Net investment income declined 14.2% to $67.9 million, generating a 6.4% yield on average portfolio company investments at cost, compared with a 7.4% yield in 2012.

Fitch believes BKCC's operating performance in 2014 will be highly dependent on the company's ability to redeploy proceeds from the sale of its equity investments into attractive risk-adjusted investment opportunities.

BKCC's asset quality has generally improved, although several larger investments needed to be restructured in recent years. As of Dec. 31, 2013, BKCC had no portfolio company investments on non-accrual status.

On Feb. 19, 2013, BKCC accessed the unsecured markets for the first time, issuing $100 million of convertible notes via a private offering, which included an overallotment option of $15 million that was exercised in March 2013. The notes bear interest of 5.50% and mature on Feb. 15, 2018. BKCC has been less active in the unsecured markets relative to its peers, but Fitch views the issuance positively and expects the company to opportunistically access these markets in the future.

BKCC's liquidity profile is sufficient with $18.5 million of balance sheet cash and $171 million of availability on its secured revolving credit facility, subject to borrowing base requirements, at Dec. 31, 2013. The facility was upsized $55 million in March 2014 to $405 million. Additionally, cash flow from investment repayments and exits has been significant, amounting to $442.6 million in 2013, compared to $314.8 million in 2012.

RATING SENSITIVITIES

The ratings of BKCC could potentially be downgraded over the next 12-24 months if net investment income dividend coverage remains relatively weak and/or leverage is not appropriately managed relative to portfolio equity exposure. Additionally, should the recent decrease in secured investments as a percentage of the total portfolio represent a shift in the firm's risk appetite, which translates into weaker asset quality performance as recent vintages season, ratings may be downgraded. Any potential reduction in equity exposure would be evaluated in the context of how such proceeds are reinvested, in terms of asset seniority and loan terms, particularly given the current aggressive credit conditions. This may take some time to observe depending on the pace at which proceeds can be deployed.

More broadly, Fitch sees a number of emerging industry challenges that could pressure ratings, or at least increase rating differentiation amongst BDCs over a longer-term horizon. These challenges include a potential increase in regulatory leverage limits and increased competition, which are yielding tighter market spreads and looser underwriting terms, including higher underlying portfolio company leverage and weaker covenant packages. Should competition continue to intensify, market yields could decline further, which would reduce earnings generation and pressure dividend coverage for the space.

Conversely, BKCC's Rating Outlook could be revised to Stable if leverage is appropriately managed relative to portfolio equity and dividend coverage aligns closer to peers.

Headquartered in New York, NY, BKCC is an externally managed business development company, formed in 2005 with an objective to generate both current income and capital appreciation through debt and equity investments. As of Dec. 31, 2013, the company had investments in 51 portfolio companies amounting to approximately $1.2 billion at fair value.

Fitch has affirmed the following ratings:

--Long-term Issuer Default Rating (IDR) at 'BBB-';

--Secured debt at 'BBB-;

--Unsecured debt at 'BBB-'.

The Rating Outlook has been revised to Negative from Stable.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Global Financial Institutions Criteria' (January 2014);

--'Investment Manager and Alternative Funds Criteria' (December 2013).

Applicable Criteria and Related Research:

Global Financial Institutions Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732397

Investment Manager and Alternative Funds Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=725057

Additional Disclosure

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.



Fitch Ratings

Primary Analyst:

Katherine Hughes, +1-312-368-3123

Associate Director

Fitch Ratings, Inc.

70 W. Madison Street

Chicago, IL 60602

or

Secondary Analyst:

Johann Juan, +1-312-368-3339

Director

or

Committee Chairperson:

Tara Kriss, +1-212-908-0369

Senior Director

or

Media Relations:

Brian Bertsch, New York, +1-212-908-0549

brian.bertsch@fitchratings.com

Source: Fitch Ratings


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