DBRS Morningstar Confirms First Eagle Alternative Capital BDC, Inc. at BB (high), Negative Trend

DBRS, Inc. (DBRS Morningstar) has confirmed the BB (high) Long-Term Issuer Rating and Long-Term Senior Debt rating of First Eagle Alternative Capital BDC, Inc. (FCRD or the Company). The trend on the ratings is Negative. The Company’s Intrinsic Assessment (IA) is BB (high) and its Support Assessment is SA3.

KEY RATING CONSIDERATIONS
The rating confirmation considers FCRD’s acceptable franchise in lending to U.S. middle market companies and seasoned management team. The Company’s prudent management of leverage, modest near-term refinancing requirements and funding profile that is more balanced than most business development companies (BDCs) are also considered in the ratings. FCRD has deliberately managed leverage below its long-term target while completing the repositioning of the investment portfolio. The lower leverage allows the Company a significant leverage buffer as compared to its requirements, which is helpful in the still uncertain environment. FCRD’s earnings generation has been challenged by the contraction in the investment portfolio as the Company completes its repositioning, as well as realized and unrealized losses in the investment portfolio. With the repositioning nearly complete and the balance sheet modestly levered, the Company has made several new and follow-on investments since the onset of the pandemic, which should benefit earnings in 2021.

We are maintaining a Negative trend due to the challenging and uncertain environment having the potential to further adversely impact the performance of the investment portfolio. While we note that the performance of FCRD’s investment portfolio through the coronavirus has been acceptable with just one investment company on nonaccrual due to the impact of the pandemic on its business, we see the headwinds for middle market borrowers in the current environment as substantial. These concerns are somewhat mitigated by support from private equity sponsorship, which may selectively invest additional capital in their portfolio companies.

RATING DRIVERS
Given the Negative trend, a ratings upgrade is unlikely in the near-term. The trend would revert to Stable if FCRD were to demonstrate improving diversification in the investment portfolio and good credit quality. Conversely, a sizeable loss that materially reduces the Company’s cushion to the bank facility covenants for several quarters would lead to a ratings downgrade. The ratings could also be lowered if FCRD were to report sustained negative earnings generation or an elevated level of non-accrual investments.

RATING RATIONALE
FCRD’s franchise is acceptable benefiting from its relationship with First Eagle Alternative Credit (FEAC or the Advisor), including its position within the FEAC platform. This platform was strengthened following the acquisition of the Advisor by First Eagle Investment Management in January 2020. First Eagle had more than $103 billion of assets under management (AuM) as of September 30, 2020, including about $20.6 billion of AuM in its credit strategy platform. DBRS Morningstar continues to see the acquisition as potentially a credit positive for FCRD over the longer-term. We see First Eagle as providing FCRD with access to a larger investment management platform with a long operating history.

FCRD benefits from solid sourcing capabilities derived from the Advisor’s national direct origination platform that focuses on lending to sponsored-backed middle market companies, reflecting the Advisor’s view that these portfolio companies have the scale, access to capital and better resources to navigate an economic downturn. The Advisor sources investment opportunities from the more than 75 sponsors its management has worked with over their careers. At September 30, 2020, the Adviser had over $20.6 billion of AuM, across its BDC, private credit funds, separately managed accounts, and CLOs. Importantly, FCRD has received co-investment exemptive relief from the SEC so it may invest alongside other FEAC private credit funds and separately managed accounts, allowing FEAC greater flexibility to negotiate terms of co-investments. DBRS Morningstar views this exemptive relief favorably, as it allows FCRD to lead and close larger deals. As of September 30, 2020, FCRD’s investment portfolio totaled 47 investments with a fair value of $343.4 million, with 83% of the investment portfolio comprised of first lien senior secured, 10% second lien, 6% equity investments, and 1% investment in funds.

FCRD’s earnings generation has been challenged by the repositioning initiative which has resulted in a reduction in the size of the investment portfolio, as well as some realized and unrealized losses on the investment portfolio. We see earnings as remaining challenged heading into 2021, due to the modestly sized investment portfolio and the uncertain economic environment. For 9M20, FCRD reported a net decrease in net assets from operations (net loss) of $36.8 million, driven by a large mark-to-market (MTM) loss in 1Q20. Subsequently, for 2Q20 and 3Q20, FCRD generated net income of $29.4 million in aggregate, driven by the material write-up in fair value of portfolio investments as credit spreads tightened, reversing most of the MTM losses.

While FCRD has made notable progress in improving the risk profile of the investment portfolio by shifting to more first lien, senior secured, sponsor-backed loans, we see the potential for credit performance to be impacted by the uncertain economic environment caused by the coronavirus pandemic. At September 30, 2020, the Company only had three investments remaining that were non-sponsored back, including one that is an equity investment and well-performing, compared to 14 at the time the shift in the investment strategy was initiated. FCRD had very limited exposure to cyclical industries that have been the hardest hit by the sudden and severe shock to the U.S. economy from the coronavirus pandemic including, hospitality, retail, leisure, gaming, and energy. Indeed, the Company only had a portfolio company, smarTours, a high-end travel tour operator, move to nonaccrual status due to the impact of the pandemic. We note that the Company’s investment in smarTours is very modest at less than 1% of the portfolio at fair value, consistent with FCRD’s investment strategy of avoiding large hold positions.

Overall, credit performance of the investments originated under the new investment strategy introduced in 2015 has been solid with only one investment out of 50 being placed on nonaccrual status and no realized losses. Investments on nonaccrual status has recently improved benefiting from the restructuring of an investment in OEM Group, the Company’s largest exposure. At September 30, 2020, the Company had two investments on nonaccrual status accounting for 5.09% of the portfolio at cost and 2.84% of the portfolio at fair value, respectively compared to 21.14% and 14.42% at March 31, 2020.

Similar to other BDCs, FCRD incurred significant fair value marks and unrealized losses in 1Q20 due to the significant market turmoil in March 2020. However, FCRD has seen a partial recovery of these unrealized losses as the market and economy have rebounded from the trough in 2Q20. Indeed, at September 30, 2020, the Company’s total investment portfolio at fair value was 86% of cost compared to 72% at March 31, 2020. At September 30, 2020, FCRD’s average portfolio investment company score was 2.28, on its internal rating scale from “1 (outperforming)” to “5 (very weak)”, indicating that the majority of the portfolio was performing within expectations.

Balance sheet fundamentals are acceptable with prudent management of leverage and appropriate liquidity for requirements. Leverage (debt-to-equity) was 0.94x at September 30, 2020, well within its bank covenant limit and the regulatory limit of 2.0x. With FCRD nearly complete with the exit from legacy non-core investments, the Company expects to expand the investment portfolio in 2021 leading to a gradual increase in leverage towards management’s stated target of 1.1x to 1.2x.

As of September 30, 2020, the Company had unfunded delayed draws and revolver commitments to portfolio companies totaling $17.6 million. FCRD had approximately $45.0 million of available liquidity, including capacity on its bank facility, which is subject to borrowing base requirements. Following the amendment and extension of the Company’s bank facility in October 2020, refinancing risk is minimal with no maturities until $60 million of senior notes mature in December 2022.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 29, 2020): https://www.dbrsmorningstar.com/research/367510/global-methodology-for-rating-non-bank-financial-institutions.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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