The regulatory leverage test of a business development company, worked from the balance sheet, with the markdown that breaks it and the borrowing it still allows.
A BDC's asset coverage ratio is its total assets less every liability that is not debt, divided by its debt. On an illustrative business development company with $2,080M of assets, $40M of other liabilities and $1,200M of borrowings, that is 2,040 over 1,200, or 170.0 per cent, which is 1.43x debt to equity. Against a 150 per cent minimum, a 12.0 per cent markdown of the portfolio takes it to the floor.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Under section 61(a)(2) of the Investment Company Act of 1940, a BDC must keep asset coverage of at least 200 per cent on its senior securities by default, or 150 per cent if it has adopted the lower requirement permitted by the Small Business Credit Availability Act of 2018, which needs approval by its board (effective after a one-year delay) or by its shareholders. Below the floor it generally cannot issue more senior securities, and it cannot declare a distribution that would leave coverage under the floor, so in practice the test caps fund leverage and decides how much of a downturn the dividend can survive. Lenders to the BDC usually write a covenant at or just above the same level. It is the private credit fund's equivalent of a leverage covenant, tested on the lender itself rather than on its borrowers.
| Item | Amount |
|---|---|
| Loan investments at fair value | 2,000 |
| Cash | 60 |
| Interest receivable and other assets | 20 |
| Total assets | 2,080 |
| Revolving credit facility, drawn | 700 |
| Unsecured notes | 500 |
| Debt (senior securities) | 1,200 |
| Payables, accrued interest and distributions payable | 40 |
| Net assets (NAV) | 840 |
1. Numerator: total assets − liabilities that are not senior securities = 2,080 − 40 = 2,040.
2. Denominator: the senior securities, here the facility and the notes = 700 + 500 = 1,200.
3. Asset coverage: 2,040 ÷ 1,200 = 170.0%.
4. The shortcut: because the numerator is debt plus net assets, coverage = 1 + NAV ÷ debt = 1 + 840 ÷ 1,200 = 1 + 0.70 = 170.0%. Debt to equity is the inverse of that 0.70: 1.43x.
In Excel: =(TotalAssets-OtherLiabilities)/Debt, or =1+1/DebtToEquity as a check.
Two questions follow, and each has a one-line answer once the shortcut is in hand.
Most managers run well inside the cap for that reason. The capacity to borrow 480 more is real, but using it converts a 12.0 per cent markdown cushion into none. What that extra leverage buys in net return, and what it costs in loss tolerance, is worked in how much leverage adds to a private credit fund's return.
| Debt to equity | Debt | Asset coverage | Loss to breach | Markdown to breach | NAV fall to breach |
|---|---|---|---|---|---|
| 1.00x | 840 | 200.0% | 420 | 25.6% | 50.0% |
| 1.25x | 1,050 | 180.0% | 315 | 17.0% | 37.5% |
| 1.43x | 1,200 | 170.0% | 240 | 12.0% | 28.6% |
| 1.75x | 1,470 | 157.1% | 105 | 4.6% | 12.5% |
| 2.00x | 1,680 | 150.0% | 0 | 0.0% | 0.0% |
The cushion does not fall in proportion to leverage. Going from 1.25x to 1.75x, a 40 per cent increase in debt to equity, cuts the markdown the BDC can absorb from 17.0 to 4.6 per cent. Fair value marks on private loans move with spreads as well as with credit, so a spread widening that impairs nothing can still push a BDC at 1.75x close to its floor.
Unfunded commitments are outside the ratio until they are drawn. Fund $150M of revolver and delayed draw commitments with borrowing and coverage falls from 170.0 to 162.2 per cent, debt to equity rises to 1.61x, and the markdown cushion drops from 12.0 to 7.7 per cent. A downturn is exactly when borrowers draw their revolvers.
Reading 150 per cent as 1.5x leverage. Coverage of 150 per cent means assets net of other liabilities are one and a half times the debt, which allows debt of twice net assets: 2.00x debt to equity. A BDC running at 1.5x debt to equity has 166.7 per cent coverage, not zero headroom. The opposite error is subtracting cash from debt before dividing. The statutory test uses the gross amount of senior securities; cash already sits in the numerator, so netting it again double counts it. Run the ratio on the gross balance sheet, then express the headroom as a markdown, because that is the number an investment committee can compare with a spread shock. How the market prices a BDC that is close to its floor is in is a BDC trading below NAV cheap; the European equivalent, a leverage cap for loan-originating funds, is worked in how much markdown breaches the AIFMD II 175% cap.
Asset coverage = (total assets − non-debt liabilities) ÷ debt = 1 + NAV ÷ debt. Here 170.0 per cent, 1.43x debt to equity, with room for a 12.0 per cent markdown or 480 of further borrowing, but not both. The fund-level bridge from loan yield to net return, leverage included, is in the free workbook for this case.
2.00x. Asset coverage equals one plus net assets over debt, so 150 per cent means net assets are half the debt, which is 2.00x debt to equity. The default 200 per cent requirement allows 1.00x. Reading 150 per cent as 1.5x leverage is a common slip: a BDC at 1.5x debt to equity actually has 166.7 per cent coverage and real headroom left.
Net assets less half the debt, at a 150 per cent floor. A BDC with $840M of net assets and $1,200M of debt can lose $240M, a 12.0 per cent markdown on $2,000M of investments and a 28.6 per cent fall in NAV. At 1.75x debt to equity the cushion shrinks to a 4.6 per cent markdown.
Not until they are drawn, but when they are funded with debt both the numerator and the denominator rise by the same amount, which lowers the ratio. Funding $150M of commitments with borrowing takes an illustrative BDC from 170.0 to 162.2 per cent coverage and its markdown cushion from 12.0 to 7.7 per cent.
This article is one calculation from The Private Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: credit, private credit and distressed debt → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.