Asset coverage test

The asset coverage test (ACT) is a key leverage restriction under the 1940 Act, applicable to Business Development Companies (BDCs). BDCs are the public sister of Private Credit funds. The test measures a BDC’s ability to cover its senior securities (primarily outstanding debt/borrowings and any preferred stock) with its assets. Most BDCs today adhere to the lower coverage ratio of 150% (effectively 2:1 debt to equity) post 2018 (it used to be 200%), provided they have approval from their respective boards and/or investors. In the chart below, you can see that BDCs loan portfolio would need to decrease in value by 20% (that’s the median), to breach the ACT. What happens if the test is breached? (1) The BDC cannot issue any additional senior securities (no new debt, borrowings, or preferred stock) until compliance is restored. (2) The BDC cannot declare or pay cash dividends or distributions to common shareholders. (3) Most BDCs credit facilities and debt indentures include maintenance covenants that require the regulatory asset coverage ratio to be maintained. A breach can trigger an event of default, leading to accelerated repayment demands and/or blocked access to revolving facilities. To cure a breach, a BDC typically repays debt, raises new equity (often challenging if trading below NAV), sells assets, or waits for portfolio valuations to recover. The key point for private credit investors is, if credit quality of the loans deteriorate, BDCs and likely private funds, become forced leveraged sellers, at the same time, of illiquid assets. There are $2.5Tn in Private credit funds and BDCs.

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