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L.6 · INTERMEDIATE · 2 MIN

Leverage and Regulatory Limits

BDCs are regulated under the 1940 Act, which limits leverage. Historically the limit was 1:1 debt-to-equity (200% asset coverage). The 2018 Small Business Credit Availability Act reduced required asset coverage to 150%, allowing 2:1 debt-to-equity for BDCs whose boards or shareholders approve.

Quiz · 5 questions ↓

How leverage cuts both ways

Higher leverage amplifies yield in good times and accelerates NAV destruction in bad times. 2008 wiped out several over-levered BDCs; 2020 stressed more.

Leverage regimes before and after 2018

Leverage regimeMax debt / equityAsset coverageRisk profile
Pre-2018 (legacy)1.0x200%Conservative
Post-SBCAA (modern)2.0x150%Higher yield, more risk
With SBIC subsidiaryExcludes SBA debtEffective ~2.25xCheap gov-backed leverage

Find a BDC's asset coverage cushion

In ARCC's filings, find the asset coverage ratio. Anything below 165-170% means cushion is thin and a downturn could force forced asset sales.

How leverage magnifies NAV losses

With 1.5x debt-to-equity, every dollar of equity supports $2.50 of assets. A 10% asset value loss = $0.25 hit per dollar of equity = ~25% NAV decline. This is why BDC leverage matters so much. Pre-2008, several BDCs ran 1.5-2x and were wiped out when credit spreads widened. Always pair the headline leverage ratio with the asset coverage ratio (200% pre-2018, 150% post-SBCAA) — when asset coverage gets within 10-15 points of the regulatory floor, forced asset sales become a realistic risk in the next downturn.

Is boosting leverage strictly good for shareholders?

A BDC just increased regulatory leverage from 1.2x to 1.7x (debt/equity). Management says this boosts ROE. Honest assessment?
Check your understanding

Sit with the ideas.

A BDC operates at 1.5x debt-to-equity. The portfolio loses 10% of value. Roughly what happens to NAV per share?

Why:
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Other lessons in this course.

  1. 01What is a Business Development Company?
  2. 02Reading a BDC's Schedule of Investments
  3. 03NAV and Premium / Discount
  4. 04Yield Decomposition -- Is the Dividend Safe?
  5. 05Non-Accruals -- The #1 Credit Metric
  6. 06Leverage and Regulatory Limits— reading now
  7. 07Manager Quality and Alignment
  8. 08Building a BDC Watchlist
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