S&P Revises Solar Capital Outlook to Negative

S&P’s Statement regarding Solar Capital:

Overview

Solar Capital Ltd. has agreed to restructure its largest investment holding, DS Waters of America Inc., and its obligor concentration remains high.   As a result, we revised our rating outlook on Solar to negative from stable.  – At the same time, we affirmed our ‘BBB-’ issuer credit rating on the company.  – The negative outlook reflects our view of the company’s poor portfolio diversification and the significant payment-in-kind income.

Rating Action

On April 13, 2012, Standard & Poor’s Ratings Services revised its rating outlook on Solar Capital Ltd. to negative from stable. At the same time, Standard & Poor’s affirmed its ‘BBB-’ issuer credit rating on Solar.

Rationale

The rating actions reflect our view of Solar’s restructuring of its largest investment holding, DS Waters of America Inc., which we believe increases the investment portfolio’s credit risk even though Solar’s financial results have remained stable.   In addition, Solar has a high obligor concentration, mostly resulting from its two largest holdings–DS Waters and Midcap Financial Intermediate Holdings LLC. When we rated the company in November 2011, we believed its portfolio diversification would improve as it reinvests proceeds from legacy investments into smaller, new vintage investments with higher quality earnings (see ”Research Update: S&PCORRECT: Solar Capital Ltd. Assigned ‘BBB-’ Rating; Outlook Stable,” published Nov. 18, 2011, on RatingsDirect on the Global Credit Portal).

In addition, Solar has a high obligor concentration, mostly resulting from its two largest holdings–DS Waters and Midcap Financial Intermediate Holdings LLC. When we rated the company in November 2011, we believed its portfolio diversification would improve as it reinvests proceeds from legacy investments into smaller, new vintage investments with higher quality earnings (see “Research Update: S&PCORRECT: Solar Capital Ltd. Assigned ‘BBB-’ Rating; Outlook Stable,” published Nov. 18, 2011, on RatingsDirect on the Global Credit Portal).

Since the 2008 financial crisis, more than 70% of Solar’s investments were repaid (as of year-end 2011). However, the DS Waters restructuring has slowed down the transition, in our opinion. The restructuring did not result in DS Waters repaying the existing loan from Solar. Further, DS Waters remains Solar’s largest obligor concentration, at 10.2% of the investment portfolio, and it generates payment-in-kind (PIK) income, which further increases Solar’s exposure to the company. Given the absence of a maturity date for the investment now that it’s no longer a debt instrument, DS Waters could remain a large concentration in Solar’s portfolio.

As of result, we believe Solar’s credit risk has increased partly because its investment portfolio isn’t as diversified as we’d expected. Nevertheless, we believe Solar could quickly reduce its exposure to its largest obligors. In addition, we expect Solar to grow this year by issuing debt and additional equity. The increased portfolio size would reduce the concentration of Solar’s existing investments.

As part of the DS Waters restructuring, Solar has agreed to convert its current debt exposure into a preferred stock investment. The financial impact of this is limited, in our view. Solar’s position in DS Waters’ capital structure remains the same, attaching at 3.14x leverage and detaching at 6.04x leverage. (Attaching and detaching refer to the multiple of operating cash flow that would repay the first dollar of Solar’s lending exposure to the last dollar, based on the size of the loan). In fact, Solar’s position may have improved somewhat because, together with its co-lenders, it will take control of DS Waters’ board of directors.

Of Solar’s 39 portfolio investments, some generate PIK income, which is noncash income. We consider this a negative rating factor because we view PIK income as lower quality income.

Solar’s other financial metrics remain quite strong. Leverage is very low at 0.29x. And in a stressed scenario where we assume the three largest obligors default with no recovery, leverage remained below 0.6x (a benchmark we often consider for our ratings on business development companies), at 0.42x. Earnings also remained strong under those stress scenarios, and EBIT, excluding market sensitive income and PIK accruals when measured against interest expense, remained a healthy 3.5x. The rating on Solar reflects current leverage and interest coverage.

Outlook

The negative outlook reflects our view of the company’s poor portfolio diversification and significant PIK income. The company’s strong capital, high interest coverage, and low leverage offset those weaknesses and support the rating. If Solar reduces and consistently maintains its obligor concentration at levels below 5%, with peak concentrations of 7%, we could revise the outlook to stable. However, if leverage increases beyond 0.6x, we could lower the rating. We don’t expect to raise the rating during the next 12-18 months.

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