OREANDA-NEWS. Fitch Ratings has affirmed the long-term Issuer Default Rating (IDR), secured debt rating, and unsecured debt rating of Solar Capital Ltd. (Solar) at 'BBB-'. The Rating Outlook has been revised to Stable from Negative. Today's rating actions have been taken as part of Fitch's periodic peer review of Business Development Companies (BDCs), which comprises 10 publicly rated firms.

BDC INDUSTRY OUTLOOK
Fitch's outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.

BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at an 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.

The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms' underwriting.

Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of approximately 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy if and when underwriting conditions improve, thus weakening earnings upside.

KEY RATING DRIVERS
IDRs AND SENIOR DEBT

The rating affirmation reflects Solar's low balance sheet leverage, sound liquidity, minimal portfolio energy exposure, low non-cash income, prudent dividend management and a demonstrated willingness to moderate portfolio growth and move up the investment capital structure in a highly competitive underwriting environment. Solar's measured growth and low leverage relative to its long-term operating target have also left it well-positioned to capitalize on investment opportunities at a time when many of its BDC peers are more capital constrained, which Fitch views as a strength.

Rating constraints for the BDC sector include the capital markets impact on leverage, given the need to fair value the portfolio each quarter, dependence on the capital markets to fund portfolio growth, and a limited ability to retain capital due to dividend distribution requirements. Rating constraints for Solar, more specifically, include weaker-than-peer asset quality performance since inception, although this has improved more recently, and higher relative exposure to non-qualifying assets, which were 21.7% of the portfolio at Sept. 30, 2015.

The Outlook revision to Stable from Negative reflects a reduction in the firm's expected investment in its off-balance sheet Senior Secured Unitranche Loan Program (SSLP), combined with the firm's low leverage and strong dividend coverage. In Fitch's opinion, the latter two elements provide Solar with additional financial flexibility to weather the current challenging operating environment for BDCs, while also potentially capitalizing on investment opportunities.

The measured growth of the SSLP reduces the impact on the firm's effective leverage and is expected to keep the firm's non-qualifying assets below the 30% regulatory limit, which Fitch views favorably. The SSLP recorded its first investments in the quarter ended Dec. 30, 2015; more than one-year after Solar announced the formation of the program. Fitch expects the ramp of this portfolio will improve the firm's earnings prospects over the medium-term and leverage is likely to move closer to the targeted range as commitments to the program are funded.

The SSLP was initially set up as a joint venture with an affiliate of Pacific Investment Management Company, LLC (PIMCO), whereby each party committed $300 million to the unitranche strategy. However, in October 2015, the structure of the SSLP changed when Voya Investment Management LLC (Voya) committed $25 million to the program and PIMCO's SSLP commitment of $43.25 million was moved over into its co-investment separate account which now totals $300 million of equity. Solar then reduced its SSLP commitment to $175 million, which will provide for about $500 million of total purchasing power assuming the SSLP is levered 1.5x. Additional investment capital will be provided by PIMCO's separate account. Voya may also allocate additional capital of its insurance company affiliates and third party clients for co-investment opportunities.

Fitch views the addition of Voya to the SSLP favorably, as Voya has successfully partnered with Solar's affiliate, Solar Senior Capital Ltd. (SUNS), in the formation of its First Lien Loan Program (FLLP), since September 2014. At Dec. 31, 2015, the FLLP had a $74.4 million investment portfolio, across 15 issuers. Fitch believes growth of the SSLP will improve Solar's earnings and dividend coverage, should a fully ramped portfolio provide mid-teen returns, as expected. Still, Fitch believes it will take some time to observe the performance of the program from a credit and return perspective. At year-end 2015, Solar had funded $80.7 million of its commitment to the SSLP, which had $91.8 million of investments across four borrowers and had no leverage.

The reduction of Solar's initial commitment to the SSLP, from $300 million to $175 million, is also viewed favorably by Fitch, as the original commitment would have pushed the firm's non-qualifying assets beyond the 30% limit, which may have garnered additional SEC scrutiny.

Solar's equity investment in Crystal Financial LLC (Crystal) accounts for the majority of its non-qualifying assets, having a cost basis of $275 million and a fair value of $290 million at year-end 2015. Crystal is a first lien, asset-based lender, with $465.1 million of loans to 26 borrowers, and leverage of approximately 0.92x at Dec. 31, 2015, or 0.84x net of cash. The Crystal investment provided Solar with a yield of about 11.5% for the year, which was recorded in dividend income. While Fitch believes the equity investment could yield modestly more valuation volatility over time, the agency does consider the first lien nature of the underlying portfolio, in addition to its diversity, and Crystal's strong track record.

Fitch looks at Solar's leverage in a variety of ways. Balance sheet leverage, as measured by debt to equity, was 0.49x at Dec. 31, 2015, which is below the peer average and compares to a firm target of 0.65x-0.75x. If the firm's investment in Crystal were consolidated onto the balance sheet, total leverage would be approximately 0.59x, which is still below the firm's long-term target, and below the peer average. Solar has been under-levered for several years given elevated repayment activity and slower-than-peer growth. Still, balance sheet leverage is expected to increase, as Solar capitalizes on improving market spreads and credit terms and continues to fund its commitment to the SSLP. Once leverage is added to the off-balance sheet program, Fitch will also consider what impact that has on Solar's overall risk profile.

On a reported basis, Solar had above-average exposure to equity at Dec. 31, 2015, given its investments in Crystal and the SSLP, but Fitch looks through to the underlying portfolios to assess overall credit risk. Assuming the Crystal and SSLP portfolios were consolidated onto the balance sheet, Solar's portfolio would have above-average diversity and would be largely senior secured exposure.

Fitch believes Solar's longer-term credit investment track record is weaker-than-peer, given significant losses realized coming out of the financial crisis. However, the portfolio risk profile has changed considerably since then, as management rotated out of unsecured debt and paid-in-kind investments, into a cash-paying senior secured portfolio. Non-accrual investments represented 0.14% of the debt portfolio, at value, at Dec. 31, 2015, which was below the peer average, and direct exposure to energy was zero.

Solar's earnings have declined in recent years as the portfolio contracted and repayment proceeds were deployed into lower-yielding, more senior investments. Management prudently right-sized the dividend in 2013, given an expected decline in earnings, but pressure on the lower dividend has mounted in recent years as market spreads have tightened and portfolio growth has been below-average. However, starting in the third quarter of 2015 (3Q15), management voluntarily waived a portion of its fees to ensure net investment income (NII) fully covered the dividend. Additional fees were waived in the December 2015 quarter and management committed to waiving fees, as necessary, for 2016 to ensure NII coverage of the dividend, which Fitch views favorably. That said; Fitch believes earnings are poised to increase, as the SSLP has begun to invest and the firm has dry powder to put to work at a time when market spreads are widening.

Solar's liquidity remains sound with $282.1 million of borrowing capacity on its corporate revolver, at Dec. 31, 2015, and no 2016 debt maturities. The corporate revolver begins its one-year amortization period in June 2017, but Fitch believes the firm will look to extend the facility over the next year. Solar also has $75 million of secured term debt maturing in May 2017, which could be refinanced with revolver borrowings or an opportunistic term debt issuance. Unsecured debt represented 23.1% of debt outstanding at Dec. 31, 2015. Fitch would view an increase in unsecured debt favorably.

RATING SENSITIVITIES
IDRs AND SENIOR DEBT

Negative rating momentum for Solar could develop from a material alteration of the portfolio risk profile, asset quality deterioration, declines in operating performance and dividend coverage, a reduction in funding flexibility, impairment of the liquidity profile and/or an increase in firm leverage above the targeted range, with consideration given to Crystal and SSLP leverage.

Upward rating momentum is viewed as limited over the outlook horizon given challenging sector fundamentals, but could develop over the long term with strong credit performance on recent vintages, improved earnings consistency, enhanced funding flexibility, strong dividend coverage, and proven performance of the SSLP.

Headquartered in New York, NY, Solar is an externally managed BDC, founded in November 2007 and completed an initial public offering in February 2010. As of Dec. 31, 2015, the company had investments in 54 portfolio companies amounting to approximately $1.3 billion.

Fitch has affirmed the following ratings:

Solar Capital Ltd.
--Long-term IDR at 'BBB-';
--Senior secured debt at 'BBB-';
--Senior unsecured debt at 'BBB-'.

The Rating Outlook has been revised to Stable from Negative.