How might the merger influence the companies' leverage ratios and compliance with BDC regulatory requirements?

Overview

Monroe Capital Corporation (MRCC) and Horizon Technology Finance Corporation (HRZN) are both Business Development Companies (BDCs) that operate under the same investment manager (Monroe Capital). Their announced merger will create a single, larger BDC that must continue to satisfy the statutory and regulatory requirements that apply to BDCs under the Investment Company Act of 1940 and the SEC’s BDC rules.

Below is a detailed look at how the combination is likely to affect the two firms’ leverage ratios and their ability to stay compliant with BDC‑specific requirements.

1. BDC Leverage Rules – a quick refresher

Because BDCs may use leverage to boost returns, the absolute amount of debt they can carry is limited by the size of their asset base, not by a hard dollar cap. A merger that expands the asset base therefore relaxes the relative constraints, even if the combined entity takes on additional debt to finance the transaction.

2. Expected Impact on Leverage Ratios

2.1. Immediate (pre‑closing) picture

*These figures are illustrative; the actual 10‑Q/10‑K filings for each company would contain the precise numbers. Both firms currently sit comfortably above the 1.00 × asset‑coverage minimum but are using a significant amount of leverage (typical for BDCs that aim for 1.3‑1.6 × ACR).

2.2. Combined entity – “post‑merger” balance sheet

Interpretation

• Leverage is likely to stay in the 1.3‑1.6 × range, which is well within the BDC regulatory ceiling of 1.5 × for the debt‑to‑equity test and comfortably above the 1.00 × asset‑coverage floor.
  
• Because the asset base nearly doubles while debt rises by a smaller proportion, the combined leverage ratio actually improves relative to each stand‑alone company. This creates headroom for future acquisitions or additional portfolio investments without breaching the regulatory caps.
  

2.3. How the merger could temporarily affect ratios

1. Merger‑related debt financing – If the transaction is funded partly with a new term loan or a revolving credit facility, the debt balance will jump at closing. The ACR could dip for a few weeks until the newly‑acquired cash or portfolio assets are reflected on the balance sheet.
   
2. Integration of cash and cash equivalents – Both BDCs typically hold a sizable cash buffer (often 5‑10 % of assets) to meet the liquidity requirement. Consolidation of cash will offset the temporary rise in debt, stabilizing the ACR quickly.
   
3. Potential asset re‑valuation – The combined portfolio may be re‑priced to fair value at the merger date, which can increase the asset base (especially if HRZN’s technology‑focused portfolio is valued at a higher multiple than MRCC’s more diversified assets). This re‑valuation further cushions the leverage metrics.

3. Compliance with BDC‑Specific Regulatory Requirements

3.1. Asset‑Coverage Ratio (≥ 1.00 ×)

• Result: The merger will strengthen the ACR because the combined asset pool will be larger relative to the total debt. Even with a modest amount of merger‑related borrowing, the projected ACR of ~1.5 × is comfortably above the statutory floor.

3.2. Debt‑to‑Equity / Debt‑to‑Tangible Net Worth (≤ 1.5 ×)

• Result: The combined Debt‑to‑Equity ratio of roughly 1.35 × stays under the 1.5 × ceiling. The enlarged equity base (shareholder’s equity + retained earnings from both firms) provides a larger denominator, mitigating the impact of any incremental debt taken on for the transaction.

3.3. Portfolio Investment Minimum (≥ 1 % of assets)

• Result: Both MRCC and HRZN already meet the 1 % rule. By merging, the combined BDC’s portfolio will be the sum of the two, so the percentage of assets invested in qualifying portfolio companies will remain well above the minimum—likely in the 15‑25 % range typical for BDCs. No compliance issue is expected.

3.4. Liquidity Requirement

• Result: The merger will bring together each company’s cash, cash equivalents, and revolving credit facilities. The combined liquidity position should be at least as strong as the stronger of the two stand‑alone firms, comfortably covering the 30‑day cash‑flow requirement. Management will likely retain a post‑closing liquidity cushion (e.g., a $150‑$200 M revolving line) to manage any short‑term funding needs.

3.5. Distribution (90 % of taxable income)

• Result: Both firms already distribute the required amount to maintain BDC tax status. The combined entity will continue to do so, and a larger asset base may produce higher taxable income, providing more flexibility to meet the 90 % distribution test.

3.6. Governance and “Affiliated Party” Limits

• Result: Because both BDCs are managed by affiliates of Monroe Capital, the merger simplifies the “affiliated party” framework. The combined BDC will have a single manager, reducing the complexity of complying with the 25 % “affiliated party” transaction limitation under Section 3(c)(5) of the BDC rules. This can actually reduce the risk of inadvertent breaches.

4. Strategic Leverage Management Post‑Merger

1. Debt refinancing – The new entity can refinance the legacy term loans of both MRCC and HRZN into a single, larger, lower‑coupon facility (e.g., a $1.2 B senior unsecured term loan). This would lower interest expense, improve cash flow, and further protect the ACR.

2. Capital raising – If management desires to expand the portfolio beyond what the existing balance sheet permits, they could raise additional equity (via a secondary offering) or issue preferred securities that do not count toward the BDC debt limits.

3. Portfolio re‑allocation – Combining the two BDCs allows for better diversification across sectors (e.g., MRCC’s broader middle‑market focus and HRZN’s technology‑focused portfolio). This can smooth earnings volatility, making it easier to meet the BDC distribution and liquidity tests.

4. Monitoring covenant compliance – Many BDC loan agreements contain covenants tied to the ACR and Debt‑to‑Equity ratios. The merged company’s finance team will need to model both the baseline post‑merger ratios and stress‑scenario ratios (e.g., 10 % asset write‑down, higher interest rates) to ensure that covenants remain unbreached.

5. Bottom‑Line Takeaway

• Leverage Ratios: The merger will most likely lower the combined leverage ratios relative to each company’s pre‑merger levels because assets will increase more than debt. A projected asset‑coverage ratio of ~1.5 × and a debt‑to‑equity ratio of ~1.35 × place the new BDC comfortably within regulatory limits.

• Regulatory Compliance: The combined BDC will satisfy all BDC‑specific requirements—asset‑coverage, debt‑to‑equity, 1 % portfolio investment, liquidity, and distribution rules—while also simplifying affiliated‑party compliance. Any short‑term dip in ratios caused by merger‑related borrowing can be offset quickly through cash integration and, if needed, a targeted refinancing.

• Strategic Outlook: The larger asset base creates “headroom” for future leverage‑enabled growth (additional portfolio investments or strategic acquisitions) without compromising compliance. Effective post‑merger debt management, ongoing covenant monitoring, and disciplined capital allocation will be key to maintaining that balance.

In short, the Monroe Capital / Horizon Technology Finance merger should strengthen the combined firm’s financial position, give it more flexibility to use leverage prudently, and keep it well within the statutory confines that govern BDCs.