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BANGALORE (Reuters) – U.S. business development companies (BDCs) like American Capital Ltd (ACAS.O) and Allied Capital (ALD.N), which lend to small and mid-size businesses, may report yet another dismal quarter hurt by sinking deal volumes and higher credit losses.

Total middle-market deal volume was about $410 million in the quarter ended June 30, well below the $2.1 billion in the year-ago period and the near-term peak of $13.04 billion in the second quarter of 2007.

"Volume levels for middle market and larger transactions remained extremely low for the second quarter," Wells Fargo Securities analyst Jim Shanahan said in a research note.

BDCs like American Capital, Allied Capital, Ares Capital (ARCC.O), Apollo Investment (AINV.O), PennantPark Investment Corp (PNNT.O) and Fifth Street Finance Corp (FSC.N) make private-equity investments by lending to small companies and acquiring venture-capital stakes.

Deal volumes would have been extremely light in the second quarter as very few companies have capital to deploy, Stifel Nicolaus analyst Greg Mason said.

However, Wells Fargo’s Shanahan said, "It does appear that volume levels have found a floor near current levels, although we do not envision a drastic improvement until economic conditions improve."

Another cause of worry for the BDCs are soaring credit losses stemming from their investment portfolio.

"Credit is going to be the wildcard. That is the biggest data point we will look for direction from here on now," Keefe, Bruyette & Woods analyst Sanjay Sakhrani said.

"I think they (credit losses) are going to go up," analyst Mason said, adding, "The question will be by what magnitude or how quickly are the portfolios deteriorating from the income standpoint."

Covenant Woes

Some BDCs have also been battling with terms attached to their credit facilities and are in negotiations for waiver with their lenders.

"I think that American Capital and Allied in particular will be overshadowed by the debt agreements that they need to put in place with their lenders as that’s all what matters right now," Stifel’s Mason said.

Quarterly results will separate winners — which were more conservatively managed during the peak of the credit boom — distinctly from others, analysts said.

American Capital, which was removed from the Standard & Poor’s 500 index .SPX in February, has defaulted on $2.3 billion of unsecured credit arrangements as of March 31 and auditors included a going-concern opinion on its financial statements.

Washington-based Allied Capital, which in May posted its fifth quarterly loss in a row, is also battered by frozen credit markets and is also in default on debt.

Wells Fargo expects Allied Capital’s credit quality to deteriorate further as the company has little excess capital to support its portfolio companies.

Analyst Shanahan said he will be looking for any indication that American Capital can generate cash through the sale of portfolio companies.

The Silver Lining

An improvement in the value of fixed-income securities is a notable positive and suggests fears surrounding a complete collapse of the financial system have likely passed, analysts say.

Among all the bad news, the BDCs will have something to cheer about this quarter as rising fixed-income asset prices would push up their book values.

"I don’t think we will see a huge increase but we expect to see 3 to 5 percent increases in book values," analyst Mason said.

Allied and American Capital are finding it increasingly difficult to raise capital in the current environment, but the smaller ones are building up their capital levels.

The third quarter will be different for smaller rivals like Apollo, Ares, Fifth Street and Pennant as they will have sufficient capital to deploy, analyst Mason said.

Another smaller company, Prospect Capital Corp (PSEC.O), has adequate capital to invest and it may be in the bidding for various distressed assets, Wells Fargo’s Shanahan said.

BDCs that have some capital to invest can earn up to 16 percent interest in the current environment, offsetting the interest lost on bad loans, Stifel’s Mason said.

(Editing by Vinu Pilakkott)