Credit-rating agency Fitch laid out the succinct bear case for Apollo Investment (AINV -0.07%) and PennantPark Investment (PNNT 0.93%) in a recent note to investors.

"Leverage ratios for these two firms are the most affected from an oil and gas write-off scenario, with both experiencing an increase in leverage above 1.0," Fitch declared.

Fitch is alluding to a somewhat obscure law that requires business development companies to maintain no greater than a 1:1 debt-to-equity ratio, excluding a certain type of inexpensive, long-term debt financing from the government. Put simply, a BDC must generally have $2 in assets for $1 of debt.

When a BDC fails to keep to the 2:1 coverage requirement, nothing good comes of it. Here are a few options:

  1. Begin selling assets to pay down debt. The disadvantage is that every buyer knows you're a forced seller and will bid appropriately.
  2. Issue more stock, probably at prices below net asset value, diluting the wealth of existing shareholders.
  3. Issue new stock to your existing investors through a rights offering, which is expensive and time-consuming and requires your investors to put up more cash to buy more shares to avoid dilution.
  4. Cease to pay cash dividends, substituting stock for cash to tidy up the balance sheet. This nuclear option is one most BDCs will generally avoid at all costs.

Of these options, issuing more stock directly into the market is the most common choice. A number of BDCs made this very difficult choice during the financial crisis, Apollo Investment included. (It's interesting that we're talking about Apollo Investment and PennantPark today. PennantPark Investment was founded by an ex-Apollo Investment executive.)

Fun with numbers
Given the liberties of Level 3 accounting, failing the asset coverage requirement is almost done by choice. Write downs can be pushed off for months and years. Level 3 assets are inherently illiquid and difficult to value. 

Troubled assets can be held at unrealistic valuations, helping BDCs avoid problems with the asset coverage requirement, at least for a time. Eventually, though, all losses must be realized.

But let's not get too far off the path here. The point is that PennantPark and Apollo Investment, if their oil and gas investments are written off in total, would need to raise dilutive equity, or become forced sellers of assets.

Apollo and PennantPark currently trade at 36% and 46% discounts to their last-reported net asset values, respectively. Issuing new stock will be highly dilutive to earnings and book value on a per-share basis.

There's your bear case. After writedowns impair book value and earnings, a dose of dilution will further erode book value and earnings power.

Editor’s Note: A previous version of this article suggested Apollo Investment owns the quoted, unsecured Venoco bonds. Apollo Investment only holds first- and second-lien notes in Venoco, neither of which are quoted. The Motley Fool regrets this error.