2 BDCs On Sale: Horizon Technology And Gladstone Investment Are Well Below Book Value

Includes: GAIN, HRZN
by: Philip Mause

Gladstone Investment (NASDAQ:GAIN), which closed Tuesday at $7.01, and Horizon Technology Finance (NASDAQ:HRZN), which closed Tuesday at $14.34, are two Business Development Companies (BDCS) trading well below book value with generous dividends and bright prospects for shareholders.

Before I address each of these companies, I should explain why I consider discount to book value or net asset value (NAV) as an important investment criterion for BDCs. If we were to do a pro forma of a typical debt instrument oriented BDC, we might see a balance sheet with $300 million in debt instruments yielding 10% as assets, and $100 million in borrowings at 5% with a net interest income of $25 million and $5 million in expenses producing net income of $20 million. If such a BDC pays out 90% of its income in dividends, it will pay $18 million in dividends and retain $2 million for growth. Assuming the BDC has 20 million shares and the shares trade at book value, the shares would trade at $10 and pay a 90 cent a share dividend. The problem with this picture is that it is very hard for either the NAV or the share price to increase using this model. Debt instruments mature and the proceeds are reinvested in other debt instruments. Depending upon interest rates, earnings may increase or decrease but NAV is unlikely to appreciate substantially.

If this were the end of the story, there might be no problem. An investor could simply collect his 9% and consider the investment to be a stabilizing element in an income-oriented portfolio. The problem is that, while there is very little upside, there is always a degree of downside. NAV and earnings (and possibly dividends) can be very negatively affected by defaults on the loan instruments or even the perception that defaults may occur leading to unrealized depreciation in the value of the instruments. An investor is, thus, faced with a kind of asymmetric risk.

On the other hand, if the stock can be bought for $8 a share, the opportunities for appreciation are manifest. First of all, the stock is more likely to be able to use its asset base to support a generous dividend yield on an $8 share price. If there are underperforming assets in the portfolio, there is the possibility that they can be liquidated and the cash redeployed at a higher yield producing more income and higher dividends. If the discount is deep enough, there may be potential for a takeover. In short, there are a variety of ways that the stock can go up 25% to equal NAV.

Of course, the situation is never that simple. BDCs do not conform to the pro forma - most have some equity holdings, some have SBICs or CLOs. The BDC trading at a discount has probably had some problematic assets and this may suggest management deficiencies or a failed strategy. Recent write-offs may be a good predictor of more write-offs and the NAV may be heading down further. All of these are legitimate concerns. I am not suggesting that discount to NAV is the ONLY criterion for investing in BDCs; I am only suggesting that it is an important marker to help identify potential investments for further investigation.

The Table below provides the recent price, the NAV for each company as of the most recent quarterly financial report, the percentage discount to NAV, the dividend yield and a recent low price the stock has traded at:

GAIN $7.01 $8.93 22% 8.5% $6.74
HRZN $14.34 $16.41 13% 9.8% $13.46

GAIN provides funding for buy out transactions and participates with management as an equity holder. Its portfolio consists of over 70% of debt instruments, some 24% preferred equity and a small proportion of common equity. It has had some unrealized depreciation of assets - most notably in the wake of the crash but also in recent quarters. It is not heavily leverage, although it borrows a significant amount at the end of each quarter to pile up cash on the asset side and reduce the percentage of gross assets devoted to certain large positions in conformity with BDC regulations. An investor should review the financial report to get a sense of the asset base, but it appears that the downside protection associated with the discount should protect an investor who is patient. The equity positions, of course, have upside as well as downside and a number of GAIN's investments have worked out very well.

HRZN follows a different strategy. It provides secured loans to development stage companies backed by Venture Capital Investors or Private Equity Firms. Its asset base is made up of over 96% debt instruments and only 3.8% warrants and common equity. It is a relative newbie on the BDC scene and so its investments are of post-Crash vintage. It often invests with leading Venture Capital firms. By getting warrants in exchange for providing financing, HRZN has the possibility of seeing its NAV increase as the warrants appreciate in value. It traded over $16 for quite a while and it is not exactly clear why it dropped to the $14 range but it has been moving back up recently. Dividends were recently cut from a higher level but at this price level HRZN certainly pays a nice yield. HRZN probably involves less risk than GAIN and is logically trading at a much smaller discount to NAV.

BDC investors should have a list of stocks they are interested in and watch for dips. It would have been great to get HRZN below $14 and a few weeks ago you could have. These stocks are often lightly traded and can jump around. Small investors can get in there on the dips and not move the stock much with their action. I would still be a buyer of GAIN and HRZN at current prices.

Disclosure: I am long GAIN, HRZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.