The economy looks like it is firing on all cylinders - well, a few of them at least. More and more talking Fed heads are talking about the need to remove stimulus by ending QE3, even if expectations of actual rate hikes are still being delayed. While you may not want to bet the farm on an economic recovery gathering steam - we still have to get past the early-2014 implementation of Obamacare - what sectors of the economy and stock market excel if the economy is healing and domestic and global headline risks are fading (Cyprus aside) ?
The Business Development Companies (BDCs) are registered investment companies that pay out 90% or more of their income to investors, much like REITs. They tend to be small-cap in size and their investments are generally to smaller and mid-sized firms that are under the radar screen of Wall Street and most banks. Because most of the investments will re-price more than the liabilities, they tend to do well in a rising rate environment. Such rate hikes would also likely indicate a stronger economy, a boom for smaller, riskier companies that BDCs work with.
This chart from Raymond James shows that the distribution of returns following a 25 bp. Fed rate hike - usually indicative of more tightening later - is skewed strongly positive:
I gave more details on the BDC model last year for those of you who need to get up-to-speed on the BDC basics. Today I'd like to look at 5 BDCs, revisiting 3 of my favorites with 2 new additions. Together this basket of conservative BDCs yields 9.7%. It would be easy to boost the yield by seeking out higher-yielding BDCs but I am emphatic that stretching for yield is how most investors make their biggest mistakes, particularly in an aggressive sector like the BDCs.
One of my concerns is credit quality and the analysts at Keefe, Bruyette & Woods have a unique method of analyzing credit risk. It's very simple: higher yield = higher risk. They break down the investment portfolios for BDCs by analyzing how much of the portfolio is comprised of various yielding buckets:
Another component of credit risk is the relative price paid for the underlying investments. If BDCs pay-up for riskier loans and competition forces looser credit standards, Payment-In-Kind (PIK) interest, and lower overall yields, then when the economy turns down your portfolio is at greater risk. Investments made late in an economic recovery tend to be at greater risk than those made in the depths of a recession or early in a recovery. The BDCs, which made large amounts of debt and equity investments in 2006 and 2007 were the ones most hurt in the subsequent sell-off. This chart shows in what year and what amount of the total portfolio BDC investments were made:
Finally, the entire BDC sector is better prepared for any downturn in that they have generally gravitated towards higher-quality investments: more debt, less equity; more senior loans, less mezzanine/subordinated debt. Additionally, the liability side of the balance sheet is less exposed to short-term fluctuations with longer-term debt issuances ('baby bonds'), SBIC loans from the Small Business Administration, and more equity. It does not mean the stocks won't get hit in any economic or credit slump. It does mean the depths of the declines seen in 2008-09 should not be seen during the next downturn.
Let's see where some quality, conservative BDCs, which collectively yield almost 10% can be found:
Fifth Street Finance (FSC): This monthly payer has been plagued by its own aversion to taking leverage anywhere close to the BDC maximum in the last few quarters. As a result, the dividend has not been fully earned. The dividend should be safe since FSC should be able to take up leverage, harvest gains, and/or accelerate fee income.
Like many BDCs, FSC saw a lot of early-2013 activity pulled forward into Q4 2012 because of concerns regarding the Fiscal Cliff. Originations were slow through mid-Q1 2013, but have picked up in March and appear to be stabilizing. Fee income should strengthen in future quarters from FSC's ability to syndicate deals. Future platforms for lending and syndication may include asset-based lending, energy projects, aircraft leasing, senior loans, and even an equity REIT.
Fifth Street recently issued $75 million in 'BDC Baby Bonds' at a yield of just over 6%. While more expensive than traditional short-term financing, these funds are locked-in until 2028. If rates rise (FSC has a call option exercisable in 2018) or the economy retrenches, permanent funding of this kind is invaluable and was sorely missed in 2008-09.
Here's what FSC's asset and liability structure looked like at year-end:
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More details can be seen here:
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In Q4 2012, FSC saw book value decline slightly but earnings narrowly beat consensus on a recurring combo for the BDCs in the fourth quarter: strong originations and higher fee-income, resulting from seasonal and Fiscal Cliff factors. One small new non-accrual ($6 million or 0.4% of the debt portfolio at cost) bears watching but should not be a trend.
FSC shares are currently trading at a 10.8% earnings yield on calendar 2014 estimates of $1.15, a discount to the peer average of 10.0%. While the stock is cheap relative to peers the Street wants to see leverage and EPS increase before valuations move to the peer group. FSC is currently trading with a dividend yield of 10.5% (a higher yield than the BDC group average of 9.2%) and trades at 106% of NAV.
Hercules Technology Growth Capital (HTGC): Hercules Technology Growth Capital is based in Palo Alto, Ca., which is appropriate for a BDC that specializes in equity and debt financing to early-stage technology and life sciences companies. HTGC works with leading venture capital and private equity firms. It also invests in some publicly traded companies for added portfolio liquidity.
The shares are pricey by BDC standards at 125% of NAV, but that is a reflection of the niche sector that HTGC focuses on. HTGC is yielding 8.2% on its $0.25 quarterly dividend, which was bumped 1 penny in Q1 2013. The dividend has recovered from the shellacking during the Credit Crisis and has been increased five times to the current rate. More importantly, the company is expected to fully earn the 2013 dividend and earnings for 2013 and 2014 are forecasted to grow close to 10% in each year, meaning the dividend will be fully-covered with room to boost. Getting back to the pre-Credit Crisis level of $1.20 annually will be a stretch before 2014 but dividend increases are likely.
HTGC offsets the inherent increased risk of a concentrated portfolio of technology companies by minimizing PIK income, amortizing debt investments, and aiming for shorter-term investments. HTGC faces less competition in this niche area because of the specialized lending needs of technology and life science startups. HTGC's shareholder base includes a very high level of institutional ownership in a sector known more for retail investors, an added vote of confidence in both management and the type of investments HTGC is making.
Earnings in Q4 2012 were above consensus from higher fee income. Credit quality remained strong and actually improved as no non-accruals materialized but positive reversals/upgrades took place. Book value increased to $9.75 from $9.42 due to portfolio appreciation from the credit improvement and a small accretive secondary offering.
HTGC's upside-biased investment portfolio and long-duration liability structure are allowing it to generate ROEs in the 10% range. HTGC management has said it wants to run with net leverage (Total Debt - Cash / Equity) in the 1.25x range but figure it will run closer to 0.75-0.85x. Regulatory leverage (SBIC funding does not count in this calculation) is even lower, a drag on maximum earnings potential but a safeguard against a repeat of 2008-09.
HTGC has a number of earnings drivers that should materialize over the 2013-14 time horizon. First, the company is utilizing its balance sheet effectively by increasing leverage in recent quarters. Regulatory debt/equity (excluding SBIC debt) was 46% in Q3 2012 but has since been increased to 74%. Second, the internal management structure of HTGC means that fixed overhead declines as income and the investment portfolio are ramped up, the opposite of what happened during the Credit Crisis of 2008-09 as the fixed costs were spread over a smaller asset base. Third, besides the SBIC funding (which could increase from $225 million to $350 million, pending Congressional legislation) the company has plenty of firepower following an equity offering last month and sales of debt securities and available credit lines. Fourth, the company has a well-diversified liability structure including 'BDC Baby Bonds,' lines of credit, convertible debt, and twin SBIC loans. The average weighted cost of the debt is just under 5% with an average maturity just over five years.
An added kicker for HTGC is the warrants it receives as an 'equity kicker' from many of its debt deals. While most expire worthless, 1 or 2 can be home runs (even grand slams), which can greatly boost portfolio NAV and earnings. Because of their speculative nature, they are not included in analyst or company earnings guidance, so any such gains are the quintessential upside surprise.
TICC Capital Corp (TICC): TICC Capital Corp. (formerly Technology Investment Capital Corporation) is a BDC concentrating in senior-secured loans, mezzanine loans, and equity securities. TICC's strategy and portfolio is different than other BDCs and can be likened to a 'barbell' strategy. TICC combines senior, more liquid loans (safer but lower yielding) and CLO debt and equity (riskier but higher yielding). Most of the underlying loans within the CLO debt and equity are similar to the individually-owned loans that TICC makes in the middle market. However, within the CLO structure they are effectively leveraging up the asset class.
This strategy is not unlike a Mortgage REIT leveraging up very liquid, very safe mortgage assets (but the CLO structure utilizes much less leverage). So TICC probably has lower credit risk at the asset level in the event of a credit or economic slump. However, publicly traded CLOs have more volatility than a traditional middle-market senior loan because of their public pricing and higher leverage.
It's not what TICC owns, but when it acquired it that bears watching. With numerous capital raising activities since mid-2012, TICC has originated over 50% of its investment portfolio in the last two quarters. While not at 2006-07 cut-throat competitive levels, prices for credit and covenant protection have been weakening for over a year. TICC recently raised more capital via an equity offering, which means more of the portfolio will be skewed to the recent heightened pricing levels where competition for new loans has increased, leveraged EBITDA multiples are higher, spreads are compressed, and loan covenants looser.
Q1 2013 earnings were lower than expected due to the weighted average yield of debt investments falling by approximately 1% in the quarter (that heightened yield compression again). Originations of $247 million were in line with consensus and credit quality improved slightly as no new loans were placed on non-accrual. TICC continued its rapid deployment of capital from late 2012 and early 2013 debt and equity raises. Drag from deploying the capital - even TICC can't spend funds instantaneously - will lead to pressure on 2013 and 2014 earnings, but no shortfall that should jeopardize the dividend per se. Book value increased to $9.90 from $9.85. So TICC can be purchased at a slight discount to NAV and the dividend yield is 11.8%.
TICC continues to benefit as BB-rated debt continues to perform very well in recent quarters. The weighted average yield on the company's debt investments decreased to 9.4% from 10.3% the prior quarter, likely on account of a shifting asset mix through new originations and asset sales. The percentage of senior secured notes increased to 74% of the portfolio from about 66% the prior quarter, while CLO debt investments came down by roughly half to about 8% of the portfolio. Leverage at the end of the quarter was 0.81x Debt/Equity.
At the end of the year, about 61% of the company's CLO portfolio was still invested in vintages originated from 2005-08, with the remainder of the CLO portfolio invested in 2010-13 tranches. Management indicated that it intends to place more emphasis on equity tranches for CLO assets originated from 2010-2013 going forward. Liquidity remains strong, with a secondary offering a few weeks ago providing added firepower to earlier equity raises and the CLO debt sale (and taking the risk of an equity offering decline off the table for the near future). Leverage should go up, giving a boost to earnings.
PennantPark Investment Corp. (PNNT): PNNT is a conservatively managed BDC with a six-year history of consistent dividends. The company has a super-strong credit history with six non-accruals out of over 225 investments during its lifetime. Even during 2008-09, PNNT managed to maintain its dividend -- in fact, it increased ! PNNT trades at about 106% of NAV and yields 10.0% with a $0.28 quarterly dividend.
Q4 2012 results were in line with no surprises. NAV rose 1.5% to $10.38 and net interest income of $0.28 was slightly above consensus. Origination and repayment volumes were more robust because of the acceleration of early-2013 originations and fee income into 2012. PNNT put $168.4 million to work at an average debt yield of 12.7%. Liquidity for future investments is plentiful: at year-end, the company had $31 million of unrestricted cash, $190 million of available borrowing capacity in its credit facility and SBIC funding (the company recently received a second SBIC license). In January the company issued $67.5 million of 6.25% 12-year debt.
Portfolio composition remained fairly constant from the previous quarter with 29% senior secured loans, 20% second-lien secured debt, 39% subordinated debt, and 12% equity. PNNT has several sizable publicly traded and liquid equity positions that have become meaningful in size. If sold, they could be redeployed into new investments for a nice boost to earnings. Realogy and Magnum Hunter are among the publicly traded holdings. One sell-side analyst estimates an additional $0.10 annual EPS boost if the proceeds from the larger holdings are sold and put into debt investments.
NIM continues to compress because of higher funding costs (good because the BDCs are insulated from rising rates and margin calls) and lower asset yields (bad as it indicates heightened competition in the middle market where BDCs operate):
The dividend is well-protected; PNNT learned the lessons of the 2008-09 Credit Crisis well. PNNT's defensively-oriented portfolio has 2.9x interest coverage and 4.5x debt to EBITDA, which gives PNNT a rare BDC debt rating of investment grade (BBB-). The current $0.28 dividend payout has $0.04 of support via undistributed taxable net income. With only 12% of investments in equities, excellent interest coverage, moderate debt/EBITDA, and having come through 2008-09 unscathed, PNNT is one of the 'rocks' in the BDC world and a core holding in any BDC basket for investors.
Golub Capital Corporation (GBDC): One of the most conservative BDCs alongside PNNT, Golub had an outstanding Q4 2012. EPS came in at $0.34 which beat the high-end and analyst consensus. NAV ticked up slightly to $14.66. Most notably, yields on new investments ticked up to 8.3% from 8.0% in Q3 2012 despite the heightened competition in the middle market. Credit quality remained stellar: no new non-accruals. With an equity offering in January and two SBIC funding arms, GBDC has plenty of liquidity for future investments.
Those investments in Q4 helped bring up the total portfolio yield to 9.7%:
GBDC should be earning close to $1.30 - $1.35 for 2013 and 2014, meaning the dividend at current levels should be safe. GBDC runs the portfolio full-out compared to others in terms of maximizing leverage: Q3 2012 total Debt/Equity was 0.94x (regulatory leverage at 0.61x) and at Q4 2012 total Debt/Equity was 0.95x (regulatory at 0.63x). Despite the higher leverage compared with peers, Golub's overall investment portfolio is ultra-conservative, as evidenced by the 8.7% weighted average yield (see chart near top of page), second lowest only to a floating rate-focused BDC.
GBDC yields 7.8% and trades at 112% of Q4 2012 NAV. You are sacrificing yield and paying a premium for book, but you have a conservative BDC that will let you sleep at night.
GBDC, like all the BDCs mentioned here, would get a big boost if the SBIC expansion program were to pass Congress. The bill would expand the SBIC program to allow $350 million of SBIC debentures to be drawn, up from the current $225 million. Not only is this a longer-term source of cheap funding but it does not count in the regulatory leverage calculation as we indicated above for several of the companies. Another bill to allow maximum leverage on a Debt/Equity basis to go from 1x to 2x would also be a game-changer for BDC upside - as well as downside. And a recent article mentioned that in order to evade the limitations on Dodd-Frank, Goldman Sachs was forming a BDC to invest in unrated corporate debt, potentially more competition in the sector. More on those in a future article.
As always with any yield sector, I recommend utilizing a 'basket approach' to the stocks and buying several of them. These five BDCs are among the more conservative in their approaches to leverage, debt vs. equity investments, diversified funding sources, portfolio investment sectors targeted, etc. While they will not be immune to any stock market decline - particularly one accompanied by any financial/credit/global problems like in 2011 - the massive downside seen in 2008-09 should be off the table.
The ultra-cyclical nature of the BDC sector and their mandate to pay out 90% of all earnings remain long-term structural impediments to increased institutional ownership. But in a world of 0.01% money market funds and 2% five-year CDs, there are worse things than buying a diversified basket of BDCs yielding close to 10%.
Additional disclosure: Online portfolios managed and advised by the author have a position in the listed stocks.