This is Part 3 of a short series of articles that will compare the risk profiles for the 25 business development companies ("BDCs") recently covered in my "The Good, The Bad, And The Maybe" series. This article focuses on the use of debt for portfolio growth and the impacts to risk and earnings.
Previous Risk Profile Articles:
When evaluating BDCs I focus on five general criteria: profitability, risk, payout, analyst opinions, and valuation. When assessing risk relative to other BDCs I take into account many factors including: portfolio credit quality, investment asset classes, diversification, non-accrual rates, portfolio yield, fixed/variable rate loans, leverage, volatility ratios, market capitalization, insider ownership and trends, institutional ownership and trends, and management/operational history. I will cover each of these areas as well as the other factors I use to rank the risk profiles for each BDC. Below are the current risk rankings for each BDC and for the most recent overall rankings see "Latest BDC Rankings For Q1 2013".
When evaluating the amount of leverage a BDC uses I consider many things and will focus on debt to equity and interest coverage. Most BDCs are Regulated Investment Companies ("RICs") designed to avoid double taxation, using the "conduit theory," where capital gains, dividends and interest are passed onto shareholders avoiding taxation at the corporate level but are required to distribute at least 90% of interest, dividends, and gains earned on investments. As a result, BDCs must use debt or issue additional shares to fund growth. BDCs are also limited in the amount of debt and "are only allowed to borrow amounts or issue debt securities or preferred stock, such that asset coverage, as calculated in accordance with the Investment Company Act, equals at least 200%". This equates to debt to equity ratio of 1.00 but there are certain exceptions that allow them to borrow more including SBA loans which are exempt from the coverage ratio allowing BDCs such as Hercules Technology Growth Capital (HTGC) to have higher leverage.
When calculating debt to equity I do not take into account cash and assume it will be used for working capital or portfolio investments. The ratios are as of March 31, 2013 (except AINV which has not reported yet) and do take into account subsequent debt or equity offerings such as TCP Capital (TCPC) who recently announced a $70 million equity offering to repay amounts outstanding under its revolving credit facility, which would reduce the ratio from 0.64 to 0.42. Also, when calculating debt for TCPC I included the 'Series A Preferred' as well as the dividends paid on it for coverage ratios.
Interest coverage is calculated by taking net investment income ("NII") and adding back interest expenses and then dividing the total by the interest expense. I use the most recent quarter and do not adjust for all one time income or expenses to normalize income and assume that the interest paid is close to a normalize run rate based on debts owed, making this a rough estimate and leave the normalizing to contributors such as Scott Kennedy and Factoids.
Below is a chart showing the most recent debt to equity ratios and interest coverage by BDC as well as the average.
Obviously there are a few outliers with better than average debt to equity but low interest coverage such as BlackRock Kelso Capital (BKCC), Ares Capital (ARCC), and Gladstone Capital (GLAD), which are potentially not using leverage in the most effective manner. Conversely, there are BDCs such as TCPC, Main Street Capital (MAIN), Medley Capital (MCC), New Mountain Finance (NMFC), and Fifth Street Finance (FSC), with higher debt to equity ratios but have adequate NII to support interest payments and potentially could be using leverage more effectively.
The BDCs with the best leverage ratios and interest coverage are Solar Senior Capital (SUNS), American Capital (ACAS), THL Credit (TCRD), and Solar Capital (SLRC), giving them the ability to grow portfolio value and income without share dilution. On September 30, 2011, ACAS changed from a RIC to a Subchapter C, discontinued paying dividends and currently is using its portfolio earnings to reduce debt and buyback shares.
Both Horizon Technology Finance (HRZN) and HTGC are highly levered with low coverage reducing the amount of potential income for paying dividends as well as increased risk of rising interest rates, especially if they do not have a large portion of variable rate investments (covered later).
Leverage, volatility ratios, portfolio investment grades, and non-accruals are just a few of the many considerations when evaluating risk for BDCs and I will try to cover the basics in the remainder of this series.
For more information about BDCs and how I evaluate them, please see this article.