This is Part 8 of a series of articles that compare the risk profiles for the 25 business development companies ("BDCs") recently covered in my "The Good, The Bad, And The Maybe" series and focuses on the portfolio yields and credit quality trends for Medley Capital (MCC), New Mountain Finance (NMFC), Ares Capital (ARCC), MCG Capital (MCGC), and Fidus Investment (FDUS).
Previous Risk Profile Articles:
- Part 1 - Portfolio Asset Classes and Non-Accrual Rates
- Part 2 - Volatility Ratios
- Part 3 - Leverage
- Part 4 - Insider and Institutional Ownership
- Part 5 - Industry Diversification
- Part 6 - Interest Rate Sensitivity
- Part 7 - Credit Quality [BlackRock Kelso Capital (BKCC), KCAP Financial (KCAP), PennantPark Investment (PNNT), Apollo Investment (AINV), and Solar Capital (SLRC)]
When evaluating BDCs I focus on five general criteria: profitability, risk, payout, analyst opinions, and valuation. When assessing risk relative to other BCDs I take into account many factors including: portfolio credit quality, investment asset classes, diversification, non-accrual rates, portfolio yield, fixed/variable rate loans, leverage, interest rate sensitivity, 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".
Portfolio Credit Quality
Portfolio credit quality is one of the most important indicators for many areas of BDC analysis including earnings predictability, NAV growth, dividend sustainability, valuation, and risk profile. BDCs have many different methods of indicating the credit quality of the portfolio and are often inconsistent, making it difficult to compare. A few measures that are consistent but not necessarily the best are average portfolio yield and asset class mix, but I will cover portfolio leverage and interest coverage ratios as provided by each BDC.
Below is a table showing the average "portfolio grades", portfolio yields, the general direction of yields and credit quality, as well as the debt to EBITDA (described below) and Fitch debt ratings when it is available. I did not include interest coverage ratios because very few BDCs disclose them and I will continue to add measurements as they become available. The BDCs with increasing or flat yields such as BKCC, KCAP, MCGC, PNNT, and AINV, are potentially investing in riskier assets, in order to maintain or grow income from investments.
The portfolio debt/EBITDA measures the weighted average portfolio debt as a multiple of EBITDA. As discussed in Part 7, debt to EBITDA ratios greater than 4 or 5 usually indicate that a company is likely to face difficulties in handling its debt burden, and is less likely to be able to raise additional loans required to grow and expand the business and it can result in a lowered credit rating. The chart below indicates how ARCC classifies different investments with higher rates of return and higher leverage multiples.
MCC has one safest asset class mixes with 99% of its portfolio in senior secured debt and regularly assesses the risk profile of each investment rating them on a scale of 1 to 5 (1 involves the least amount of risk and 5 indicates higher). Recently the portfolio measured a weighted average risk rating of 2.04.
MCC has decreased average yield on debt investments from 14.5% in 2011 to 13.9%.
MCC uses a loan to value ratio ("LTV") for each portfolio investment as an indicator of the riskiness of the portfolio investment, or its likelihood of default and seeks to structure transactions with downside protection and LTVs lower than 65%. LTV is calculated by taking the amount of total net debt in the portfolio company's capital structure divided by the enterprise value of the portfolio company. As of March 31, 2013, the weighted average LTV of portfolio investments was approximately 54.7% compared to 49.4% in 2011.
On the most recent earnings call the CEO stated: "We are at a stable market environment, lender values are sensible, credit metrics are sensible. I think clearly all of the positioning in the market is, it has a higher amount of value or higher debt to EBITDA than we did 18 or 24 months ago, but in the context of historical levels, I would say, we are at or slightly below average in terms of overall credit risks. As of March 31, the credit quality of the existing portfolio remained stable and no loans were on non-approval status."
New Mountain Finance
NMFC has decreased average yield on debt investments from 10.7% in 2011 to 9.8% and it currently has one of the lowest yields in the industry. On a recent earnings call the CFO indicated a potential move toward higher yields: "we're going to certainly work very hard to at least keep that sort of 10.4% portfolio yields plus or minus where it is and where it's been. And I think we're - we've got a number of initiatives underway to continue to make sure that we're able to access within our risk metrics and risk tolerance, the type of investments that can generate that yield and that's consistent with what's rolling off".
NMFC monitors the performance and financial trends of its portfolio companies on a quarterly basis and uses a rating system to characterize the credit profile and expected level of returns on each investment in the portfolio. As of March 31, 2013, all investments had an Investment Rating of 1 or 2 with the exception of two portfolio companies; one with an Investment Rating of 3 and the other with an Investment Rating of 4 at an aggregate cost basis of $5.9 million. Rating 1 is performing materially above expectations, Rating 2 is performing materially in-line with expectations, Rating 3 is performing materially below expectations, and Rating 4 is performing substantially below expectations and risks have increased substantially. This is slightly worse than 2011 with no investments with a Rating of 3 and $4.5 million of investments with a Rating of 4.
ARCC has been consistently decreasing its weighted average yields for each asset class as well as the overall portfolio. The average yield on income producing investments was 11.0% as of March 31, 2013, down from 12.0% in 2011 as shown in the chart below:
Ares Capital Management, the investment adviser, employs an investment rating system to categorize investments on a scale of 1 to 4 to reflect the underlying risk of a portfolio investment relative to the initial cost basis with a grades between 1 and 4 (Grade 4 indicates the least amount of risk). The table below shows the various breakdowns of each grade by fair value and a slight improvement from 2011 to 2012:
The chart below shows the portfolio leverage multiples increasing from 4.3x to 4.6x but also the interest coverage ratio increasing to 2.7x as well.
MCGC has a shrinking portfolio, declining income, sinking net asset value and inability to cover dividends over the last few years, as well as an increasing portfolio yield and riskier mix of assets as shown in the chart below:
Below is a table showing the portfolio by investment rating since 2011 and a general decline in credit quality:
MCGC did not disclose leverage ratios in its most recent earnings call.
FDUS currently has a declining to flat yield on debt investment and during the latest earnings call the CEO mentioned investing in larger and safer companies (going up market) and seeing a drop in yields.
FDUS tracks several measures of portfolio quality, one of which is an internal system of portfolio investment rating that has shown a modest increase in portfolio quality since 2011. Another is debt to EBITDA of 3.6x as of March 31, 2013, which was an increase from the previous quarter's 3.4x, but still lower than many other BDCs. The third measure used is the combined ratio of total EBITDA to total cash interest expense of 2.8 times, which FDUS believes "provides a significant cushion for them to meet their debt service obligations to us".
Portfolio credit quality, portfolio yields, interest rate sensitivity, fixed/variable rate investments, industry diversification, market capitalization, insider and institutional ownership, leverage, volatility ratios, portfolio investment grades, and non-accruals are many of the considerations when evaluating risk for BDCs. In the remainder of this series I will cover the portfolio credit quality for the remaining 15 BDCs, using the metrics they provide, as well as other risk considerations.
For more information about BDCs and how I evaluate them, please see this article.