This is Part 12 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 American Capital (ACAS).
Previous Risk Profile Articles:
Part 2 - Volatility Ratios
Part 3 - Leverage
Part 4 - Insider and Institutional Ownership
Part 5 - Industry Diversification
Part 6 - Interest Rate Sensitivity
Part 8 - Credit Quality ([[MCC, [[NMFC, [[ARCC, [[MCGC and [[FDUS)
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 ratio (described below) 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 "Quarterly Interest & Dividends Percentage" metric is the amount of dividend and interest income (excluding income resulting from amortization of fees, discounts, or other income) in the most recent quarter annualized and divided by the average fair value of the income-producing investments during that quarter. ACAS has a much larger portion of low-income equity investments than any other BDC so I used the interest income on the fair value of its debt investments.
Each BDC is placed into groups based on weighted average yields, leverage ratios of the portfolio companies, credit quality trends and yield direction.
The asset class mix of ACAS's portfolio has shifted away from senior and subordinated debt toward equity investments as shown in the table below:
As discussed in other articles ACAS is an outlier in the BDC industry in many respects including being the only BDC with a majority of investments in equity rather than debt. Its equity investments are low yielding and usually riskier. Over the last few years, the yield on debt investments has increased from 14.8% to 16.8% as shown in the chart below:
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 Solar Senior Capital (SUNS) classifies different investments with higher rates of return and higher leverage multiples.
(click to enlarge)
Portfolio leverage ratios for ACAS are higher than most BDCs who report this metric and currently the debt to EBITDA ratio is 5.5 times but has remained stable over the last two years. The debt service coverage ratio that measures the adjusted EBITDA divided by the total scheduled principal amortization and total cash interest expense of the portfolio company has declined from 2.0 to 1.6 over the last two years. Both of these measures indicate that the portfolio companies of ACAS are highly levered, with a decreasing ability to service debt payments, and potentially at risk of attaining non-accrual status.
When interest and/or principal payments on a loan become past due, or if the borrower is not expected to be able to service its debt and other obligations, loans are placed on non-accrual status. As of March 31, 2013, ACAS had non-accruing loans at cost totaling $313 million, 16.3% of total loans at cost, or 11.3% of total loans at fair value, and is the highest in the industry.
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 three remaining 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.