Because Business Development Companies pay out essentially all their realized income in the form of regular distributions, any reduction in those pay-outs will greatly affect an investor’s cash on cash return (a term I picked up from the real estate industry) and a company’s stock price.
As we invest in the industry full-time, we spend much of energies trying to divine which of the 21 companies we track might cut their distribution in the months ahead. (By the way, we include Compass Diversified on our tracking list, which is not strictly speaking a BDC). The earlier a likely reduction can be flagged and acted upon, the lesser the stock price drop.
Of course it’s easy to be trigger happy and sell any BDC at the first sign of trouble and sit on the sidelines earning sub-1% returns. So we try to be cool headed, and also differentiate with minor adjustments to pay-outs and major cuts. Of course we’re just emerging from a period where there have been many unexpected dividend reductions after years of pay-out stability, and we’ve not been able to predict every cut.
Still, we soldier on in the new year and thought it would be useful to look at the big picture and highlight those companies we have doubts about their ability to maintain their current level of distributions. We call these red flag warnings. We’re not certain a cut will happen, but only that a reduction is more likely than not in the next 12 months.
Starting at the top, there are 17 BDcs which are currently paying regular monthly or quarterly distributions. Currently, four BDCs have suspended their dividends (ACAS, ALD, GNV and MCGC). Allied Capital (ALD), though, will shortly be bought by Ares Capital, and its assets will contribute to the combined company’s healthy pay-out. (Word on the street is that MCG Capital (MCGC) might resume its pay-out this year. So we might shortly be at 20 companies in the universe, and 18 regular payers).
Of the 17 BDCs paying a regular dividend, we have concerns about four companies:
- Gladstone Capital (GLAD): We’ve written about our GLAD recently. We’ll just say that we believe an impending restructuring of the company’s capital structure could result in a moderate dividend cut to bring the pay-out in line with earnings.
- Gladstone Investment (GAIN): Like its parent, GAIN has financing issues so is finding it hard to increase assets and earnings. Moreover, the company has a portion of its investments in preferred and common stock of portfolio companies, which brings in no cash with which to pay the distribution. Plus bad debts are a concern. When GAIN refinances its Revolver in the spring, management might have to make the cut.
- Kohlberg Capital (KCAP): It’s a miracle that Kohlberg-who is in dispute with its lenders and auditor, and which is not receiving cash distributions for many of its CLO investments-has managed to keep paying a distribution through 2009. However, short of a major resolution of its disputes, KCAP’s distribution should drop or even be suspended in 2010.
- TICC Capital (TICC): The company was the first to fully de-leverage at the beginning of the Great Recession. Moreover, TICC had to take major Realized Losses on several investments or 11% of equity at cost. The company has some cash to spend and assets that turn relatively fast, but is also wrestling with numerous still troubled loans. The distribution is already slightly in excess of earnings and might have to be cut if non-performing loans increase.
In closing, and to put our projection for 2010 in perspective, 10 of the 17 companies cut their distribution in 2009 from their 2008 level. The BDC industry is healing fast, but still has a ways to go to compare with the 2004-2007 period when no company reduced its pay-out from year to year.