- Recent articles about PSEC prompted me to review my BDC sector allocation.
- It is difficult, if not impossible, to know which BDC loans will survive the next recession.
- Given the inherent risks and all the unknowns, diversification is crucial for BDC investors.
The BDC Portion of my Retirement Income Portfolio
A Flurry of PSEC Articles
As a PSEC shareholder, I was pleased to read Brian Grosso's February 28 SA article, Interview with Prospect Capital President and COO Grier Eliasek, as well Adam Aloisi's interview, Everything You Wanted to Know about Prospect Capital - I Was Able to Ask that was published on March 3. The Oxen Group published a two-part article about PSEC, on February 28 and March 4, stating that PSEC is the "Best in BDC."
On March 3, Lawrence Zack Galler published an article, Prospect's Growth Hides Bad Underwriting. This was his second SA article aimed at fellow Nicholas Financial (NASDAQ:NICK) shareholders to encourage them to vote against a proposed buyout by PSEC. He mentioned two loans that were converted to equity in Q4 2013, Ajax and Gulf Coast. The Ajax investment originated in 2008. The Gulf Coast investment originated in 2012.
Because the article included earlier examples of non-accruals or write-offs, the author was criticized in a number of comments for using pre-recession data. In spite of the Gulf Coast example, several comments echoed Grier Eliasek's statement to Brian Grosso: "We're now going on more than 6 years without originating a deal in our book that has gone on non-accrual."
In response to these comments, Lawrence Zack Galler published a follow-up article on March 6 about a loan to NMMB Holdings that originated in 2011. The article stated that when NMMB ran into difficulty in 2013, PSEC provided new funding that was used to repay all or part of previous loans from PSEC and to issue additional shares of preferred stock. In short, PSEC participated in a workout of the problem, which led among other things to an equity interest that was in the same quarter written down to $0.04 on the dollar.
The conversation about non-accruals, defaults, and workouts convinced me that PSEC's refinancing of NMMB is just part of the way BDCs conduct business. From this point on, I will more closely scrutinize any BDC's claims about the absence of non-accruals.
Time for Homework
I spent part of the March 8-9 weekend researching BDCs in general, and PSEC in particular. A footnote in Lawrence Zack Galler's March 3 "Bad Underwriting" article contained a link to his February 21 article about the proposed PSEC buyout of NICK, Nicholas Financial: A Bad Deal - Vote It Down, Replace Directors, And Profit.
In the comment section of the February 21 article, Lawrence Zack Galler made reference to a September 13, 2012 SA article by Hype Zero, Be Wary of Prospect Capital. Another reader's comment linked a December 18, 2013 blog by Eddy Elfenbein about the proposed buyout of NICK, which concluded:
I have to admit that I'm baffled by this. I think NICK is very much selling itself short. I can't think of another company that sold itself for 10 times trailing earnings, and a dividend yield of 3%. Management clearly wanted out. Only two months ago, NICK traded for as much as $17.20 per share. Sixteen dollars is a premium of less than 5%.
Enter Nicholas Marshi
My weekend homework introduced me to the work of Nicholas Marshi, a contributor to SA and Chief Investment Officer of Southland Capital Management. He and Bill Hansen, Southland's Chief Marketing Officer, publish the BDC Reporter, which "seeks to provide broad news and analytical coverage of the Business Development Company industry." Some of Nicholas Marshi's SA comments about the "Bad Underwriting" article later appeared in the BDC Reporter.
I found these excerpts from Nicholas Marshi's comments to be instructive:
Maybe it's creative, maybe it's investing outside the box, maybe it will all pay off, but there's no doubt in my mind that PSEC's management is still taking a great deal of "equity risk" with a substantial portion of the portfolio, and has great confidence in its ability to be more than a lender. Last time round (i.e. 2006-2009) that was a disaster for American Capital, MCG Capital, Allied Capital and Prospect Capital itself.
So we are Long, but we worry.
He is long PSEC, but he is cognizant of the risks. This gave me a deeper glimpse into the murky world of middle market finance:
As someone who has been investing in the sector for over 10 years, and full time for 7 years, I've invested in every BDC at one time or another. We're in two dozen or more BDCs at any time, and reviewing the others, looking for an entry point. I've learned to have a high level of skepticism about every BDC. There is a natural tension between the Company, which wants to keep it's stock price high (especially where BDCs are concerned as raising new equity is the main route to growth) and investors, who want the earliest signals of any deterioration in the company's prospects. The result is that there is a large amount of obfuscation in Company reporting across the sector: in the filings, press releases and Conference Calls. We remember in 2009-2010, when market conditions were bad, how most every BDC doled out information in very self serving ways as they tried to remain afloat.
This was a sobering word about the industry from one who knows it and lives it every day. It was this comment, however, which prompted me to take some action:
Beyond that, there is a structural problem: nobody knows where the bad debts are going to come from in the next recession. You can look at the loans on the books today but they will have largely been repaid or restructured by the time the Piper comes to be paid. We get valuations from outside firms, but we otherwise have little idea what the underlying financial condition of the underlying borrowers is, the covenants they have agreed to and what business plans were used in the underwriting. We doubt that the BDCs or the borrowers themselves have any certainty about who will prosper and who will fail in the next recession.
I know this view frustrates many investors, but it's better to know what you don't know than have the illusion that you do, and act accordingly. Of course, we do have favorites (TCAP, MAIN, TCRD) but I assume that any of my BDC investments could break my heart in the next recession.
I added the bold type to underscore one of the key risks involved with BDC investing.
Enter BDC Buzz
My final homework exercise was to revisit articles by BDC Buzz, who has been my "go to" resource for BDCs. BDC Buzz is long PSEC and generally he has been favorable toward PSEC. But, sometimes I find helpful information in strange places. In a comment following his October 11, 2013 article about KCAP Financial (KCAP), BDC Buzz makes this statement: "PSEC is about as renegade as I can handle but the others payoff big if they perform. Risk is double edged."
Sometimes when I'm in "decision mode," one or two pieces of data linger in my mind. One was Nicholas Marshi's comment about the uncertainties that are inherent in BDCs and the other was BDC Buzz' comment about PSEC being "about as renegade" as he can handle.
I decided that if I am going to continue to have a BDC representation in my retirement income portfolio, I needed to further diversify it. So I decided that I would hold two BDCs, with a combined portfolio allocation of 2.5%. This was down from 10% one year ago when I had a 5% allocation for PSEC and a 5% allocation for PennantPark (NASDAQ:PNNT).
After reading numerous articles by BDC Buzz, I decided to take a look at each of the BDCs of which he is long. (I always take note of where physicians send their family members for medical care!) While not a fool-proof technique, I looked at his long positions: HTGC, MAIN, TCPC, FSC, ARCC, FDUS, TCRD, PSEC, NMFC. In the back of my mind were the three favorites named by Nicholas Marshi (TCAP, MAIN, TCRD).
Many of these names were on my "short list" a year ago when I made my initial purchases of PSEC and PNNT. I settled on four BDCs to study in addition to PSEC: Ares Capital (NASDAQ:ARCC), Main Street Capital (NYSE:MAIN), THL Credit (NASDAQ:TCRD), and Triangle Capital (NYSE:TCAP). I read SA articles, various analysts' reports and company materials. I read transcripts of quarterly conference calls and I listened to webcasts of those conference calls.
A helpful resource was a two-part article on November 3 and 4, 2013 by BDC Buzz about BDCs with the Lowest Fees, including an expense and performance comparison BDCs that are externally managed and those that are internally managed. PSEC, ARCC and TCRD are externally managed. I decided that - for now, at least - I will hold two internally managed BDCs: MAIN and TCAP.
Let me hasten to add that BDC Buzz holds both internally and externally managed BDCs and that among Nicholas Marshi's three "favorites," one is externally managed. At some point in the future, I may again hold shares of an externally managed BDC, including PSEC.
One more statement in the interest of full disclosure. Two weeks ago, PSEC was the only BDC in my portfolio and in my wife's portfolio. I sold my shares of PSEC and divided the proceeds to purchase shares of MAIN and TCAP. However, my wife continues to hold shares of PSEC.
The Importance of Net Asset Value
I realize that net asset value is one metric among many, but it is for me an important measure of a business development company's long-term health. PSEC went public in 2004 at $15.00 per share. In the September 13, 2012 article, Hype Zero pointed out that at the end of June, 2012, NAV was $10.83, which is approximately the NAV today. Even though PSEC investors have enjoyed hefty dividends, I would like to see a gradual turnaround in PSEC's net asset value. In my mind, this would in some sense "settle" the issue of whether Grier Eliasek is right that net asset value is down because the company is making investments to capture future value and that the focus should be on the company's cash flow generation (as he stated in the Adam Aloisi interview), or Lawrence Zack Galler is right that PSEC's rapidly-growing asset pool is hiding bad underwriting:
As a stock, Prospect will work as long as the defaults, which take time to emerge, are compared to the so-much larger pool of today's loan assets, and not against the much smaller loan pool in place when the original commitments were made.
But when growth stops, the bad outcomes as a percentage of loan assets will begin their inexorable rise.
The Importance of Diversification
Given Nicholas Marshi's comment about the nature of the BDC sector, investors have no way of knowing who will be right. In light of this, it seems that the most prudent path is to diversify one's BDC holdings as much as possible. I shuddered when I read Brian Grosso's statement in his March 3 follow-up article about Prospect Capital: "I'd be comfortable weighting PSEC as much as 20% of my portfolio."
I am convinced that with all portfolios - particularly retirement income portfolios - diversification is our friend. I have opted for a more conservative approach (less "renegade," to use BDC's term), which means - for now, at least - less income.
I will say more about MAIN and TCAP in a few weeks when I write a Q1 update about my retirement income portfolio. My purpose in writing this article is not to convince anyone (particularly my spouse!) to abandon PSEC in favor of MAIN, TCAP or any other investment, but simply to tell the story of how one dividend investor made a decision about BDC sector allocation after several factors were brought to light in the wake of the flurry of articles about PSEC.
Disclosure: I am long MAIN, TCAP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As noted in the article, my spouse is long PSEC.