Over the next few weeks I will be assessing dividend coverage for most of the 26 BDC that I cover in an effort to uncover companies that have the potential to sustain or increase current dividends. I will also be using this information to update my latest "BDC Rankings: May 2014". For more details regarding this series and for the dividend coverage results for TCP Capital (NASDAQ:TCPC), Ares Capital (NASDAQ:ARCC) and Medley Capital (NYSE:MCC) please see:
I have recently downgraded THL Credit (NASDAQ:TCRD) to a 'Hold' due to the potential for dividend coverage issues partially due to its falling portfolio yield and the analysis included in this article. Over the last five quarters TCRD has seen its portfolio yield decline from 13.7% to 11.0% and is currently lower than the average BDC (closer to 11.5%). These declines are higher than most due to the rapid shift of investments toward more secured loans as shown in the chart below.
During Q1, TCRD received onetime dividend income of $2.1 million related to its investments in YP Equity Investor and Surgery Center Holdings. I have projected lower amounts of dividend income for the coming quarters. Most BDCs have a base management fee of 1.75% to 2.00% of total assets and TCRD has one of the lowest at 1.50%. Incentive fees are a standard 20% of pre-incentive fee income and gains, but for projection purposes I use core net investment income ("NII") that excludes both income and incentive fees related to capital gains.
The following table shows the results for the most recent quarter along with projections at various levels of leverage and using a stable yield of 11.0% to determine the impacts on dividend coverage. Each of these scenarios assumes a full quarter of benefit from interest income but also a full quarter of interest expense, management and incentive fees.
These scenarios assume the highest level of efficiency and actual results could be lower because there will always be some turnover in the portfolio (that could drive higher fee income). This analysis implies that there is the potential for dividend cuts especially if TCRD continues to experience declines in portfolio yield. Keep in mind that the most recent quarter had the benefit of $2.1 million in onetime dividend income that helped to cover dividends as well as lower its operating cost ratio for the quarter.
Side by Side Comparison:
For the side by side comparison I will be using the amount of equity as of March 31, 2014 (or most recent) along with a debt-to-equity ratio of 0.80 and current portfolio yield to project income and expenses, tracking the following metrics:
- Dividend coverage (using a debt-to-equity 0.80)
- BDC expenses (as a % of available income)
'Available income' is total interest and fee income less interest expense from borrowings and is the amount of income that is available to pay management expenses and shareholder distributions. BDCs with lower expenses can pay higher amounts to shareholders without investing in riskier assets.
The following table compares the results for TCRD to TCPC, ARCC and MCC. I will continue to add BDCs in the following articles. As you can see TCPC and ARCC both have lower cost structures than TCRD and better dividend coverage. It is also important to point out that MCC has a higher portfolio yield that could decline more than other BDCs.
For more details including some of the potential variances to this methodology for assessing dividend coverage please see "Part 1" of this series. Investors should only use this information as a starting point for due diligence. See the following for more information:
Disclosure: I am long ARCC, TCPC. 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.