- This article uses my "optimal leverage" analysis to assess dividend coverage for Gladstone Capital.
- The BDC industry is experiencing yield compression and 7 out of the 26 BDCs that I cover have recently cut dividends.
- I will use this series to project which BDCs are more likely to increase or cut dividends in the future.
Over the next two 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 Golub Capital BDC (NASDAQ:GBDC), PennantPark Investment (NASDAQ:PNNT), Hercules Technology Growth Capital (NYSE:HTGC), FS Investment Corp (NYSE:FSIC), Ares Capital (NASDAQ:ARCC), TCP Capital (NASDAQ:TCPC), THL Credit (NASDAQ:TCRD), New Mountain Finance (NYSE:NMFC) and Medley Capital (NYSE:MCC) please see:
- Part 1: Ares Capital
- Part 2: Medley Capital
- Part 3: TCP Capital
- Part 4: THL Credit
- Part 5: New Mountain Finance
- Part 6: FS Investment Corp.
- Part 7: Hercules Technology Growth Capital
- Part 8: PennantPark Investment
- Part 9: Golub Capital BDC
Over the last five quarters Gladstone Capital (NASDAQ:GLAD) has had a stable portfolio yield near 11.6% and just above the average BDC (around 11.5%). This seems like an appropriate yield in the industry given its portfolio mix with almost 50% of investments in higher yielding subordinated debt compared to the industry average closer to 20%. GLAD prefers a debt-to-equity ratio of between 0.40 and 0.70 but it is currently near the lower end of the range as shown in the chart below.
Other income is usually not a significant amount except for in the most recent quarter, primarily due to $1 million from increased success and prepayment fees as well as dividend income, mostly received from Francis Drilling Fluids which was recapitalized during the quarter. I have used the average excluding this onetime amount for projection purposes.
GLAD has a shareholder friendly relationship with Gladstone Management Corporation (the "Adviser") that has been willing to waive certain management fees to insure continued coverage of distributions. On each call the CFO reminds shareholders with statements similar to the following: "The credit this quarter was needed to ensure distributions to stockholders, were covered entirely by net investment income. 100% of common and preferred stock distributions paid in over the last three years were covered by NII. This highlights our commitment to prudent growth." This makes projecting net investment income ("NII") easy for analysts using the dividend of $0.21.
GLAD is an externally managed BDC that pays its Investment Adviser a base management fee of 2.00% of total assets "less any uninvested cash or cash equivalents resulting from borrowings." Incentive fees are a standard 20% of pre-incentive fee income and gains, but for projection purposes I use core 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 portfolio yield of 11.6% 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, base management and income 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). Since the external adviser is willing to waive fees so that the company can continue to cover dividends would imply that the current dividend is sustainable.
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 table below is a "what if" scenario for ARCC with a similar fee structure to GLAD which would be a base management fee of 2.00% instead of 1.50%. The first column for ARCC is with the higher fee structure and shows how the dividend coverage and expense ratios change. The difference between 1.50% and 2.00% seems small but has a large impact on how a BDC can support dividends.
The following table compares the results for GLAD to GBDC, PNNT, HTGC, FSIC, TCRD, TCPC, ARCC, NMFC, GLAD and MCC. As you can see GLAD has a much higher than average "operating cost as a percentage of available income" and a similar fee structure as PNNT but a lower portfolio yield which is most likely why it does not cover its dividend as well. At this point I believe TCPC, HTGC and FSIC have a much higher potential for dividend increases than the average BDC. I will continue to add more companies in the following articles.
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 and to learn more about GLAD please see "Gladstone Capital Articles."