This is a series of articles to find BDCs to include in my updated "Total Return Portfolio" for Q3 2014. Please read "Part 1" for complete description of the portfolio but basically it is for investors that want dependable regular dividends and the potential for special dividends as well as long-term capital appreciation from increased stock values. The other four portfolios that I will cover in following articles are 'High Yield', 'Risk Averse', 'Value' and the 'Underdog' portfolios that will be updated on my "Portfolio Updates" page . This article will cover the potential for net asset value ("NAV") per share growth.
Part 1: Introduction
Part 3: Portfolio Growth Potential
Many BDCs are price based on a multiple of NAV per share which is why it is important to consider growth potential when looking at projected total returns. Most BDCs are Regulated Investment Companies ("RICs") designed to avoid double taxation, using the "conduit theory," where capital gains, dividends and interest are passed onto shareholders; they avoid taxation at the corporate level, but are required to distribute at least 90% of interest, dividends, and gains earned on investments. RICs are also required to distribute 98% of net investment income to avoid paying a 4% excise tax. These mandatory distributions make it difficult to grow the value per share because they are not reinvesting in the company. American Capital (NASDAQ:ACAS) is not an RIC and does not make distributions to shareholders so it has much higher amounts of NAV per share growth.
However there are other ways that BDCs can create higher values to shareholders such as:
- Portfolio value appreciation.
- Higher amounts of dividend coverage from core net investment income.
- Large amounts of onetime income or gains (usually from equity investments).
- Issuing shares at a premium.
Historical NAV Per Share Growth
The table below shows the cumulative NAV per share growth for each BDC grouped into higher vs. lower dividend yields. Higher yield BDCs have lower amounts of NAV per share growth for many reasons including paying higher distributions to shareholders such as Full Circle Capital (NASDAQ:FULL), Prospect Capital (NASDAQ:PSEC), KCAP Financial (NASDAQ:KCAP), Fifth Street Finance (NASDAQ:FSC), TICC Capital (NASDAQ:TICC) and Medley Capital (NYSE:MCC). These BDCs are usually priced at lower multiple of NAV and are not able to issue shares at a premium.
Historical & Potential Dividend Coverage
The following table is from Part 2 of this series and combines the recent amount of dividend coverage for each BDC with my "optimal leverage" analysis that uses the current cost structure and capital expenses for each BDC, along with the amount of equity as of March 31, 2014 (or most recent), a debt-to-equity ratio of 0.80 and the current portfolio yield to project income and expenses. For more information on this approach to projecting dividend coverage, please read "BDC Dividend Coverage Part 1".
Much of the NAV per share growth for BDCs comes from having equity participation in the portfolio companies. BDCs such Main Street Capital (NYSE:MAIN) and Triangle Capital (NYSE:TCAP) have historically had much larger amounts of equity investments and NAV per share growth than the average BDC but recently TCAP has had lower growth. Other BDCs such as Hercules Technology Growth Capital (NYSE:HTGC) have focused on equity participation in venture capital backed portfolio companies driving higher growth in its investments as these companies are eventually acquired or go public. TCP Capital (NASDAQ:TCPC) has recently hired some of the origination team from HTGC and will have a similar focus that should drive higher amounts of growth in the coming quarters. FSC has also started to use this strategy as a part of its "multi-point plan" discussed in my "FSC Articles". Gains from equity investments can be onetime dividends or capital gains from increased values and can be distributed as special dividends or invested in other income producing assets for a higher NAV per share and income for dividend growth.
Issuing Shares at a Premium
BDCs can increase NAV through equity offerings at a premium such as MAIN did last quarter with an offering of 4.6 million shares for $140 million at a 51% premium to book value after taking into account offering expenses. This will have an immediate 5% accretive impact to the current shareholders as well as provide low cost capital for the company to grow its portfolio.
BDCs that are currently trading at a premium to NAV have the ability to make accretive offerings in the future that could result in higher amounts of NAV per share growth. Also BDCs that can raise capital at lower cost have the ability to pay shareholders more with increased dividend coverage.
Which BDCs have the highest NAV growth potential?
After taking into account historical NAV per share growth, dividend coverage, the amount of equity in each portfolio and the ability to raise capital at premium I have ranked each BDC by the likelihood of NAV growth potential as follows:
Using this analysis I would not consider many of the higher yield BDCs but I will be considering TCAP, Apollo Investment (NASDAQ:AINV) and Fidus Investment (NASDAQ:FDUS). New Mountain Finance (NYSE:NMFC) and Gladstone Capital (NASDAQ:GLAD) are the lowest ranked of the current total return portfolios but there are many other considerations as well. The rest of this series will continue to look at historical results and projected performance of each BDC to uncover the best BDCs for this portfolio. The key criteria that I will be analyzing are:
- Dividend growth potential
- Special dividend potential
- Relative valuations
- Risk to reward ratio
I will try to cover each of these areas using available public information as well as my own analysis and I will most likely be investing in all of these BDCs personally. Investors should only use this information as a starting point for due diligence and please see the following for more information:
Disclosure: The author is long ARCC, FSC, FSIC, GBDC, HTGC, MAIN, NMFC, PFLT, PNNT, PSEC, TCPC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.