This is a series of articles to assess risk for the 26 BDCs that I cover and a follow up to my other "BDC Risk Profile" articles. There are many reasons why assessing risk for BDCs is important, including expected returns, valuations, and the potential loss of capital during an economic downturn or general business cycle. I use 'relative risk rankings' in many of my articles for valuation purposes, because I believe BDCs should be measured on projected risk vs. return. This series will take into account new metrics, and I will be adjusting my rankings accordingly, as well as updating my suggested 'risk averse' BDC portfolio.
The following are some of the indicators of risk and portfolio quality that I will be discussing in this series:
- General portfolio mix and yield
- Portfolio debt-to-EBITDA
- Average investment size and portfolio concentration risk
- BDC leverage vs. portfolio mix
- NAV growth vs. declines
- Fair value of investments as a percentage of cost
- Dividend coverage and the need to reach for yield
The previous articles in this series are:
- BDC Risk Profiles Introduction
- Apollo Investment (NASDAQ:AINV)
- PennantPark Floating Rate Capital (NASDAQ:PFLT)
- THL Credit (NASDAQ:TCRD)
- Fidus Investment (NASDAQ:FDUS)
I consider New Mountain Finance (NYSE:NMFC) to have a better than average risk profile for many reasons including the amount of credit quality information provided by the company, such as portfolio leverage ratios, credit performance statistics, portfolio concentration risk and tracking of cumulative realized gains and losses as discussed in my "NMFC Articles".
Personal note and disclosure: NMFC is one of my larger BDC holdings for many reasons including having a higher 'qualitative' ranking that I use internally. BDCs that disclose supplementary information about portfolio credit quality metrics have a higher ranking. Also BDCs that are more responsive to my requests for information when putting together research for articles and offline reports rank higher as well. Through continued contact with the CFO, David Cordova, I have been able to pull together relevant risk-related metrics publicly available to shareholders.
The following are statements and the associated presentation slides from the most recent earnings call:
"Our highest priority continues to be our focus on risk control and credit performance which we believe over time is the single biggest differentiator of total return in the BDC space."
"The credit quality of the company's loan portfolio continues to be strong with once again no new loans placed on non-accrual this quarter. We have had only one issuer default since October 2008 when the debt effort began representing less than 0.3% of cumulative investments made to-date. If you refer to Page 12, we once again the layout the cost bases of our investments with the current 6-30-2014 portfolio and our cumulative investments since the inception of our credit business in 2008 and then show what has migrated down the performance ladder."
"Since inception, we have made investments of over $2.6 billion in 139 portfolio companies, of which only one representing just $6 million of cost has migrated to non-accrual."
As I have mentioned in other risk-related articles, many BDCs will dispose of potentially non-performing loans/investments before the end of the quarter to preserve optics for shareholders. Basically, these BDCs may have lower amounts of non-accrual status loans but also very little net asset value ("NAV") growth or potentially NAV declines related to realized losses from investments. NMFC tracks this information and voluntarily provides it to investors:
"We focus on below the line items. First, we look at realized gains and realized credit and other losses. As you can see looking at the row highlighted in green, we had success generating real economic gains in every quarter through a combination of equity gain, portfolio company dividends and trading profits. Conversely, we have had only one material realized loss representing the realized fall off of $4.3 million on ATI in 2013. Beyond that, the numbers highlighted in orange show that we are not avoiding non-accruals by selling poor credits at a material loss prior to actual default. The net cumulative impact of this success to-date is highlighted in blue which shows cumulative net realized gains of $28.1 million since our IPO. Next we look at unrealized appreciation, and depreciation. As you can see highlighted in grey, we have cumulative net unrealized appreciation, or $28 million. Finally, we combined net realized with unrealized appreciation to derive the final line of the table, which in the yellow box shows the current cumulative net realized and unrealized appreciation of $56 million."
"The point here is to show that on both the realized and combined realized unrealized basis, we have consistently and methodically more than offset any credit losses or impairments below the line gains elsewhere in the portfolio. In fact, by this methodology we have now built a $56 million cushion to offset any future credit losses, some of which we have paid out as special dividends. While market-driven volatility around unrealized appreciation and depreciation may cause the bottom-line number to vary over time through economic gains and losses we will accumulate in the realized bucket where we will strive to retain a positive balance."
Debt-to-EBITDA measures the weighted average portfolio debt as a multiple of EBITDA. Ratios greater than five times usually indicate that a company is likely to face difficulties in handling its debt burden, and is less likely to be able to raise additional loans required to grow and expand the business and it can result in a lowered credit rating.
NMFC provides various detail regarding its portfolio leverage ratios including the changes since the original investments.
"Slides, 13 and 14 shows leverage multiples for all of our holdings above $7.5 million when we entered an investment and leverage levels for the same investment as of the end of the current quarter. Well, not a perfect metric, the asset-by-asset trend and leverage multiple is a good snapshot of credit performance and helps provide some degree of empirical, fundamental support for our internal ratings and marks. As you can see by looking at the two tables, leverage multiples are in almost all cases trending in the right direction with only two exceptions."
With a range of 3.6 to 4.6 times, NMFC's portfolio has near average leverage ratios. As a comparison, I recently reviewed the risk profile for PennantPark Floating Rate Capital (NASDAQ:PFLT), THL Credit (NASDAQ:TCRD), Fidus Investment (NASDAQ:FDUS) and Apollo Investment (NASDAQ:AINV) with ratios of 3.7, 4.2, 3.7 and 5.4 times, respectively.
NMFC has a stable portfolio mix of over 90% in senior secured loans while growing its equity participation in portfolio companies.
The stable portfolio mix has also resulted in a stable portfolio yield as discussed in "NMFC: BDC Dividend Coverage Part 5" and shown in the table below:
Portfolio Concentration Risk
Currently, the top ten portfolio investments for NMFC account for 32.4% implying an average amount of concentration risk compared to the previously reviewed BDCs.
Portfolio concentration is a metric that NMFC watches closely as shown in the chart below with the top 15 companies as a percentage of the portfolio over the last four quarters.
I will be updating the following table to include the other BDCs, as well as new risk-related metrics throughout this series. The goal of using a side-by-side comparison is to show an 'apples to apples' view of each BDC in an attempt to clarify my revised relative risk rankings. I have included the results for PFLT, TCRD, FDUS and AINV, showing NMFC closer to the safer end of the spectrum. At this point I would consider NMFC safer than most of the others, due to its better than average portfolio investment mix, lower than average portfolio yield, and slightly better than average leverage ratios and concentration risk. Other reasons for considering NMFC to have a safer risk profile is its growing NAV per share related to the cumulative realized gains on investments discussed earlier.
For more information about this series, please read "BDC Risk Profiles: An Introduction", and I will be adding my 'vintage analysis', as well as including information about BDCs with 'recession-resistant investments'. For updates to this series and links to previous risk-related articles on Seeking Alpha, please check my "BDC Risk Profile" page, as well as the "BDC Research Page" that I will continue to update as well as my "Index to BDC Articles" for more information on specific BDCs.
Disclosure: The author is long NMFC, PFLT.
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.