An examination of the charts of many Business Development Companies (BDCs) reveals enormous price appreciation since March 2009. The industry had a near-death experience as Allied Capital (AFC) was subjected to a widely publicized short attack and many BDCs had to write down assets and as a result got into ratio problems and covenant violation problems with lenders.
Fortunately, no BDCs actually went into chapter 11. There were a couple of takeovers and there have been some secondary offerings at less than book value, but investors with patience have been generously rewarded. It is not hard to find examples of BDCs that are up more than 500% from the early 2009 bottom. American Capital, Ltd. (ACAS) and MCG Capital Corporation (MCGC) are two that come to mind. Most BDCs are generating attractive yields but are also trading at or above book value. I am now often asked the questions whether BDCs are overpriced, and whether there is any significant potential for further price appreciation.
I initially approached this sector through the window of debt and invested in Allied Capital debt. This debt has now been assumed by Ares Capital Corporation (ARCC). I therefore have tended to focus on balance sheets and book value in analyzing this sector. From this perspective, the prices can go up only two ways - the book value can increase or the price/book ratio can increase. Because almost all BDCs invest primarily in debt instruments, there is a limit to the potential for book value appreciation. Nevertheless, looking over the sector, there is still significant potential for appreciation.
1. Some BDCs are still trading below book value. In these cases, assuming normal performance and a reasonably steady flow of dividends, the stocks should trade up to or above book value. Some of the BDCs trading below book value do not as yet pay cash dividends. Two of these are Saratoga Capital Corporation (SAR) and ACAS; others have emerged from various problematic situations recently and investors may be waiting for assurance that problems are finally resolved. In this group there are Gladstone Investment Corporation (GAIN), MCGC, and Kohlberg Capital Corporation (KCAP). I am not exactly sure why NGP Capital Resources Company (NGPC) has been trading below book, and I will discuss it further below.
2. Almost all BDCs are substantially below the debt ratio limit (debt can be no more than 50% of total assets) and thus have some potential to leverage up. On the other hand, the events of 2008-09 will reverberate for a long time and will understandably make the sector hesitant to push to the edge of the leverage limit. Some BDCs have no net debt. This group includes TICC Capital Corporation (TICC), SAR, GAIN and NGPC. These companies could employ some leverage without going anywhere near the limit. This may give them the opportunity to earn more income on the spread between the interest earned on the new loans facilitated by the leverage and the interest paid on the borrowings. This additional income may permit such stocks to trade higher.
3. Many BDCs have equity investments in the form of common stock, convertible securities, warrants and royalty interests. These can, of course, appreciate in value and increase the book value of those BDCs. Hercules Technology Growth Capital, Inc. (HTGC) seems to have consistently taken equity "kickers' in its deals and may realize some gains in this area. NGPC has taken royalty or other income oriented interests in many energy deals it is involved in.
4. Although BDCs pay out 90% of income as dividends, they can retain 10% and this may create some opportunity to increase book value.
5. Almost all BDCs have written down their portfolios below the face value of the loans and there is potential for a reversal of some of these write-downs as the economy improves. I will try to analyze this potential in a future piece, but it is inherently speculative.
6. At least two BDCs - NGPC and Prospect Capital Corporation (PSEC) - are heavily invested in the energy sector and have some positions with equity-like characteristics which could create the opportunity for appreciation if energy prices increase. These stocks may simply go up in a generally bullish environment for the energy sector or may actually see earnings increase due to better portfolio performance. In this regard, it is interesting to note that in the midst of a market downturn, NGPC has been going up the last couple of days.
Thus, a number of BDCs still have considerable potential for price appreciation. This potential will also tend to counteract any the tendency of income oriented investments like BDCs to decline as interest rates increase. I am still bullish on NGPC and PSEC as a conservative way to be long on energy. These stocks provide a very attractive yield and also considerable upside in the event energy prices continue to rise. I think that ACAS and SAR will eventually resume dividends and that, by the time they do, book value will have increased from here.
When dividends resume, SAR and ACAS will trade up to or above book value and so they are each attractive investments here. GAIN and KCAP appear to have all creditor problems behind them and as soon as this sinks in with investors, they should trade up to or above book value. HTGC is an interesting way to play the small cap space because of its equity holdings, and I am long this position as well.
TICC has the potential to increase leverage (as do many of the others) and could increase earnings substantially if it does so; I am still long TICC.
This list is not exhaustive. There are a number of other BDCs which are attractive here. I still like Fifth Street Finance Corporation (FSC), ARCC and Apollo Investment Corporation (AINV). On the other hand, some BDCs are reaching relatively high price/book ratios and, in my approach to the sector, that is a bit of a red flag. As I pointed out in an earlier article, there is no substitute for elbow grease in analyzing this sector.
In that regard, if interest rates increase, it will be important to analyze the percentage of BDC loans that are floating rate, as opposed to fixed, to assess how each BDC will perform in an increasing interest rate environment. Fortunately, the financials of BDCs generally have a high level of transparency so that the individual investor can get under the hood and see what is driving the vehicle forward (or backward). I encourage readers to do exactly that in approaching this sector. I still believe that the effort will be rewarded.