BlackRock Kelso Capital Corporation (BKCC) announced its fourth quarter and full year 2010 earnings this week. Fourth quarter earnings were only 3 cents a share and in the context of a $1.28 annual dividend, this created an understandable fear that the dividend was threatened. BKCC traded as high as $12.95 before the announcement, but traded down sharply on the announcement, reaching a low of $10.01 and closing at $10.20 (considerably lower than the price at which shares were sold in a secondary offering last year).
Investors have lost more than 25% from the top and an investor who bought Monday at $12.95 would take more than two years to collect enough dividends at $1.28 a share (the current level which, of course, may change) to get his money back.
Does this mean that income-oriented investors should head back to the bunkers and retreat into money market funds and treasuries -- or is it a great buying opportunity? An answer to this question requires an understanding of the fundamental dynamics of Business Development Companies (BDCs).
Most BDCs lend money to small and mid-sized businesses, often in connection with a change of control. Their leverage is limited to 100% of net asset value. Put another way, a BDC cannot have borrowings of more than 1/2 the total value of all of its assets. BDCs generally can obtain favorable terms for the loans they make -- often obtaining upfront fees, sometimes getting an "equity kicker" and usually getting interest rates in the 10-13% range, often in the form of a LIBOR plus structure.
Because of the limited leverage, BDCs should be able to borrow at favorable rates and thus earn a substantial "spread" on the difference between their borrowing costs and lending rates. BDC earnings can vary depending on loan performance, how much capital is lent out, interest expense, administrative expense, and depreciation or appreciation in the "fair value" of the portfolio.
BDCs' loan portfolios are typically marked to fair value on a quarterly basis; this process can result in losses (or gains) depending upon whether loans go into non-accrual, borrowers are perceived as risky, and rates rise or fall. During the financial crisis, there were large-scale writedowns that resulted in some BDCs violating the leverage limit and covenants associated with their borrowings. This time of troubles seems to be behind us, and BDC loan portfolios seem to be performing and holding stable fair value levels.
BKCC had very low fourth quarter earnings because almost the entire 2010 management fee of some $15 million is allocated to the fourth quarter. This resulted in fourth quarter expenses of $22.4 million, or roughly half the full-year 2010 expenses of $45.7 million. Thus, the fourth quarter results cannot be projected forward to estimate typical quarterly returns.
In its conference call, BKCC indicated that, had the management fee been spread ratably over the four quarters, fourth quarter earnings would have been 19 cents a share. Still, fourth quarter earnings were below "consensus" estimates, and there is a legitimate concern that earnings may not support dividends on a going forward basis.
Like most BDCs, BKCC's loans are mostly short-term; thus, BKCC must constantly find new ways to deploy capital as old loans mature or are repaid before maturity. In 2010, there appears to have been a substantial recycling of money on this basis, and at times BKCC's funds were not fully deployed.
In the conference call, BKCC indicated that it had roughly $200 of unused credit available and that it was comfortable with the leverage that a full deployment of that credit would involve. This could of course create a significant source of additional revenue due to the spread between the rate at which BKCC would lend funds out and the rate BKCC would pay on the borrowings.
I started following BDCs closely in 2009 when I noticed that many of them were trading well below book value. My first big position was Allied Capital (AFC) -- now ARES Capital (ARCC), debt -- which was trading as low as roughly 25 percent of face value. A careful analysis of Allied's balance sheet revealed that it was very unlikely that Allied would go into liquidation and that, even if it did, substantially more would be realized on AFC than the price indicated.
I started looking at balance sheets of BDCs very closely and found that many of them were trading at ridiculous discounts to reasonably calculated book value. Buying BDC shares at substantial discounts to book value turned out to be a great investment strategy.
Unfortunately, or perhaps fortunately, that window seems to have closed and, although there are some BDCS trading below book value, the discounts are not as generous as they used to be, and many BDCs are trading above book value.
BKCC's book value was $9.62 as of the end of calendar 2010. It appears to have followed a reasonable policy of valuing its assets, as demonstrated by the fact that, upon exit, it has generally realized amounts equal to or in excess of book value. Thus, the $9.62 book value represents a reasonably solid valuation of its assets.
There are certain equity positions which may lead BKCC's book value to increase, but the opportunities for its loan assets to increase in book value are inherently limited. I think that BKCC is a strong buy at or below book value of $9.62, and that income-oriented investors can probably feel comfortable paying up to 10 percent or so above book value. Looking back, when the price hit $12.95 Monday, BKCC was trading more than 30 percent above book value and I probably should have sold or at least lightened up; of course, that is a lot clearer now than it was at the time.
The lesson here may be to "dance with the one who brought you" and get in and out of BDC stocks based on some range of book value multiples. When a portfolio consists primarily of short- or intermediate-term loan instruments, the book value of that portfolio is a reasonably good guide to future income.
I tend to think that BDCs priced above 125% of book value are getting toppy, and that BDCs priced below 90% of book value merit a careful review of the assets to determine whether the book value is solid. If book value is solid, then buying at more than a 10% discount is likely a decent investment strategy at a time when it is harder and harder to find underpriced assets.
Disclosure: I am long BKCC, ARCC, AFC.