I have written a fair amount about Business Development Companies (BDCs) and I won't reiterate all of the background described in previous pieces, here. I became very interested in the sector in 2009 because the corporate credit market was recovering and BDCs seemed to offer an opportunity to buy corporate debt instruments at large discounts.
In 2009 and well into 2010, there were BDCs whose assets consisted almost entirely of cash and corporate loans trading at discounts of 30 or 40 percent below book value. This offered the promise of enormous yield on the price paid and ultimate price appreciation as well due to the hunger of investors for yield instruments.
The opportunities to buy BDCs below book value have narrowed considerably and now we are in a situation in which BDCs trading below book have to be scrutinized to determine whether there is, indeed, a very good reason that they are trading below book. The deep discounts are gone and an investor has to determine whether the discount provides a sufficient cushion against unpleasant surprises in the future.
I have selected six BDCs that all were trading at more than 10% below book value as of Friday's close - in each case, after the company's name and symbol, I will provide the book value per share, the share price and the percentage discount:
- MCG Capital Corporation(MCGC): (7.54, 6.23, 17%)
- MVC Capital (MVC): (17.33, 13.47, 24%)
- Gladstone Investment Corporation (GAIN): (9.00, 7.80, 13%)
- American Capital, LTD (ACAS): (10.71, 8.94, 13%)
- NGP Capital Resources Company (NGPC): (10.90, .9.55, 12%)
- Saratoga Investment Corporation(SAR): (24.95, 21.90, 12%)
The first thing that occurs to me when I look at this list and think back to the opportunities that were available in 2009 and much of 2010 is the old joke - "We done shot all the slow rabbits." While I think this list offers investors some interesting opportunities, there is no longer either the potential upside or the enormous margin of error that much lower prices(and bigger discounts to book value) provided during the financial crisis. The list really breaks down into three categories: 1. companies which have significant parts of their portfolio in equity investments rather than debt instruments (MVC and MCGC); 2. companies that are not currently paying dividends(ACAS and SAR); and 3. companies with neither of these problems (GAIN and NGPC).
The first group of companies (MVC and MCGC) have significant amounts of equity investments in their portfolios. In the case of MVC, equity investments constitute some 72% of portfolio value; in the case of MCGC, it is a much lower percentage (25% as of the end of the last reporting period and probably considerably lower now).
While equity investments offer significant upside, they have several disadvantages. First of all, they present greater downside risks than debt instruments generally do; both MVC and MCGC have had disappointing quarters because the write-down of various equity investments offset other income and produced overall results that were below expectations. Investors realize that this can happen at any time and that, therefore, a BDC with substantial equity exposure is not necessarily a reliable income generating machine. Because the equities are shares of small, illiquid companies which are not publicly traded, the process of valuing the equity interest is inherently subjective and perhaps even a bit arbitrary and this adds an element of uncertainty to the calculus of book value and perhaps merits a discount.
MCGC appears to be intent on reducing the percentage of equity interests in its portfolio. After the close of the last reporting period, it announced the sale of two of its holdings - Superior Industries and Avenue Broadband - for a total of some $93 million. These sales include substantial equity interests and, depending upon how the funds are reinvested, MCGC may have reduced the equity percentage of its portfolio to 20%. The sales were also very close to the fair value of the holdings reflected on MCGC's books and this tends to validate the accuracy of MCGC's valuation process.
Still, MCGC has a very large equity position (roughly $100 million) in Broadview Networks; the write-down of this position in the most recent quarter was the major factor in disappointing financial results. Broadview has publicly traded bonds and, thus, has to make financial filings at the SEC. It is due to file an annual report within the next month or so and I would advise any MCGC investor to review the Broadview financial report to assess this important element of MCGC's portfolio. On balance, an investor is getting a big discount to book value with MCGC and I think it is a buy at this price.
MVC is very different. It has a very large proportion of its investments in equity interests and does not seem to have articulated any intention to redeploy assets in the direction of debt instruments. It appears to have a capable management team but it is extremely hard to evaluate its portfolio and it is unlikely to produce the steady stream of income that a well-structured debt portfolio will generate. I am still kicking the tires on this one to determine if there is a better way to evaluate the elements of its portfolio.
SAR and ACAS are not yet paying dividends. As a fundamentalist, I believe that this should not (necessarily) effect valuation. I have written about SAR before and I consider it a buy. ACAS is also attractive. Of course, it would be nice to go back one year in a time machine and buy a ton of it for $5.25 a share like Paulson (John, not Hank) did, but I still think that investors at this price will be rewarded. These stocks will each resume dividends and will tend to pop up when that happens.
That leaves NGPC and GAIN. They have each had problems in the past. GAIN had a nasty dispute with a lender; NGPC had to restate financials. Those problems are now in the past and probably do not justify a discount. I have recently written about NGPC; it is an attractive way to get exposure to the energy sector with a big dividend. I wrote about GAIN in my Instablog last summer - I recommended it on August 30 when it was trading at $5.77. I still like it, although I would love to buy it at $5.77(another slow rabbit bit the dust).
An investor in this sector should try to diversify and not load up too heavily on any one name. Recent hiccups by some BDCs underline the fact that, as these stocks close up on book value, an investor can take a hit when bad news surfaces. Because BDCs invest in the debt and equity of small companies, all sorts of developments that are not visible to analysts of macro trends can lead to disappointing results. Still, an investor using care to assemble a diversified portfolio of BDCs should be able to achieve a good overall (dividends plus price appreciation) return on his or her investment.
Disclosure: I am long ACAS, SAR, NGPC, MCGC, GAIN.