4 Business Development Companies Trading Below 75% of Book Value

by: Philip Mause

I have written several articles about Business Development Companies (BDCs) and so I will not go into excruciating detail on their characteristics. As a general matter, BDCs hold debt instruments(although some have a considerable component of equity holdings) in small companies. Their leverage is limited to 2 to 1 (that is total assets can be now more than twice net capital - another way of looking at it is that debt cannot exceed net asset value). BDCs are generally Registered Investment Companies (RICs) and must pay out 90% of earnings as dividends or face adverse tax consequences. The advantage of being a RIC is that no income tax is paid at the corporate level.

BDCs got clobbered in the 2008-09 Panic for a number of reasons. Some of them had pushed leverage right up to the limit and, once asset write downs became necessary because of concerns that certain entities which owed money to the BDCs might default, there were violations of the leverage limit leading to a cessation of dividends and/or an assertion by the bank lending to the BDC that the BDC's obligations to the lender were in default.

In early 2009, I looked over the sector with an eye to trying to determine which entities would survive without massive dilution. I was fortunate in being able to pick up many BDC stocks at valuations well below 50% of book value. I was always concerned about book value because I wanted to have a sense of what would happen if a liquidation became necessary. I have read other analysts of the BDC space who seem to deemphasize book value. I certainly do not think that book value has some sort of talismanic significance but I still believe it is very relevant.

BDCs earn money several ways. In some cases, they make money due to the appreciation of equity interests in small companies. But the dominant source of revenue is generally interest payments on debt instruments. To the degree that some BDCs employ limited leverage, they can make money on the "spread" between the interest rate they pay on borrowings and the interest rate they earn on debt instruments. In addition and primarily, they make money on the capital they invest through interest payments.

A BDC's earnings capacity is thus dependent upon its net capital and upon the spread it is or will be able to earn on the levered part of its balance sheet. It is true that some BDCs are better than others at lending in a profitable way and it is also true that some BDCs have legacy loans on their balance sheets that are in some cases above and in some cases below current market interest rates. But, because most BDC lending is relatively short term, the legacy loan advantage tends to be short lived. Most BDCs will recycle whatever is now on their balance sheets within three to five years, with a great deal of capital constantly being redeployed as loans are paid off or portfolio companies are sold.

Book value(assuming that assets have been valued fairly) is thus a useful barometer in determining a BDCs future earnings potential. It also provides guidance as to how much leverage the BDC can deploy since the limit on debt is based on the net asset value of the BDC. Finally a big discount to book value tends to give the investor a cushion to absorb any future write downs.

For each BDC, I will give the symbol, Monday's closing price, the ratio of price to book value, and the current dividend yield.

  1. American Capital (NASDAQ:ACAS)(8.66)(.63)(0)

  2. Saratoga Investment (NYSE:SAR)(17.74)(.62)(0)

  3. Kohlberg Capital (NASDAQ:KCAP)(6.04)(.71)(11.75)

  4. MCG Capital (NASDAQ:MCGC)(4.45)(.68)(16.30)

A few points. These are high beta stocks(if this website were named "Seeking Beta" - these stocks would be the talk of the town). They have been on a real rollercoaster ride since 2008. When I started outlining this article over the weekend, they were priced more attractively and the title was going to use the phrase "Below 70% of Book Value" - Monday's price jump has moved the numbers a great deal.

Two of the companies, SAR and ACAS do not currently pay dividends but will likely resume dividends within the next two years. The failure to pay dividends makes the stocks even more volatile. I believe that these two companies are well on the way to recovery. They each have paid down debt and are in good shape on the leverage issue.

MCGC invested heavily in equity positions in Competitive Local Exchange Carriers (CLECs) and this had led to a fairly steady stream of write downs. In many cases, we are getting near the end of the tunnel because the CLEC stocks have been written down so much that there really isn't much asset value left on MCGC's books. MCGC is redeploying assets into the conventional BDC activity of lending to small and middle sized businesses. As this strategy is implemented, there will be more and more quarterly interest income, and fewer and fewer write offs of equity positions.

KCAP had serious problems with lenders during the Panic of 2008 and thereafter but these have apparently been resolved. It manages several CLOs and, because its position is subordinate to other investors, it will take the brunt of the initial hit if the economy tanks later this year.

These stocks are all way off their highs and, as I mentioned, quite volatile. The path up will not be straight and steady. But, over time, I have done well when buying BDCs at the currently available ratios to book value.

Disclosure: I am long ACAS, SAR, KCAP, MCGC.