Moving right along in revisiting this series from 2011, the second article in the original series dealt with six BDCs which, at the time of the article (September 2, 2011), were recovering from ratio or credit problems which arose during the Panic of 2008. What typically happened was that a BDC would find that its debt instrument assets had to be written down due to either actual default or a perception that a default was likely. This would reduce the gross assets of the BDC and could create "ratio" problems in that the BDC would have borrowings in excess of 50% of gross assets due to the shrinkage in the fair value of the assets or could create covenant problems with lenders. Some BDCs would suspend dividends, others would be forced to sell assets at the bottom of the market and the general effect would be reduced income and Net Asset Value (NAV).
At the time the article was written, this group of BDCs was generally trading well below NAV; I found some of the valuations attractive and this is a group of stocks in which I made substantial investments (in some cases, dating back to 2009). While I do not generally consider "book value" a critical element in stock valuation and stock selection, I think it is important when you look at BDCs. BDCs generally hold a portfolio of business loans and use very limited leverage. Even if they are trapped in some low interest loans, the loans are generally of short duration (5 years or less) and the money can be redeployed at a higher interest rate. Accountants are supposed to revalue the loans based on default risk and, thus, NAV should provide some guide as to how much money will be collected on the loan. In this context, I believe that NAV is ONE (not, by any means, the only) very useful metric in valuing BDC shares and I have tended to load up on BDC stock of BDCs trading at less than 75% of NAV as long as no leverage problems were present. It has generally paid off very well as the stocks have tended to trade up toward NAV - although NAV itself has varied with some big gainers and some big losers in the group. With respect to each stock, after providing the name and the symbol, I will provide the price on September 2, 2011, the date of the original article, Tuesday's closing price and the current dividend yield.
1. American Capital (ACAS) (8.36) (11.67) (0) - This is an unusual situation for a BDC in that the dividend is still suspended. ACAS has generally made a nice recovery with NAV moving up from $13.16 to $16.62 during this time period. This is partly due to the retention of cash which would have otherwise been paid as a dividend and share repurchases as well as some asset appreciation. ACAS (previously named, American Capital Strategies) is one of the larger BDCs and has a broad portfolio of assets across a variety of industries. ACAS is also the management company for a large agency REIT and so it has an additional source of revenue. The stock dropped sharply in price about a year ago because a large hedge fund sold a very large position in the stock (which, I believe, was due to redemptions). Because of the very large discount to NAV and the healthy trend in operations, I still consider ACAS a very attractive investment at this price.
2. MCG Capital (MCGC) (4.53) (4.73) (11.6%) - MCGC has undergone a painful transition from being an equity investor in certain focused industries to being a lender to a broader group of companies. It has replaced its equity positions with senior debt and now is similar to many other BDCs with an orientation to lending to small and middle sized companies. With respect to one equity holding, Broadview, MCGC suffered repeated write downs of book value often at the level of $25 million per quarter. In the process, it has written off substantial amounts of book value so that NAV has gone from $6.93 per share to $5.26 per share. At this point it appears that most of the bad news is behind it and there does not appear to be substantial potential for more write downs because most of the remaining assets are loans made since the Panic of 2008. MCGC has paid out a generous dividend but there is often speculation to the effect that the dividend may or may not be sustainable. I had hoped that NAV would stay high and that the stock would trade up to that level and I have generally been disappointed but I have been able to "suffer in comfort" with a nice dividend.
3. Gladstone Investment (GAIN) (6.60) (7.46) (8.1%) - This BDC had been oriented to mezzanine debt and ran into lender problems during the Panic. It has gotten the situation under control and seems to be operating on an even keel. GAIN is one of a group of companies founded and led by David Gladstone and definitely appears to be on the mend. NAV per share has actually gone up from $9.06 to $9.10 and the stock has gradually traded up closer to NAV. There is still a nice discount to NAV and a solid dividend so I am still long this stock as a good element in a yield oriented portfolio.
4. Saratoga Investment (SAR) (16.98) (17.75) (annual dividend varies - the most recent dividend was $3.00 per share) - SAR has stabilized itself. SAR is the renamed product of a capital injection and a takeover of a failing BDC by a new management team. It has two large CLOs which are hard to value and could produce additional value over time. Its other activities are oriented to the normal BDC focus of business loans to middle and small sized companies. NAV has come down to $25.94 from $28.01 but it is still an attractive discount. SAR is one of the smallest BDCs and it could be a takeover target due to the combination of its size and discount to NAV. It has paid dividends annually rather than quarterly and, although the dividends have been generous, they can vary from year to year.
5. Kohlberg Capital (KCAP) (6.29) (8.98) (10.20) - KCAP had a War of the Roses style dispute with a lender involving extensive litigation and it seems to have been resolved. NAV per share appears to have declined from $8.52 to $7.66 and I will dive into these numbers more thoroughly in a subsequent article. It is another BDC which operated CDOs and these tend to complicate the accounting process. This one was originally deeply discounted to NAV; the stock has paid off nicely so far but I may have to reassess it on a go forward basis but for now, I am still long.
6. Ares Capital (ARCC) (14.73) (17.33) (9.1%) - ARCC was never really in trouble itself but it acquired Allied Capital at a time when there were still concerns about Allied's leverage and other problems. ARCC was therefore heir to a set of assets facing serious write down potential. The Allied acquisition made ARCC one of the largest BDCs and it is a favorite holding of those who participate in the sector. NAV per share has increased modestly from $15.28 to $15.51 and the Allied Capital write downs appear to be in the rear view mirror now. The dividend is reliable although it may jump around a small amount depending upon quarterly income. ARCC seems to have resolved transitional issues associated with the Allied Capital takeover and should be a solid, reliable investment for a dividend oriented portfolio.
I am long all of these stocks because I think that there is still latent asset value and there may be ways of using financial engineering to lead to its reflection in stock price.