Sometimes the comments to an article on Seeking Alpha are more compelling than the article itself. In this article on BDC valuations Robin Heiderscheit commented (2nd comment down),
"The market is very efficient.
Assume two years of 10% defaults and 50% recovery. That is an average loss of 10% over that period. Multiplied by 1.75x, a ballpark leverage average for the typical BDC, you get a 17.5% NAV decline. And most BDCs are trading 10-25% below NAV.
The market is very efficient indeed."
So I decided to test Robin's hypothesis. First let me congratulate him for going one step further than the original article author did and adding to the discussion. Switching his wording around a little, in effect he is saying current market average discounts of about 17.5% in BDC's implies 10% defaults for the next two years with 50% recoveries. I agree that is a rough but fair representation of what the market has priced in. But is it appropriate?
According to the above referenced article Moody's is currently estimating a 5.1% average default rate for North American non-investment grade companies. This is a decent proxy for the customers BDC's lend to. However it is an average; the estimated default rates will be higher for BDC's who make a significant amount of loans to upstream oil producers, hold riskier junior debt, or CLO's, but lower for BDC's who issue mainly senior debt and/or who mainly have borrowers whose end markets aren't undergoing a crash. So again I feel I must emphasize, 5.1% is an estimated average. One needs to look more in depth into actual holdings before choosing a specific BDC.
Now let's look at historical recoveries on defaulted loans. Remember for most of the BDC's we are talking senior debt here. Not junior debt, CLO's, preferred or common shares. Moody's keeps a database on such things with over 3500 data points (in other words it is statistically significant) and has published a white paper which anyone can access for free on the internet. I highly recommend those interested in BDC's at least skim it so they can base their judgments on actual facts and figures instead of fear.
If you click on the above link, you will see average recovery for loans in default has historically been 82% (see graph on page 5). Senior debt recoveries average 93% (see debt structure graph on page 6). That's not recoveries cherry picked from one abnormally beneficial year and a few defaults, the database being referenced includes more than 3,500 defaults from a 20 year period which included a major market downturn. These high recoveries may not be intuitive to the reader so a relevant current example may help.
AINV's holds senior debt in Miller Energy, an upstream oil company currently in bankruptcy. The revolving note holder, Keybank, was paid off immediately prior to bankruptcy with cash on hand. So AINV's position is the sole senior debt in the structure and they in effect are in the drivers seat. Using third party valuations, MILL assets, even discounted for current oil prices and an additionally bankruptcy discount, are still probably worth well more than this senior debt. So even in a Chapter 7 bankruptcy sale AINV is likely to be made whole. However, AINV didn't push Miller into a chapter 7 bankruptcy, instead Miller filed for a chapter 11 reorganization. In doing so, it opens the way for AINV to petition the court to take over 100% ownership of the equity in Miller. Thus AINV doesn't just stand to recover 100% of what it is owed, if it is successful in it's petition, it stands to potentially make a size-able profit (at the expense of the preferred and common shareholders) over and above the debt owed. This isn't the first time such a thing has happened, senior debt holders were able to take over Thornburg Mortgage back during the crash with a very similar maneuver which netted them significant profit on the actual debt owed. In all likelihood AINV purposely pushed Miller into bankruptcy, with the boards blessing, with a goal of taking all of Millers assets over in mind. Anyway the point is even at ground central of the problem, loans made to upstream oil producers which subsequently go bankrupt, recoveries on senior debt can still be quite high.
So recapping, from Moody's we have two important data points: 5.1% estimated default frequency and 82% estimated recovery rates on those defaults (93% for those with senior debt). Additionally, we will take the estimated 2 years worth of these defaults and 1.75x BDC leverage from the comment. This gives us 3.2% estimated loss to NAV (= 5.1% default frequency X (1-.82%) loss rate X 1.75 leverage X 2 years) for the average BDC over the next two years. Thus an appropriate discount to book for the average BDC's is about 3.2%, not the 17.5% discount they currently trade at. In my opinion BDC's are significantly undervalued and thus I have chosen to take a significant long position in the leveraged ETN BDCL as well as smaller positions in individual BDC's such as: FULL, TPVG, HTGC, FSIC and TCPC.