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Credit Suisse Call On BDC Sector And BDC Reporter's View

|Includes:BKCC, FSC, Hercules Capital, Inc. (HTGC), MCC, PNNT

Barron's printed the following recommendations for the Business Development Company sector, which we thought we'd bring to everyone's attention. Here is the full text. Read below for our Two Cents:

Credit Suisse

We are expanding coverage of the business-development-company sector.

We are initiating on PennantPark Investment (ticker: PNNT) at Outperform, and Medley Capital (NYSE:MCC), Fifth Street Finance (NYSE:FSC) and BlackRock Kelso Capital (NASDAQ:BKCC) at Neutral. We are also downgrading Hercules Technology Growth Capital (NASDAQ:HTGC) to Underperform.

View the full PNNT chart at Wikinvest

Our two preferences within the business-development-company (NYSE:BDC) sector are for higher returns, with a focus on returns on equity (ROE), and confidence in the coverage of the dividend.

The BDCs should deliver an 11.2% ROE in 2013, a 70 basis-point increase from 2012. We expect Medley and Fifth Street to deliver the highest ROE in 2013 through both strong return on assets and leverage.

With the BDC structure this higher ROE will flow through to investors as a dividend. A key challenge for the BDC business model is maintaining appropriate amounts of leverage to optimize ROEs to shareholders.

We view coverage of the dividend through net investment income as a key measure of the quality and sustainability of the current level of dividends. We see Medley Capital, Hercules and PennantPark as well positioned to cover the current dividends in 2013 with possible dividend increases from Medley Capital and Hercules.

We expect continued interest in the higher-yielding sectors like the BDCs as this current low-rate environment persists. The BDC sector is cheap versus history on a relative basis, but in line on an absolute basis on dividend yield and price-to-book.

We believe the absolute level of valuation will act as more of a ceiling for the sector and limit the majority of the total return to the dividend yield.

BDC REPORTER TWO CENTS: This is written in analyst-ese, but suggests that Credit Suisse thinks most BDC dividend pay-outs will hold or increase in the months ahead, but don't expect prices to rise much. (The same is being said across the leveraged debt space. We've been reading similar comments about junk bond and floating rate loan investments).

We don't know if analyst calls such as these are useful, but the wording of the release does suggest that Credit Suisse is highly focused on the earnings of the BDC sector, and where those earnings are versus the dividend. The theory is that if the BDCs continue to make similar or higher earnings than they are today, the dividend will be sustained, and the value of the investment will be maintained. In the short run that's all well and good, but somewhat obvious.


More interesting would be a discussion of what might happen to earnings and the dividend in a modest recession, with resulting higher bad debts in the portfolio. It is easy for most every BDC to make money now when the sun is shining, but what happens when a little rain doth fall ? Amongst the names mentioned above, our bet would be on the one name Credit Suisse reduced to Underperform: Hercules Technology. This mid-sized, specialty BDC has a good track record of minimizing credit losses during difficult times. Moreover, the Company has a very large portfolio of borrowers, which diversifies risk. HTGC has adopted a relatively conservative dividend policy so a modest drop in earnings due to a recession, should it occur, would not immediately impact the distribution. Furthermore, the Company does have considerable capital resources available to deploy, whose earnings might offset any losses. Finally, with virtually all debt outstanding in the form of SBIC and Term debt, HTGC won't be pressed into selling assets at fire sale prices to avoid defaulting under it's Revolver loan agreements.

If we ranked the five names mentioned by Credit Suisse as to how well they would weather a pro-forma recession in the near future, we would give a thumbs up (trademark pending) to Hercules Technology, Pennant Park Investment (mostly because of it's track record in the last recession even though that credit history has been tarnished somewhat of late). We would be more cautious about Fifth Street Finance, and Medley Capital (mostly due to a short history as a public company and suggestions in their initial prospectus that they had credit issues during the Great Recession when they were operating as a private partnership). Bottom of the list would be BlackRock Kelso, which is competing in a very unfavorable segment of the market and has racked up substantial bad debts in recent years, and has limited "dry powder". Only time and a recession will tell if we are right, but that's our Two Cents.

We are Long Hercules Technology, Fifth Street Finance and Pennant Park Investment. We have no position in medley Capital. We are short BlackRock Kelso.

Disclosure: I am long PNNT, FSC, HTGC.

Additional disclosure: I am short BKCC