BDC Risk Profiles: Part 9 - Credit Quality

by: BDC Buzz

This is Part 9 of a series of articles that compare the risk profiles for the 25 business development companies ("BDCs") recently covered in my "The Good, The Bad, And The Maybe" series and focuses on the portfolio yields and credit quality trends for Solar Senior Capital (NASDAQ:SUNS), Horizon Technology Finance (NASDAQ:HRZN), PennantPark Floating Rate Capital (NASDAQ:PFLT), Golub Capital (NASDAQ:GBDC), and Fifth Street Finance (FSC).

Previous Risk Profile Articles:

When evaluating BDCs I focus on five general criteria: profitability, risk, payout, analyst opinions, and valuation. When assessing risk relative to other BCDs, I take into account many factors including: portfolio credit quality, investment asset classes, diversification, non-accrual rates, portfolio yield, fixed/variable rate loans, leverage, interest rate sensitivity, volatility ratios, market capitalization, insider ownership and trends, institutional ownership and trends, and management/operational history. I will cover each of these areas as well as the other factors I use to rank the risk profiles for each BDC. Below are the current risk rankings for each BDC and for the most recent overall rankings see "Latest BDC Rankings For Q1 2013".

Portfolio Credit Quality

Portfolio credit quality is one of the most important indicators for many areas of BDC analysis, including earnings predictability, NAV growth, dividend sustainability, valuation, and risk profile. BDCs have many different methods of indicating the credit quality of the portfolio and are often inconsistent, making it difficult to compare. A few measures that are consistent but not necessarily the best are average portfolio yield and asset class mix, but I will cover portfolio leverage and interest coverage ratios as provided by each BDC.

Below is a table showing the average 'portfolio grades', portfolio yields, the general direction of yields and credit quality, as well as the debt to EBITDA ratio (described below) when it is available. I did not include interest coverage ratios because very few BDCs disclose them, and I will continue to add measurements as they become available. The "Quarterly Interest & Dividends percentage" metric is the amount of dividend and interest income (excluding income resulting from amortization of fees, discounts, or other income) in the most recent quarter annualized and divided by the average fair value of the income producing investments during that quarter. Each BDC is placed into groups based on weighted average yields, leverage ratios of the portfolio companies, credit quality trends and yield direction.

The portfolio debt/EBITDA measures the weighted average portfolio debt as a multiple of EBITDA. As discussed in Part 7, debt to EBITDA ratios greater than 4 or 5 usually indicate that a company is likely to face difficulties in handling its debt burden, and is less likely to be able to raise additional loans required to grow and expand the business, and it can result in a lowered credit rating. The chart below indicates how SUNS classifies different investments with higher rates of return and higher leverage multiples.

Solar Senior Capital

SUNS has the lowest weighted average yield of 7.0% on its debt investments and has decreased yields from 8.5% in 2011.

Part of the decrease in yield was explained in the most recent earnings call the CEO stated:

Although spreads have tightened in credit with the (inaudible) we continued to find attractive opportunities in the senior secured space for commercial banks to become less active. In the new issue market during the first quarter, the average debt multiple for liquid highly levered loans was 4.7 times and the new and the average new issue yield was 5% resulting in a yield of less than 1.1% for debt multiple of EBITDA. For our Q1 investments and the fair value weighted average basis, the leverage through our security was just 3.9 times and the yield was 6.2%, which equates to a yield of 1.6% for each step multiple of EBITDA.

Currently SUNS has an average cash interest coverage of 3.3x across its portfolio, which is better than most BDCs.

Horizon Technology Finance

HRZN recently decreased its average yield on debt investments to 12.8% after remaining mostly flat over the last two years as shown in the chart below:

HRZN uses a credit rating system which rates each loan on a scale of 4 to 1, with 4 being the highest credit quality rating. Recently the weighted average credit rating has been declining as seen in the chart below:

PennantPark Floating Rate Capital

PFLT is another BDC with a low average yield on debt investments of 8.8% but has increased its yield slowly since 2011. I use interest and dividend income only to measure yield of 8.1% for the most recent quarter.

The PennantPark BDCs (including PNNT) disclose leverage metrics on a quarterly basis. PFLT currently has weighted average portfolio debt to EBITDA of 3.6x with a weighted average interest coverage of 3.4x, both of which are healthy ratios relative to other BDCs.

In a recent earnings call the CEO was asked a question regarding how much "senior stretch" investments are in the portfolio and what is the yield on those investments versus traditional first lien secured investments, and replied:

Well, it's a great question, because you're trying to differentiate what is viewed as a traditional firstly lien versus a stretch. And (inaudible) hold just traditional first lien stopped three times. Does traditional first lien stop at four times? The stretch go to four times, the stretch go to five times. These definition or meanings are hard to really pinpoint and the market frankly has moved. Typically a year ago first lien would be the three times debt to EBITDA. It started in many cases pick it up four times. And that's not you to stretch here, that is plain old first lien bank debt have four times. So again I am not giving you a rough precise answer because these things are fluid and we do disclose as we did in our prepared remarks that debt to EBITDA on overall portfolio basis is 3.6 times and that includes some of our opportunistic second lien and sub-debt investments.

I think Arthur Penn's response is in line with many of the earnings calls as well as this section of my series regarding credit quality and increased leverage multiples. Obviously, PFLT has one of the better risk profiles with a favorable asset class mix and strict underwriting standards, but pays a lower dividend due to the lower portfolio yield. Later in the call, Mr. Penn stated

So we feel really good about that in a market where traditional first lien is starting to get the four times, non-stretch first lien is starting to get to four times and we have portfolio, which includes sub-debt and second lien at 3.6. We feel really comfortable with the credit quality.

Golub Capital

GBDC has increased its yield on investments from 8.1% in 2009 to 9.5%, which is still considered low.

Performance ratings on the investment portfolio have remained stable for the past several quarters, and over 90% of the investments in its portfolio had a risk rating of 4 or higher (5 being the highest with borrower performing above expectations) as of March 31, 2013.

Fifth Street Finance

FSC has been actively reducing its yield on investments, as seen in the chart below. I use interest and dividends only to determine yield on investments, which was 10.3%.

Three independent valuation firms collectively provide opinions on about 80% of investments every quarter to the Board with the most results in the chart below showing 98% of investments performing within or above expectations as well as debt to EBITDA ratios with an average of 4.1x.

Portfolio asset quality has improved due to a long-term shift to first lien loans with larger borrowers and sponsors as seen in the chart below:

Portfolio credit quality, portfolio yields, interest rate sensitivity, fixed/variable rate investments, industry diversification, market capitalization, insider and institutional ownership, leverage, volatility ratios, portfolio investment grades, and non-accruals are many of the considerations when evaluating risk for BDCs. In the remainder of this series, I will cover the portfolio credit quality for the remaining 10 BDCs, using the metrics they provide, as well as other risk considerations.

For more information about BDCs and how I evaluate them, please see this article.

Disclosure: I am long PFLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.