Assessing Risk Versus Reward For High Yield BDCs

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Includes: AINV, ARCC, BDCS, HTGC, MAIN, OCSL, PSEC
by: John Dowdee

Summary

BDCs typically provide yields in excess of 9%.

BDCs are substantially more volatile than the S&P 500.

Over the bear-bull cycle, some BDCs outperformed the S&P 500 on a risk-adjusted basis.

Over the past 3 years, BDCs generally under-performed the S&P 500.

Most people have heard success stories associated with venture capital and private equity firms. These firms typically offer startup capital and financing to small enterprises and if these projects meet with financial success, the investors are richly rewarded. Unfortunately, most retail investors are unable to participate due to strict income and net worth requirements. However, in 1980 the Government provided an alternative path for small investors by amending the Investment Act of 1940 to create a new entity called a Business Development Company (BDC).

A BDC is an investment company that provides financing to small and mid-sized private companies. The BDC may either issue loans or take an equity stake in the up-and-coming enterprises. Thus, BDCs have some of the characteristics of venture capital and private equity firms. One of the benefits of BDCs is that they can easily be purchased on the open market just like any other stock.

As a retiree looking for income, I was drawn to the mouthwatering yields offered by these BDCs. It is common for these companies to offer yields of 9% or more. However, total return and risk are as important to me as income. Therefore, I decided to analyze BDC to assess if the yields translated into high total return and to determine how much risk I had to assume to reap the rewards.

It should be noted that BDCs are complex companies that are difficult to evaluate. In the spirit of full disclosure, BDCs are a relatively new asset class for me and I am not experienced in valuing these companies on a fundamental basis. For those readers that would like a more in-depth coverage, I would recommend the Seeking Alpha author BDCBuzz. He has written a multi-part series that provides a wealth of information on the economic forces that drive BDCs and where they may be headed in the future. My focus is different in that I will be analyzing how well these companies have performed in the past. Before I provide the results of my analysis, I thought it might be productive to review some of the characteristic of BDCs.

  • Most BDCs elect to be treated as a Regulated Investment Company (RIC), which means among other things that they must distribute 90% of their taxable income each year. Thus, BDCs are known for their large yields but like all companies, dividends are not guaranteed and may be cut if taxable income decreases.
  • BDCs typically borrow long term and lend short term using floating rate loans based on the LIBOR. Since most of the loans are floating, BDCs are less sensitive to rising rates than some of the other high yielding assets. The profitability of BDCs is dependent on the spread between long and short term rates. In this respect, BDCs are subject to some of the same forces that were discussed in my article on mortgage REITs.
  • BDCs invest in private companies which are not liquid. If funds are needed for unexpected expenses, it may be difficult to raise cash without taking significant losses. It is important that BDCs be managed by experienced private equity professionals.

For my analysis, I chose some of the most popular and liquid BDCs. I wanted to see how these stocks reacted during a bear market so I required a history back to October, 2007 (the market top before the 2008 collapse). The following 5 companies passed my screens (note that I did not include American Capital (NASDAQ:ACAS) because the company is the midst of a reorganization and is currently not paying dividends).

  • Ares Capital Corporation (NASDAQ:ARCC). This BDC invests primarily in senior debt and private middle-market equities. This is one of the largest BDCs with a market cap of $5 billion and over $9 billion in total assets. It is externally managed by Ares Capital Management, a subsidiary of Ares. It has a diversified portfolio across multiple asset classes and yields 9.64%. The price to book value is 0.9.
  • Prospect Capital Corporation (NASDAQ:PSEC). Prospect Capital is a leading provider of senior loans and equity capital to middle-market companies. With a market cap of $3 billion, it is the second largest BDC. It is diversified over 140 investments in a wide range of industries and geographic areas. About 75% of the portfolio are first and second lien loans. The yield is a whopping 15.7% and the price to book value is 0.8.
  • Apollo Investment Group (NASDAQ:AINV). The business model is to invest in senior and mezzanine debt of middle-market companies. It has a portfolio valued at $3.7 billion consisting of 63% secured debt, 17% unsecured debt, 9% structured products, and 11% preferred equity. The focus is on business services, oil and gas, and aviation. It has a market cap of $1.7 billion and yields 11.1%. The price to book value is 0.8.
  • Hercules Technology Growth Capital (NASDAQ:HTGC). This BDC specializes in providing financing and equity growth capital to technology related companies. It has over a billion dollars in total assets and has assisted more than 300 companies since its inception in 2003. The portfolio is spread over different technologies ranging from energy to life sciences. The company has a market cap of $900 million and yields 8.65%. The price to book value is 1.4.
  • Main Street Capital (NYSE:MAIN). This BDC provides debt and equity financing to the lower-middle and middle-market companies. The lower-middle companies generally have annual revenue between $10 million and $150 million. MAIN has a market cap of $1.3 billion and yields 7.2%. The price to book ratio is 1.3.

To see how these BDCs compared with the overall stock market, I included SPDR S&P 500 (NYSEARCA:SPY) in the analysis. SPY is an ETF that tracks the S&P 500 index. SPY has an expense ratio of 0.09% and yields 1.9%.

To assess total return and risk of the BDCs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component stocks. I used a look-back period from October 12, 2007 to January 15, 2015, a period of over 7 years. The Smartfolio 3 program was used to generate the plot shown in Figure 1.

Figure 1. ETF Portfolio risks versus rewards since October, 2007

The plot illustrates that these high yielding ETFs have booked a wide range of returns and volatilities since 2007. To better assess the relative performance of these stocks, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Some interesting observations are evident from the plot.

  • BDCs were substantially more risky (higher volatility) than the S&P 500
  • MAIN had the lowest volatility and AINV had the highest
  • MAIN, HTGC, and ARCC all had about the same total return but on a risk-adjusted basis, MAIN was the best performer. These three BDCs also outperformed SPY on a risk-adjusted basis.
  • AINV booked the worst risk-adjusted performance.

In addition to good yields, BDCs have traditionally been valued because they were believed to be alternative invests that provided diversification. To validate this belief, I checked to see how much diversification you obtained from including BDCs in a general equity portfolio. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected stocks and funds. The results are provided as a correlation matrix in Figure 2. As you might expect, BDCs are not highly correlated with one another or with the SPY. MAIN had the lowest correlations ranging from 20% to 30%, likely due to its emphasis on the lower-middle tier of companies. AINV had the highest correlations within the group but the correlations were still less than 75%. Overall the BDCs lived up to their reputation of providing good diversification.

Figure 2. Correlation matrix since October, 2007

To check how the performance may have changed over a shorter, more-bullish period of time, I reduced the look-back period to 3 years and re-ran the analysis. With the shorter time period, I was able to add two more securities into the analysis. These securities are summarized below.

  • Fifth Street Finance (FSC). This BDC provides equity financing to small and mid-sized businesses. The company focuses on first liens, second liens, and mezzanine financing coupled with equity investments. The company has a market cap of $1.2 billion and yields 13.3%. The price-to-book value is 0.8.
  • E-TRACS Well Fargo Business Development Company Index (BDCs). This is an ETN that tracks the Wells Fargo BDC Index, which consists of 114 BDCs selected from the NYSE and NASDAQ. The top holdings are ACAS (10.3%), ARCC (10%), PSEC (9.7%), AINV (9.1%), and FSC (6.8%). This fund has an expense ratio of 0.85% and yields 8.18%. This fund is relatively illiquid, trading only about 35,000 share a day, so limit orders should be used when purchasing this ETN.

The results of the analysis for the 3 year look-back are shown in Figure 3. In this figure I have also added a blue line representing the Sharpe Ratio associated with BDCs.

Figure 3. Risk versus reward over past 3 years

During the past 3 years, the S&P 500 has been in a strong bull market but BDCs have not fared nearly as well. Last year in particular was a tough year for BDCs. The S&P 500 and Russell dropped BDCs from their indexes causing a selloff. Then in December, the BDCs sold off again due to concern over exposure to the energy sector, weakness in high yield markets, and tax-loss selling. Overall, BDCs ended 2014 with an average loss of about 5.4%. This lack of performance relative to the S&P 500 is dramatically illustrated in the figure.

Comparison of the individuals BDCs is more enlightening than comparing with SPY. All the BDCs were still more volatile than the S&P 500 but the BDCs fund was only slightly more risky than the general stock market. Only HTGC and MAIN were able to outperform BDCS on a risk-adjusted basis. The best performers continued to be HTGC and MAIN. The new kid on the block, FSC, had the worst performance.

Bottom Line

As I emphasized earlier, I have only looked at history and have not attempted to use fundamentals to project performance into the future. However, based on the data in the analysis, it is clear that BDCs are highly volatile and are only suitable for investors with a healthy risk tolerance. They do however, provide diversification if included in a general equity portfolio. If you would like to add this asset class to your portfolio, I would suggest considering either HTGC or MAIN. If you are more risk adverse, you should also consider BDCs.

Disclosure: The author is long BDCS.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.