Understanding BDCs (Part 2): Charge-Off Rates, Internal/External Management, Historical Share Valuation

| About: UBS ETRACS (BDCL)

Summary

Market pricing of internally managed BDCS has correlated with underwriting performance, according to annualized portfolio charge-off rates.

Market pricing of externally managed BDCs has had no apparent correlation with charge-off rates.

Big question #1: Why could some BDCs recover lost NAV while others could not, in the wake of economic shocks?

Big question #2: Do internally managed BDCs consistently behave differently compared to externally managed BDCs?

My previous article "Part 1" made claims that after this examination, must be corrected.

Update: The raw data thumbnails were broken, so I've replaced them with a link to the original spreadsheet: click here to see it.

Part 1 of this study elicited some advice from Richard Lejeune, who basically said "get more data, and be very careful about what you claim". This second part will include more data, and add more nuance to my claims examining ten BDCs and their market pricing patterns as a function of time and charge-off rates. They are:

Internally managed: (NYSE:MAIN), (NYSE:TCAP), (NASDAQ:KCAP), and (NASDAQ:HTGC).

Externally managed: (NASDAQ:ARCC), (NASDAQ:PSEC), (NASDAQ:AINV), (NASDAQ:BKCC), (NASDAQ:PNNT), and (NASDAQ:TICC).

Analysis Methods

This study will examine BDC performance metrics for two periods: IPO to 2012 (end), and 2013 (start) to 2016 (end), to uncover how the market has priced BDCs without the benefit of hindsight. 2012 (end) is a useful cutoff date for several reasons:

  • The subprime mortgage crisis approximately ended in 2009, and the European sovereign debt crises had been largely "contained" by the 2012 (end).
  • By the end of 2012, the US economic recovery had genuine signs of progress.
  • 2013 (start) - 2016 (end) were four years of stable US economic growth.

The transition from poor to good economic growth should expose corresponding shifts in BDC charge-off rates and share pricing.

It is common knowledge that BDCs were hurt during the 2007 crisis and 2015 oil price collapse because they held MBSes, CLOs, and oil & gas sector investments. For the sake of fully understanding charge-off rates as an isolated variable, BDC asset portfolios will not be discussed in detail here.

All data was taken from 10-K and 10-Q filings. BDCs with market cap under $100M were excluded. For the BDCs analyzed here, charge-off rates from years during which their market caps were under $100M were excluded from Annualized Charge-off Rate calculations. Calculations were done in a manner identical to that from Part 1 of this study.

Internally Managed BDCs - Charge-Off Rates, NAV/share, and Market Pricing

2008 (start) - 2012 (end):

The market appeared to price these BDCs in accordance with NAV performance: the P/B ratio appears to track the speed and direction of book value fluctuations.

MAIN

TCAP

HTGC

KCAP

Annualized Charge-off Rates

Beginning - 2012 (end)

-1.89%

-0.06%

1.59%

4.20%

2012 end P/B

1.64

1.67

1.14

1.17

NAV/share performance had clearly bifurcated by 2012 (end). P/B ratios suggest that MAIN and TCAP were "first class", whose charge-off rates were below the average middle market loan charge-off rate of ~1.5%, while HTGC and KCAP were "second class" BDCs whose charge-off rates were much higher.

Comparing KCAP and HTGC pricing patterns: until 2011 (start), KCAP lost book value more quickly than did HTGC, implying KCAP had a higher charge-off rate. At 2011 (start):

  • KCAP traded at P/B = 0.85
  • HGTC traded at P/B = 1.091

Continuing to 2012 (end), their NAV/share figures stabilized, and their P/B multiples stabilized.

2013 (start) - 2016 (end):

After 4 more years performance track record, pricing shifted. Charge-off rates for this period are in the next table:

  • MAIN's period charge-off rate rose closer to par (-0.19%) while continuing to grow NAV/share, and its P/B rose slightly to 1.72.
  • TCAP's period charge-off rate rose from -0.06% to 1.07%, and its P/B fell from 1.67 to 1.21.
  • KCAP's period charge-off rate rose "slightly" from 4.20% to 5.73%, and its P/B fell from 1.17 to 0.73.
  • HTCG's period charge-off rate fell from 1.59% to 0.04%, and its P/B rose from 1.14 to 1.42.

KCAP's P/B fall from 1.17 to 0.73 reflects the market's charge-off expectations given the 4 more years of underwriting track records.

MAIN

HTGC

TCAP

KCAP

Annualized Charge-off Rates

2013 start - 2016 end

-0.19%

-0.04%

1.07%

5.73%

2016 end P/B

1.72

1.42

1.21

0.73

These shifts in price premiums are correlated very well with period charge-off rates. If charge-off rates rise, P/B ratios fall, and vice versa.

If this interpretation is correct, then MAIN appears to be currently overvalued. Perhaps MAIN's premium compared to HTGC can be attributed to the market's memory of MAIN's superior underwriting from several years ago, and an expectation that it would continue.

Externally Managed BDCs - Charge-Off Rates, NAV/share, and Market Pricing

2008 (start) - 2012 (end)

Externally managed BDCs do not appear to be priced in the same way as internally managed BDCs. Immediately after the chaos of the financial crisis, starting in 2010 (start), all of these BDCs were priced at approximately NAV during this period. This consistency in pricing is not consistent with their underwriting performance during this period:

ARCC

PSEC

PNNT

BKCC

AINV

TICC

Annualized Charge-off Rates

Beginning - 2012 (end)

-0.08%

1.69%

4.88%

4.53%

5.47%

3.40%

2012 end P/B

1.09

1.00

1.06

1.08

1.03

1.02

This result directly clashes with results from investigating internally managed BDCs, and raises many questions:

  • ARCC: NAV/share recovered dramatically during 2010 Q2. Why?
  • PSEC, AINV, BKCC, TICC: NAV/share collapsed in 2009 and did not recover - why did P/B multiples non reflect this after the fact?
  • PNNT: NAV/share rebounded during 2009 Q1. How did this happen?

Comparing the P/B charts for internally and externally managed BDCs, we can see that externally managed BDCs were hit harder by the 2007 crises. Examining their asset portfolios may later shed light on this.

2013 (start) - 2016 (end)

The reason for the very stable NAV/share figures during this period is probably because this was a time of economic growth.

  • ARCC stands out as having preserved its NAV almost perfectly during this period.
  • PSEC, PNNT, BKCC, AINV, and TICC all lost NAV/share from 2015 up to now, coinciding with the oil price collapse.

ARCC

PSEC

PNNT

BKCC

AINV

TICC

Annualized Charge-off Rates

2013 start - 2016 end

-0.04%

1.97%

1.68%

2.42%

3.30%

7.42%

2016 end P/B

0.97

0.88

0.87

0.87

0.86

0.93

Questions that immediately arise from the valuation & NAV graphs and the above charge-off rate table are:

  • ARCC and TICC: Why are they currently valued at the same P/B multiples, even though ARCC had an exemplary underwriting performance, while TICC had the worst charge-off rates out of this group?"
  • TICC: How did NAV/share recovered somewhat starting on 2016 Q2?

I believe that the explanatory power of the annualized charge-off rate has been exhausted. Charge-off rates correspond with historical market valuations of internally managed BDCs, but not externally managed ones.

Further investigations must examine the composition of these BDCs over time, and look for exactly how and where the NAV was lost, and find out how some BDCs could recover their asset values pre-crisis levels. The next section will summarize the questions raised by this part of the study.

Future Investigation Questions

1. Why have these internally managed BDCs tended to trade according to charge-off rates and NAV/share changes, but externally managed BDCs did not trade in the same way?

2. Why have these externally managed BDCs been priced at almost the exactly the same P/B multiples since 2008 (start), despite their enormously different underwriting outcomes?

3. ARCC: NAV/share recovered dramatically during 2010 Q2. Why?

4. PSEC, AINV, BKCC, TICC: NAV/share collapsed in 2009 and did not recover - why did P/B multiples non reflect this after the fact?

5. PNNT: NAV/share rose during 2009 Q1. How did this happen?

6. Why are ARCC and TICC are currently valued at the same P/B multiples, even though ARCC had an exemplary underwriting performance, while TICC had the worst charge-off rates out of this group?

7. TICC: NAV/share recovered somewhat starting on 2016 Q2. Why?

Stay tuned down the road for answers to some of these questions!

Any and all feedback is welcome.

Disclosure: I am/we are long ARCC.

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.

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