This article is a follow-up to my previous "BDC Risk Articles" and "BDC Pricing Articles" discussing methods to assess relative risk, which is necessary for valuing business development companies ("BDCs").
Previous articles in this series:
- Introduction: Changes to my BDC Investment Strategy and Historical Yield Spreads
- Part 1: BDC Pricing vs. Net Asset Values
- Part 2: Assessing Dividend Coverage
Most retail investors do not have access to research that properly assesses relative risk for BDCs and how it applies to pricing. This series is my attempt to help BDC investors properly value investments in a sector that is notoriously opaque. BDC stock prices can be volatile, providing opportunities for investors that have identified proper values based on risk and potential dividend returns. Throughout this series of articles, I will discuss some of my pricing methodologies, including general market timing for purchases and assessing relative risk and dividend coverage, which are primarily responsible for driving a wide range of values for BDCs. It is important to realize that BDCs do not report consistently, so investors need to look beyond changes to net asset value ("NAV") per share and dividend coverage from reported net investment income ("NII").
Assessing Risk for BDCs:
The following are some of the methods that I use for comparing risk profiles among BDCs:
- Portfolio credit quality: vintage analysis, concentration issues, etc.
- Exposure to cyclical sectors, structured products (CLOs and SLPs), subordinated debt
- The amount of "true first-lien" loans
- Strong dividend coverage versus "reaching for yield"
- Stable versus declining NAV per share
- Access to capital: current leverage, SBIC availability, ability to issue equity
- Fee structures and conflicts of interest versus internally managed
- Inside and institutional ownership
- Quality of management
Portfolio Credit Quality
One of the best approaches to assessing risk in a BDC portfolio is using a "vintage analysis" that takes into account many things including the time frame that each loan was originated as well as asset class, maturity, directly originated vs. syndicated, sector, PIK and cash yields. Most likely, BDCs that were lending during times of less protective covenants and higher leverage multiples while maintaining higher-than-average yields were making riskier loans at the time.
Assessing which vintages are potentially riskier than others is an evolving art and there are few key indicators that I use including historical market liquidity levels, default rates, leverage multiples and covenant light trends. More importantly, I compare the cash and PIK yields of each loan by the time frame that they were originated but also taking into account the asset class and company sector. Specifically, I am looking for "above market" yields that could imply higher risk. Another important indicator is loans that should have been refinanced at lower rates and are past their "prepayment penalty" windows. This would include loans that have much higher than current market yields and could easily be refinanced unless the portfolio company has potential credit issues. After going through this analysis each quarter, there is a clear trend with riskier vintages and ongoing or upcoming credit issues. Many of the BDCs that I have considered to have higher risk portfolios are already experiencing credit issues, but there are a few that could worsen.
Not All First-Lien is Equal
As mentioned in previous articles, Medley Capital (NYSE:MCC) grew the portfolio at potentially riskier periods and is an example that not all BDCs with large amounts of first-lien debt are necessarily 'safer' than others. Before the recent credit issues, MCC had a portfolio of almost 70% senior secured first-lien debt, that is still around 65%, but over the last 9 quarters declining credit quality has resulted in two dividend cuts and a 25% decline in NAV per share as shown in the chart below.
Strong dividend coverage versus "reaching for yield"
Another key factor is the need to "reach for yield" to sustain the current dividend. Some BDCs are actively rotating the portfolio into higher yield investments that typically involve more risk. Many BDCs have been experiencing increased credit issues and others could begin to see additional non-accruals in 2017.
BDCs that can safely cover dividends during worst case and lower yield scenarios have many advantages over other BDCs including being more selective with investments. This could include only investing in higher credit quality companies with lower leverage multiples, having stronger protective covenants and taking a higher position in the capital structure. This is what I refer to as "true first-lien."
Many of the BDCs that reduced dividends in 2016, will have much less need to reach for yield in 2017 including Apollo Investment (NASDAQ:AINV), Capitala Finance (NASDAQ:CPTA), CM Finance (NASDAQ:CMFN), Garrison Capital (NASDAQ:GARS), Horizon Technology Finance (NASDAQ:HRZN), KCAP Financial (NASDAQ:KCAP), PennantPark Investment (NASDAQ:PNNT), Triangle Capital (NYSE:TCAP), and THL Credit (NASDAQ:TCRD).
Please see the following articles in my "The Need to Reach for Yield: BDC Risk Profiles" series:
BDCs will begin reporting Q4 results next week. It is important for investors to "read between the lines" and listen to earnings calls looking for the trends to dividend coverage discussed in Part 2 of this series. For all previous articles on dividend coverage potential, risk rankings, interest rate discussion, expense ratios, the timing of BDC purchases, suggested BDC portfolios, my upcoming/historical purchases and current positions, please see "Index to Free BDC Research."
Stable versus declining NAV
Changes in NAV per share are not always a clear indicator of historical credit issues because there are many items that impact NAV including over or under paying the dividend, equity issuances and general changes in values for assets and liabilities. It is also important to recognize the difference between "realized" and "unrealized" gains and losses. BDCs that have recently cut dividends due to credit issues, likely had larger amounts of realized losses from investments sold or written off. Many higher quality BDCs have had previous NAV per share declines mostly related to unrealized losses and marking assets down to reflect general market pricing rather than changes to credit quality. Please see my previous "BDC NAV" articles for more.
Relatively stable NAV per share: Monroe Capital (NASDAQ:MRCC), Golub Capital BDC (NASDAQ:GBDC), Main Street Capital (NYSE:MAIN), Fidus Investment (NASDAQ:FDUS), TPG Specialty Lending (NYSE:TSLX), Saratoga Investment (NYSE:SAR), Ares Capital (NASDAQ:ARCC), PennantPark Floating Rate Capital (NASDAQ:PFLT), Solar Capital (NASDAQ:SLRC), Hercules Capital (NASDAQ:HTGC) and TCP Capital (NASDAQ:TCPC).
Declining NAV per share: MCC, CPTA, CMFN, GARS, PNNT, KCAP, PNNT, TICC Capital (NASDAQ:TICC), Fifth Street Finance (NYSE:FSC) and BlackRock Capital Investment (NASDAQ:BKCC). It is important to note that many of the BDCs with larger declines in NAV per share cut dividends in 2016 as discussed earlier.
It should be noted that AINV and PNNT had NAV declines related to oil exposure. Gladstone Capital (NASDAQ:GLAD) also has higher oil-related exposure that is mostly "true first-lien" helping to preserve shareholder capital. TICC and KCAP had declines related to collateralized loan obligation ("CLO") exposure. Prospect Capital (NASDAQ:PSEC) has 17% exposure to CLOs as well but has retained higher marks:
"Our structured credit portfolio consists entirely of majority owned positions. Such positions can enjoy significant benefits compared to minority holdings in the same tranche"
Fee structures and conflicts of interest versus internally managed
The older incentive fee structures can incentivize management to take on increased risk with investors' capital. Management benefits from higher yields (through higher income incentive fees) with less risk related to future credit issues because capital losses are not included when calculating income incentive fees. This could lead to management taking higher risks (for increased yields) due to being insulated from potential capital losses when calculating the income portion of the incentive fees. Ultimately, management could receive higher fees during periods of declining NAV per share, resulting in lower total returns to shareholders. Please see my previous "BDC Fee Structure" articles for more.
The following chart is from FS Investment Corporation (NYSE:FSIC):
Inside and institutional ownership
Please see my previous "Insider & Institutional Ownership" articles for more.
Assessing the quality of management
This is likely the most important part of BDC analysis as management is responsible for building a portfolio to deliver returns to shareholders while protecting the capital invested. BDC management controls all the levers including the quality of the origination/credit platform, managing the capital structure with appropriate leverage, meaningful share repurchases, accretive equity offerings and dividend policy, creating an efficient operating cost structure and willingness to "do the right thing" by waiving management fees or having a best in class fee structure that protects returns to shareholders. Many of the indicators previously discussed are directly tied to the quality of management including:
- Portfolio credit quality driving stable versus declining NAV
- Dividend increases versus decreases over the last two years
- Reaching for yield
- High water mark fee structures
- Previous management trust issues
Risk Rankings: After performing the previously discussed analysis on each BDC, I assign a risk rank from 1 to 10 with 10 implying the safest. The rankings are focused on capital preservation NAV per share stability as well as portfolio strength to sustain dividend coverage. This includes the ability for the portfolio to retain value during an economic downturn and/or rising interest rates. Both these scenarios could put pressure on cash flows of portfolio companies and the ability to support debt and interest payments.
So how are BDCs valued?
Most investors choose BDCs as an income-oriented investment rather than for capital gains. Consequently, BDCs are usually valued based on potential risk-adjusted returns to shareholders, which is measured by assessing capital preservation, which is closely tied to the ability to sustain its dividend payment. In the remaining articles in this series, I will cover:
- BDC pricing based on yield, multiples and total returns
- Target pricing ranges for BDCs
- Limit orders and timing
To be a successful BDC investor:
- Identify BDCs that fit your risk profile (there are over 50 publicly traded BDCs, please be selective)
- Diversify your BDC portfolio with at least 5 companies
- Establish appropriate price targets based on relative risk and returns (mostly from dividends)
- Be ready to make purchases during market volatility and look for opportunistic buying points
- Closely monitor your BDCs, including dividend coverage potential and portfolio credit quality
Personal note: I have updated my positions to reflect changes in my holdings, but please keep in mind that some of the positions are very small and mostly for research purposes. There are over 50 publicly traded BDCs and I try to cover as many as possible but I do not have the bandwidth to include each company for each article.
Disclosure: I am/we are long ABDC, AINV, ARCC, BKCC, FDUS, FSC, FSFR, FSIC, GAIN, GARS, GBDC, GLAD, GSBD, HCAP, HTGC, MAIN, MCC, MRCC, NMFC, PFLT, PNNT, PSEC, SAR, SLRC, SUNS, TCAP, TCPC, TPVG, TSLX.
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.