This article is a follow-up to my previous "BDC Risk Articles" discussing methods to assess relative risk, which is necessary for evaluating business development companies ("BDCs"). As BDCs continue to report December 31, 2016 results, investors should be watching for potential portfolio credit issues that could lead to credit rating downgrades.
Lower ratings would likely drive higher borrowing expenses that could put downward pressure on net interest margins and dividend coverage over the coming quarters. Most retail investors do not have access to research that properly assesses relative risk for BDCs and how it applies to pricing. As discussed in "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.
After going through each of these assessments/analyses, I assign a risk rank from 1 to 10 with 10 implying the safest. The rankings are focused on capital preservation and net asset value ("NAV") per share stability as well as portfolio strength to sustain dividend payments. This includes the ability for the portfolio to retain value during an economic downturn and/or rising interest rates.
Both of these scenarios could put pressure on cash flows of portfolio companies and the ability to support debt and interest payments. For all previous articles on risk rankings, dividend coverage potential, interest rate discussion, expense ratios, the timing of BDC purchases, suggested BDC portfolios, my upcoming/historical purchases and current positions, please see "Index of BDC Articles by Topic."
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. Assessing which vintages are potentially riskier than others is an evolving art and I look for "above market" yields that could imply higher risk as well as 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.
Fifth Street Finance (FSC) and Medley Capital (NYSE:MCC) are excellent examples of BDCs that were reaching for yield, and through my vintage analysis, I was able to determine that these companies had riskier profiles. Specifically for FSC, I tried to warn investors through discussing many of the potential risks, including the following articles:
- FSC: Continued Credit Issues Driving Losses For Shareholders (11-30-16)
- FSC: When to Sell? (1-26-16)
- Investor Activism Continues In The BDC Sector: Part 1 (11-19-15)
- FSC: Will New Management Do the Right Thing? (7-30-15)
Please read the comments in the articles linked above as many of them were critical of the information being presented and provide examples of what to look out for when investing in BDCs. FSC has cut its dividend three times over the last few years and credit issues have been driving lower net investment income, dividend coverage, NAV and stock price.
As anticipated, FSC continues to have portfolio credit issues driving lower earnings and NAV per share and recently resulting in a 30% dividend reduction (now paid quarterly rather than monthly):
"In addition to our previously declared monthly dividend of $0.06 per share, which is payable on February 28, 2017 to stockholders of record on February 15, 2017, our Board of Directors met on February 6, 2017 and declared the following distributions"
- Monthly dividend of $0.02 per share, payable on March 31, 2017 to stockholders of record on March 15, 2017;
- quarterly dividend of $0.02 per share, payable on June 30, 2017 to stockholders of record on June 15, 2017; and
- quarterly dividend of $0.125 per share, payable on September 29, 2017 to stockholders of record on September 15, 2017.
On April 26, 2016, Standard & Poor's Ratings issued a credit rating of BBB- with a negative outlook and discussed a potential rating downgrade if there were continued credit issues:
"The negative outlook reflects Standard & Poor's Ratings Services' expectation that we could downgrade the company over the next 18 to 24 months if credit quality of its portfolio continues to deteriorate, resulting in significant realized and unrealized losses and rise in nonaccruals. Capital, leverage, and earnings metrics are weaker than those of similarly rated peers"
An upcoming rating downgrade could result in higher borrowing rates that could put further downward pressure on net interest margins and dividend coverage over the coming quarters. Also, continued portfolio credit issues would likely drive lower net investment income ("NII"), similar to previous quarters.
Stable Versus Declining NAV Per Share:
As mentioned in previous articles, 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: Main Street Capital (NYSE:MAIN), Monroe Capital (NASDAQ:MRCC), TPG Specialty Lending (NYSE:TSLX), Fidus Investment (NASDAQ:FDUS), Golub Capital BDC (NASDAQ:GBDC), PennantPark Floating Rate Capital (NASDAQ:PFLT), TCP Capital (NASDAQ:TCPC), Solar Capital (NASDAQ:SLRC), Ares Capital (NASDAQ:ARCC), Saratoga Investment (NYSE:SAR), New Mountain Finance (NYSE:NMFC) and Hercules Capital (NASDAQ:HTGC).
Declining NAV per share and dividend cuts: FSC, MCC, KCAP Financial (NASDAQ:KCAP), Capitala Finance (NASDAQ:CPTA), Garrison Capital (NASDAQ:GARS), Apollo Investment (NASDAQ:AINV), CM Finance (NASDAQ:CMFN), Horizon Technology Finance (NASDAQ:HRZN), Fifth Street Senior Floating Rate (FSFR), PennantPark Investment (NASDAQ:PNNT) and THL Credit (NASDAQ:TCRD). As shown in the table above, most of the BDCs with larger declines in NAV per share, recently cut dividends with the exception of TICC Capital (NASDAQ:TICC), WhiteHorse Finance (NASDAQ:WHF) and BlackRock Capital Investment (NASDAQ:BKCC).
It should be noted that AINV and PNNT had NAV declines related to oil exposure. Gladstone Capital (NASDAQ:GLAD) and FS Investment Corp. (NYSE:FSIC) also have higher oil-related exposure that is mostly "true first-lien" helping to preserve shareholder capital. Yesterday, Goldman Sachs BDC (NYSE:GSBD) reported results with a 1.5% decline in NAV per share that was mostly due to unrealized depreciation in Iracore International Holdings, Inc. and Washington Inventory Service. Iracore produces lined pipe systems for oil sand slurry transport and tailings disposal.
TICC and KCAP had declines related to collateralized loan obligation ("CLO") exposure. Prospect Capital (NASDAQ:PSEC) has around 18.3% 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"
Continued declines in NAV per share for FSC?
FSC's NAV per share has declined by 48% over the last 9 years (see chart below) including 8.3% during the recent quarter, mostly due to additional non-accruals.
"Credit weakness in portfolio companies are non-accrual and on our watch list drove NAV down to $7.31 per share in December from $7.97 per share at the end of the September quarter. Additionally, we ended the quarter with 11 investments on non-accrual representing 7.3% total debt investments at fair value."
There is a good chance that NAV per share will continue to decline as the portfolio is rotated out of non-performing/non-income producing assets as mentioned by management on the call:
"While our financial statements represent the fair value of our portfolio at December 31, looking ahead we may experience further volatility and investments on non-accrual in our watch-list."
"We believe that resolving the assets on non-accrual in a timely manner and rotating these proceeds into traditional, performing senior secured loans is important to our overall portfolio repositioning."
"Credit weakness in portfolio companies are non-accrual and on our watch list drove NAV down to $7.31 per share in December from $7.97 per share at the end of the September quarter. Additionally, we ended the quarter with 11 investments on non-accrual representing 7.3% total debt investments at fair value. Our investments in the healthcare and for-profit education sectors have experienced issues due to reimbursement for regulatory changes. As these industries where we have significant exposure, such changes may affect multiple portfolio companies which is why we are actively working to decrease industry concentrations going forward."
"For example, Adventure Interactive our largest investment on non-accrual is a provider of regeneration marketing services to post-secondary education programs. The company has two divisions, marketing services and academic program management. The marketing services division has underperformed due to regulatory pressures in the for-profit education sector and although smaller part of the business, the academic program management division has been achieving its plan and is seeking additional funding for growth initiatives. While we cannot be sure of the future, we are working closely with the private equity sponsor and the management team with the goal of ensuring the best possible outcome for FSC shareholders."
Upcoming changes to FSC fee agreement: On February 9, 2017, FSC filed a preliminary Proxy regarding a Special Meeting of shareholders to be called to vote on a new Investment Advisory Agreement between the BDC and its External Manager Fifth Street Management. Included is "a proposed change to the structure of the subordinated incentive fee on income to impose a total return hurdle provision and reduce the 'preferred return'."
The proposal includes:
- Implementing a permanent total return hurdle, which may decrease the incentive fee by 25% per quarter after taking into account any realized and unrealized losses.
- Total return hurdle will have a look-back feature, which expands every quarter, scaling up to a three-year lookback once fully phased in, and will become retroactive to January 1, 2017.
- Decreasing the hurdle rate to 7.00% on the net investment income portion of the incentive fee, which is in line with the median for the Company's peer group.
My Opinion: The most important change is reducing the hurdle rate to 7% (higher is better for protecting shareholders during underperforming quarters). This makes a large difference when I am modeling 'worst-case' scenarios and 'lower yield' scenarios in the Optimal Leverage Analysis as discussed in my "Dividend Coverage Articles." Also, only choosing to partially align 25% of its incentive fees, rather than 100%, is well below expectations especially given that it is not retroactive to the large realized and unrealized losses of 2016.
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.