There is a contentious issue for BDCs that arises frequently during annual shareholder meetings and their associated proxy voting requests: The BDC asks for permission to sell shares under net asset value (NAV), given certain restrictions and clauses. Each time this request is made by a BDC, I see a heated debate that reinvents a wheel that was invented a long, long time ago, in my opinion. This article is intended to be a resource to point to regarding that debate, and a forum in which to conduct discussions helpful to BDC owners considering how to vote their shares.
BDCs, or business development companies, operate in many ways that might appear concerning or confusing to investors new to the space. In this article, I’d like to review the one element indicated above: when a BDC asks its shareholders for the right to issue shares under NAV.
Proposal II: Authorization of the Company, with Approval of its Board of Directors, to Sell Shares of its Common Stock (During the Next 12 Months) at a Price or Prices Below the Company’s Then Current Net Asset Value Per Share in One or More Offerings Subject to Certain Conditions Set Forth in This Proposal
We are a closed-end investment company that has elected to be regulated as a BDC under the 1940 Act. Generally, the 1940 Act prohibits us from selling shares of our common stock at a price below the current net asset value, or NAV, per share of such stock. However, certain provisions of the 1940 Act permit such a sale if approved by our stockholders and, in certain cases, if our Board of Directors makes certain determinations.
A bad thing under normal circumstances
Upfront: Issuing shares under NAV is generally a bad thing for existing shareholders.
Here’s why: In a hypothetical example, a BDC might say, “We believe our shares are worth $10 a share, but we’re willing to sell them to new investors at $9 a share.” This is good for new shareholders, as they are acquiring a basket of goods valued at $10 a share for $9 a share.
The same, however, is bad for existing shareholders, generally, as their shares are being diluted by new shares flooding the market, increasing the overall market cap without increasing their stake in the company, and offering $10 of value for shares purchased at $9 a share. This is a dilutive offering, reducing the overall NAV of the BDC by selling shares less than NAV. The BDC is exchanging some percent of NAV for existing shareholders for cash.
An accretive secondary offering is when a BDC, or other company, offers shares for sale enough above NAV to add value for shareholders. That kind of offering increases the NAV for existing shareholders while obtaining cash for the BDC. It is good for shareholders.
Above the NAV issuances, for BDCs trading above their NAVs, like Main Street Capital Corporation (MAIN), can create a virtuous circle for investors, in which the BDC grows its assets under management (AUM) when issuing shares above NAV, and therefore increases both the share price, the NAV, and, hopefully, the dividend. However, accretive NAV secondaries are not in scope for this discussion.
But it is a good thing for BDCs to be able to do
Based on this description, it sounds as though nobody would ever want to check Yes on the proxy vote for their shares, offering a BDC to have the right to sell shares under NAV.
However, I and other investors do it almost every time the chance occurs on a proxy statement.
Why? In short, voting No throws the BDC under the bus.
To get a more comprehensive answer, I suggest focusing on a few key terms and concepts:
The BDC is not asking to sell shares under NAV. They are asking for the right to do so.
Check the proxy statement for the conditions every time, but a safe assumption is that BDCs will not issue shares under NAV willy-nilly, destroying shareholder value, if given the permission.
The request that the BDC is making just means the BDC has the right to issue shares under NAV, and it does not say that they will. In fact, I challenge each investor or potential investor to review secondary offerings particular BDCs have done under NAV. Please do not count shares issued as part of dividend reinvestment programs, another contentious discussion not in scope here, as a means of offering shares under NAV.
Simply focus on the track record of a given BDC: How many times have they conducted At-The-Market (i.e. ATM) sales of shares under NAV? How many times have they conducted secondary or shelf offerings under NAV? The comments section below would be a good chance to air findings, but I am confident this only happens under extreme market duress and in limited and infrequent opportunities.
I’d certainly be interested in seeing cases where this has taken place, as I can’t off of the top of my head name one outside of at least one emergency action (described below) during the Great Recession. And, second, I’d like to know why and when they have done it. For BDCs like ARCC, I have no doubt they will not use this capability unless it is imperative to add value for shareholders, even though it can be valuable for them to have it.
For other BDCs like FSC and PSEC, I don’t believe they will use this capability, even though I distrust management more or less. I’ve been in this game for over 10 years now as more or less a layperson, and I’ve been burnt a number of ways I’ve had to learn from. This is not one way I have felt burnt. You’ll see below how I learned from the secondary under NAV issue.
The BDC is required to maintain an equity ratio under the restrictive covenants of its lending facilities.
BDCs, as you might know, generally have to borrow money, issue notes, or issue shares to expand their business. This is because as RIC companies, they must pay out 90% of their earnings to shareholders in the form of dividends in order to avoid certain taxes.
(Side note: When people look at BDCs and say they must be Ponzi schemes because they keep issuing shares, it makes me cringe. When people say BDCs are risky based solely on their yields being > 8%, I again cringe. Both are part of their business model. I can discuss this further some other time in another topic article.)
BDCs borrow from banks and lending facilities. Banks assert restrictive covenants on their loans to BDCs. If a BDC trips the “equity ratio” covenant, the bank can tell the BDC to stop paying dividends. While BDCs follow equity ratio rules of their own, the banks can, through the lending facilities, exert many forms of restrictive controls if a BDC trips the equity ratio limits. This is why many BDCs, especially after the Great Recession, turn to capital markets to get their cash using secondaries, baby bonds, and convertible notes rather than rely heavily on lending facilities with covenants.
It is also why, in a sudden and artificial downturn (BDC portfolio assets are not shedding income but are marked down because of “throwing out the baby with the bath water” scenarios), investors would like a BDC to get more cash with a secondary under NAV rather than be torn apart by the covenants on their bank revolvers. It might be a dilutive offering, but it allows them other options during sudden and severe downturns than falling victim to banks, who can force BK, ask them not to pay dividends, or liquidate paying assets.
The ability to get cash, even under NAV, is a powerful negotiating chip. It allows BDCs who are currently trading under NAV to bluff when they seek deals with lending facilities. They are able to say: “Oh, yeah, well we’re going to walk away with our ability to issue shares under NAV.”
For all of these reasons, I check Yes.
But what if?
If I don’t believe, in good faith, I can check Yes to the option for a BDC to issue shares under NAV if needed, I sell the stock. Actually, I would not be an owner in the first place.
This is very simple. If I were to vote No on this proxy statement question, it means I have so little trust in management that I don’t even believe they’ll act in their fiduciary duty when offering more shares for sale. As much distrust as I have had with Prospect Capital’s management, the Fifth Street management banner (prior to the acquisition by Oaktree (OAK)) for companies like Fifth Street Finance Corp. (FSC) and Fifth Street Senior Floating Rate Corp (FSFR), I certainly have not believed they would perform dilutive secondaries under NAV unless forced to by significant market conditions, nor have they.
I don’t invest in BDCs whose managers would do that without good reason. Therefore, I afford the managers the ability to do so - supporting their negotiations under duress and outside of duress in order to obtain better funding options under both.
I hope this article helps, and I look forward to the comments. In short, investors who hold a BDC’s shares should vote Yes to permit issuance of shares under NAV, if needed. If a shareholder does not trust management to use this responsibility only if needed and in a manner respecting their fiduciary duty, the shareholder should not buy the BDC and should sell any shares they own.
As a final note, for shares you own, I recommend always voting your shares, as the absence of a vote is sometimes taken as a No vote.
As with any discussion of investments, I cannot evaluate your risk tolerance or financial situation. As a result, I do not intend this to be a recommendation to buy or to sell any particular equity, nor can I tell you how to vote your shares. However, hopefully this and other analysis of the topics herein can help you arrive at a buy, sell, or hold decision based on your own financial situation and risk tolerance, and can be a helpful resource in determining how to vote your shares when you get the chance.
For additional reference, please read the following two statements directly from BDCs relating to votes on this topic:
The Company has also received stockholder approval to issue shares of its common stock under NAV for each of the last eight years (the "Annual Under NAV Approval"), and despite the Company trading below NAV for periods during such time frame, including for most of 2016, it has only used the flexibility provided by the Annual Under NAV Approval one time. In 2009, during a period of significant credit market volatility when credit spreads increased materially, the Company, acting pursuant to the Annual Under NAV Approval, prudently issued shares of its common stock at a price below NAV and invested the proceeds from such issuance at attractive returns to stockholders. These proceeds were also used to create liquidity and financial flexibility in an uncertain time of extreme volatility. While such issuance was at a price below NAV, it resulted in less than a 2.5% dilution in the aggregate net asset value of the Company. Additionally, the Company believes that this financial flexibility was a key component of the Company's ability to opportunistically acquire Allied Capital Corporation, which transaction was agreed to on October 26, 2009 and closed on April 1, 2010 (the "Allied Acquisition"). The Company's NAV increased during the one-year period following the date of the Company's most recently determined NAV prior to such issuance, increasing from $11.21 (as of June 30, 2009) to $14.11 (as of June 30, 2010). The increase in the Company's NAV from June 30, 2009 to June 30, 2010 includes a $1.11 per share increase related to the gain on the Allied Acquisition. Furthermore, for the one-year period following the date of such issuance, the Company's total stockholder return outperformed that of every other BDC with a market capitalization of greater than $500 million. Therefore, periods of market volatility and dislocation have created, and may create again, favorable opportunities for the Company to make investments at attractive risk-adjusted returns, including opportunities that may increase NAV over the longer term, even if financed with the issuance of common stock below NAV.
Prospect Capital Excerpt
On behalf of Prospect Capital Corporation (ticker symbol “PSEC”), I would like to thank you for being a supportive PSEC shareholder.
Regarding the Annual Meeting of Shareholders Proposal II (NAV Proposal), we believe voting FOR such proposal is important to help avoid losing the investment grade bond rating of PSEC. Failure of this vote might put our investment grade bond rating at risk, thereby potentially increasing the cost of capital of PSEC and restricting our access to the financing markets. We also believe market conditions will continue to provide attractive opportunities for us to deploy capital.
Disclosure: I am/we are long PSEC, FSFR, MAIN, ARCC, FSC.
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.
Additional disclosure: I do not intend to acquire OAK in the next 72 hours, but it is on my watchlist for the next few months.