Now that second quarter earnings season for Business Development Companies (“BDC”) is almost over (we’re just waiting for funds filing their 10-Ks) let’s have a look at some of the trends, ironies and outrages that we’ve noticed. The BDC Reporter – for our subscriber-only News Of The Day feature and a bargain at $50 a month – prides itself on reading every press release, news story, SEC filing, company presentation and Conference Call transcript of every publicly traded BDC out there. (OK, sometimes we skim). Given the deluge of data which accompanies every earnings season when most of the 46 BDCs we track report in a two week period, we’re still sloshing around in the disclosures, but we’ve seen enough to have some insights to share with readers who’ve been spared the duty of covering the sector wall-to-wall. Here are 3 items amongst many that we noted which readers may find of interest:
Complain, complain, complain: Virtually every quarter BDC CEOs on Conference Calls complain about how hard it is to identify good transactions; how loan pricing and terms are under pressure and how selective they’re being putting money out the door. The few quarters we didn’t hear these complaints, BDCs were just too busy lending on highly favorable terms. Like in 2010 when most every lender with any money to lend realized the sky was not falling, but borrowers were still shell-shocked from the Great Recession and deal terms were “Lender Friendly”. Or in the Q4 of 2016 when the markets inexplicably got the heebie-jeebies and loan spreads suddenly widened, if only for a short time.
However, we’ve now had just under 6 quarters of “Borrower Friendly” market conditions so there has been a constant complaint from just about every BDC on their Conference Calls. Mostly BDC managers point to new entrants arriving on the scene offering borrowers looser loan terms and cheaper pricing. Here’s the irony we promised: Much of the new competition is from the BDC Managers themselves. Increasingly the industry is populated by asset management organizations that have sponsored/raised capital for multiple private and public funds, all-looking for the same “good deals”. Not that many new BDCs have come to market of late besides TCG BDC (CGBD) but there has been a slew of new private funds and non-traded BDCs being launched or expanded. The non-traded BDCs are often in perpetual capital raising model, which is part and parcel of their business model. Goldman Sachs has a public BDC (GSBD) launched a couple of years ago but has also been busy with two non-traded funds as well, all “managed” by the same personnel of the Great Vampire Squid.
With all this capital looking for a home it’s no wonder BDC managers are complaining, even if it’s about themselves and their peers, and it’s unlikely to change any time soon given that there are only so many deals that need to be financed in leveraged finance. When you hear that total volume of new deals (as opposed to refinancing) is hitting a new record it will be time to run for the exits because it will mean marginal and previously undoable transactions are being booked.
Spread Compression: The BDC Reporter has been throwing round the term “spread compression”, which is just one aspect of the hyper-competitive environment described above, for many quarters. In the IIQ 2017, the downward pressure on lender’s loan margins appear to have flattened out after several periods of ever-lower numbers. (This varies by segment and day-by-day so we’re generalizing here). That might sound counter-intuitive given our first point, but there is a mountain of existing loans to be refinanced and even the new entrants have their limits as to how low they can go.
However, the risk from “spread compression” is far from over, even if the margins do not drop further in the future. Many loans – especially those booked in the higher end of the risk spectrum in which most BDCs operate – come with price protection for the lenders. That means big penalties for companies seeking to refinance in the first few years. (The first 3 are the most expensive, as we know from personal experience as borrowers). So there are a large number of borrowers out there waiting patiently, or otherwise, to refinance on these once-in-a-decade terms but not pay through the nose. There’s a constant stream of these credits coming to market that will keep refinancing at a high level, but which will gradually erode BDCs loan portfolio yield. How much you ask? At the higher risk end of the market yields can drop by 15%-20% or more from the levels of 2016, which was itself hardly a bargain basement period.
This is a pain that keeps on growing for BDC Managers, but many are taking evasive action. The easiest dodge when you get repaid from a loan is to book another, but with greater risk involved, and retain your margin. Nobody admits to the practice and investors have a hard time ascertaining these things given the scanty information available, but we do dig a little deeper than most when we’re reviewing BDC portfolios name by name and we’ve anecdotally noted many instances. The other way out is to put more loans to work to offset the lower yield. Given that most BDCs are already close to their regulatory 1:1 Debt To Equity the favorite method for growing or maintaining income is to add loans in their off-balance sheet JVs. Thanks to the fact that these are highly leveraged – sometimes 3:1 – a small capital contribution can achieve the intended results and leave the metrics that analysts, investors and rating agencies watch almost untouched. We could (but we won’t for sake of space) list at least a dozen BDCS (usually the larger ones) who have adopted this approach.
Those are the traditional ways BDCs – and most lenders – deal with “spread compression”. However, there is another technique that we’ve noted that is less frequent (we didn’t say infrequent though) but which we find unpalatable. Given that there are few regulators looking over their shoulders – and even analysts and investors are kept at a safe distance from the sausage making business of investment pricing and valuation – some BDCs have taken to charging very high rates to borrowers who are under-performing. Rather than forcing a default or a bankruptcy filing, the BDC Managers – under cover of “restructuring” – hike up interest rates charged. We’re not talking about the 1%-2% “default rates” built into most leveraged loan agreements. We’re talking taking an 8% cash loan and charging a 16% Pay-In-Kind. For a while everybody is happy: the borrower is spared looking around in the seat cushions for coins to pay its interest bill and the BDC can boast a still strong overall portfolio yield. Of course – in most cases – this cannot last for too long. These borrowers typically cannot attract refinancing or new capital and as their fundamentals continue to deteriorate the BDCs stop booking the PIK into income and face the deferred reality. In the interim, though, income has been greatly boosted, management and incentive fees retained and investors – looking at “earnings coverage of the dividend" pleased.
Credit curmudgeons like the BDC Reporter can only suspect individual transactions of essentially being “zombies” given that we are too far away from the source materials. We’re also sorry to say that we doubt that the Boards of the BDCs are challenging these questionable practices, but that’s a whole story unto itself. The only way we can get a better sense if BDC lenders are “extending and pretending” is to follow these investments through their whole life cycle and see how they end up. We suspect – at the end of (a very long) day – most will get written off. In the interim, though, much more chopping and changing can happen by BDCs anxious to keep hope, and NAV and compensation, alive. If switching to PIK does not work there’s always converting the debt to equity, taking a small Realized Loss or none at all, and keeping the asset going, potentially for years. You lose the investment income but otherwise…
We don’t want to point the fingers at any particular BDC. For all we know – because we’re as far away from the financials of these private companies as we are from the moon – these changes in terms are warranted and will result in successful recoupments, even if it’s in the next decade. Nonetheless, we are skeptical as we have a right to be as an investor who might get stuck with a number of Potemkin Villages when Mr. Buffett’s famous tide goes out. We suggest to readers looking at their favorite BDC and seeing if PIK income has greatly increased of late. Calculate how much of last quarter’s income came from non-cash sources. If that number is 20% or more of reported Net Investment Income you may have a long-term problem. (We’ve seen percentages as high as 50%!). Look also at how many investments that started out as loans to non-affiliates (your typical leveraged loan) have migrated to debt or equity investments under the Affiliate or Control rubrics in your BDC’s portfolio list. These were not intended to be owned by the BDC but became so to avoid taking a hit on the loan, either in good faith or not.
Fee Waivers: It’s no secret that investors are drawn principally to BDCs for that juicy dividend stream, and yields between 7%-14%, payable monthly or quarterly. Understandably the price of a BDC – and the ability of a BDC Manager to raise new equity and increase its own compensation – is closely tied to the maintenance of that distribution. You don’t need the BDC Reporter to tell you that just the suggestion that a distribution will be reduced can cause a BDC stock to drop sharply. How sharply you ask? Capitala Finance (CPTA) fessed up to several new bad loans this quarter and to the looming prospect of a distribution cut (not so long after a prior reduction) and the price dropped 30% before anyone could yell” Run For The Exits”. That’s why the BDC Reporter directs much of its research towards asking the simple question: Is the dividend “safe”?
The BDC Managers – a very bright bunch – are very much aware on which side their bread is buttered. However, all that competition and spread compression and leveraging the balance sheet to the regulatory hilt (you see how we tied all that together?) is impacting recurring earnings and the ability to maintain current dividend levels. The newer and cleverest BDCs have chosen to set their distribution levels substantially below their earnings from the outset allowing capital to build up on the balance sheet rather than be paid out to its shareholders and be able to boast of its ample “dividend coverage”. Surprisingly most BDC shareholders don’t seem to mind not being paid all they are due and being charged an Excise Tax by the government as well. Guess which asset manager named after a sea creature falls in this category? Again, that’s another issue.
Another tactic we’ve noted this quarter that’s getting ever more prevalent as BDC earnings start to drop below their distributions are fee waivers by the BDC Managers. We’ve started a list which we’ve not had time to complete but we can promise there are many of these “generous” gestures going on. The waivers – because they are voluntary acts by the BDC Managers, and every fund is different, come in all shapes and sizes. Some are multi-year, pre-determined grants. Others are a few tens of thousands in a given period just to ensure Net Investment Income meets the distribution. Some are highly complex arrangements, which you’ll need your accountant and lawyer to understand. Some have gone on for years, but most are recent.
Before readers get out their Thank-You cards to write a mash note to their BDC Manager we should add some additional color. First, we’d suggest investors take a close look at how these waivers work in each case and not just be glad your dividend didn’t change. In many cases, fees are just being deferred and will be charged down the road as the economics change. Your favorite BDC might increase its earnings in future quarters but you’ll not be participating because accrued fees will get paid out. Some of these arrangements are structured so that unpaid fees will get paid even if the BDC’s performance is poor. Back to that lawyer and accountant.
Most of all, the BDC Reporter is disappointed how few BDC Managers are willing to permanently reduce compensation arrangements, and their Boards are unwilling to engage them on the subject. Given that the economics of the industry have changed drastically over the years (you know: competition, spread compression, etc.) there’s an argument to be made that BDC Managers should share in some of the drop in earnings. To their credit we’ve seen several analysts engage BDC Managers on this subject on Conference Calls, but after a few uncomfortable moments we move on and little happens. Subscribers to Advantage Data (yes, this a plug for our favorite data aggregation firm) will know from one of their pages how widely compensation arrangements vary from BDC to BDC. Some BDC Managers have been genuinely “shareholder friendly” and cut their own take as they have had to shave down investors. Others – and this is the majority – have made small concessions or none at all. Most egregious of all – from the BDC Reporter’s standpoint at least – are the BDCs who have lost pots and pots of investor’s capital but continue to receive or accrue an Incentive Fee while shareholder pay-outs drop by 30%-50% over time.
The current wave of waivers should be seen for what they are – a marketing expense by the BDC Managers aimed as much at their own interests as yours. If you’re wondering where your own favorite BDCs sit in the spectrum of Naughty to Nice have a look at the Management Fee: If you’re paying more than 1.5% on assets you’re being over-charged. We know that’s a blanket statement, but this is no time for being mealy mouthed. Then turn to the Incentive Fee on Income. Does the BDC Manager still get paid if the value of the portfolio drops below its prior book value due to Realized and Unrealized Losses? It’s easy enough to find out. Go to the Balance Sheet and Income Statement and look at the trend in book value from one period to another and whether any Incentive Fee is charged on the P&L.
We’re simplifying because BDC Managers have been doing the opposite: blinding investors with complicated formulas (which calculations are never disclosed, by the way) about when and how and how much Incentive Fees are paid. We suspect from the occasional question from analysts that they’re not quite sure how a fee came to be a particular number. Most investors just throw away their calculators and hope for the best, but there’s a real bottom line impact that varies between BDC arrangements. (By the way, we don’t pretend to be able to follow the math on these incentive fees either. We studied History at college so we blame Tufts).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.