Dividend Increases For The High-Yield BDC Sector: Part 1

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About: Oaktree Specialty Lending Corporation (OCSL), PNNT, PSEC, Includes: AINV, ARCC, CGBD, FDUS, FSK, GAIN, GBDC, GLAD, HTGC, HYG, JNK, MAIN, MCC, MRCC, PFLT, SUNS
by: BDC Buzz
Summary

BDCs have begun reporting results, and this article discusses some of the items investors should be watching for PSEC, PNNT, and OCSL.

PSEC, PNNT, and OCSL are currently underpaying their dividends, with the lowest ratios of dividend-to-book values likely due to management wanting to sustain NAV/share.

I am expecting many changes to dividends paid by BDCs in 2019, including increases, decreases, and special/supplemental dividends.

This series of articles will discuss BDCs with the potential to increase dividends in 2019.

Business development companies, or BDCs, have begun reporting results, and this article discusses some of the items that investors should be watching.

Sources: SEC Filings and bdcbuzz.com.

In December 2018, I purchased additional shares of multiple 'oversold' higher-quality BDCs with risk-averse balance sheets prepared for a potential economic slowdown. As investors jump back into financial stocks, the average BDC has easily outperformed the S&P 500 so far in 2019, but still has an average dividend yield of around 10.4%:

Sources: SEC Filings and bdcbuzz.com.

In the previous table, Medley Capital (MCC) is an outlier for many reasons, including being one of the worst-run BDCs of all time. The stock has been rallying on merger hopes. Please note that the RSI has recently spiked to 70 and is likely in overbought territory.

BDC Dividend Changes For 2019

As mentioned in many of my recent articles, there are a handful of BDCs that will likely cut dividends in 2019. However, there are also many more that will likely increase their current regular dividend and/or pay special dividends this year. This article discusses dividend coverage for Prospect Capital (PSEC), Oaktree Specialty Lending (OCSL), and PennantPark Investment (PNNT), all of which cut dividends in 2017/2018, as predicted in my previous articles:

Source: SEC filings.

As shown below, these BDCs currently pay some of the lowest dividends as a percentage of book value, and PNNT and OCSL are continuing to rotate their portfolios out of non-core and non-income producing assets to support higher dividends. Keep in mind that BDCs such as Golub Capital (GBDC), Solar Senior Capital (SUNS), and PennantPark Floating Rate Capital (PFLT) have lower-yielding safer assets by design, and Hercules Capital (HTGC) and Main Street Capital (MAIN) are internally managed.

Sources: SEC Filings and bdcbuzz.com.

The following are the three methods I use for comparing dividend coverage:

  • Historical dividend coverage: using adjusted earnings (excludes certain one-time expenses) taking into account recurring vs. one-time revenues, cash vs. PIK interest income, etc.
  • Projected dividend coverage: using best, base, and worst case scenarios taking into account potential credit issues, portfolio growth/decline, changes to portfolio yield, various amounts of non-recurring income from dividends and fees, changes to borrowing and operational expenses.
  • Optimal Leverage Analysis: assessing future dividend coverage based on portfolio growth using available cash and borrowings (leverage) as well as changes in portfolio yield, apples-to-apples comparison of BDC dividend coverage using similar amounts of leverage.

Historical Dividend Coverage

Most investors rely on historical dividend coverage for assessing potential dividend coverage. However, when it comes to weighting the previously mentioned three categories of dividend coverage, historical is typically the least reliable indicator for future coverage. There are many reasons for this, including constantly changing income and expense trends as well as portfolio credit issues. Many of the BDCs that have recently cut dividends, announced that the primary drivers of the reduced distributions were related to potentially lower yields on investments either due to yield compression, rotating into safer investments and/or recent portfolio credit issues. Most of these BDCs had "spillover" or excess distributable income and gains that could have been used to cover shortfalls, but management decided to align the dividends with projected earnings.

Oaktree Specialty Lending

For the quarter ended September 30, 2018, OCSL reported between my base and best case projections due to the acceleration of interest income and prepayments fees earned in connection with the exit of a certain investment. There was another meaningful decline in its portfolio yield from 8.8% to 8.4% that will likely result in lower interest income after excluding the benefit of one-time prepayment-related income. As shown in the table below, the company would have mostly covered the current dividend without the benefit of prepayment-related interest income. The company is near its target leverage, and I am expecting limited portfolio growth over the coming quarters:

We are taking a conservative approach to managing leverage and the amount of leverage we deploy will also depend on the growth of our portfolio. It's something that we're monitoring, there's lots of different constituencies from rating agencies to shareholders to the banks to just the asset investment environment.

Source: Oaktree Specialty Lending Corporation (OCSL) CEO Edgar Lee on Q4 2018 Results -Earnings Call Transcript

Sources: SEC Filings and bdcbuzz.com.

PennantPark Investment

For the quarter ended September 30, 2018, PNNT reported just below my best case projections mostly due to much higher-than-expected portfolio growth covering 112% of its quarterly dividend during the recent quarter and has covered by an average of 108% over the last 6 quarters. Previously, I was expecting minimal portfolio growth "as the company is keeping a conservative leverage policy of GAAP leverage (includes SBA debentures) near 0.80 until it can rotate the portfolio into safer assets." However, the company has already increased the amount of first-lien debt from 40% to 47% of the portfolio over the last two quarters.

We've said consistently that on first lien debt, you can prudently leverage first-lien debt more than 1:1 and still provide a safe return. And that for second-lien or mezzanine, even if you could leverage that those assets more than 1:1 you shouldn't. So as we go forward, we're going to look at the underlying portfolio and assess what we think is prudent leverage depending on the investment and type of investment.

Source: PennantPark Investment (PNNT) CEO Art Penn on Q4 2018 Results - Earnings Call Transcript

Sources: SEC Filings and bdcbuzz.com.

There was another decline in the overall portfolio yield from 11.4% to 11.2% as the company invests in safer assets at lower yields, including the most recent investments at an average yield of 10.1%. However, there was a meaningful increase in interest income due to the last two quarters of higher portfolio growth as well as a reduced amount of non-income producing equity investments. I have taken this into account with the updated projections.

Prospect Capital

For the quarter ended September 30, 2018, PSEC reported just below my best case projections mostly due to dividend income of $15 million or $0.04 per share from NPRC ($11 million dividend) and Valley Electric ($3.5 million dividend). Also, there was higher-than-expected net portfolio growth driving leverage closer to its upper target and increased portfolio yield mostly due to higher yields from its CLOs. There will likely be continued higher dividend income in 2019 as discussed by management on the recent call:

We would expect for Valley that dividend to continue, at least in the current quarter and 2019 is looking quite promising as well, given the growing backlog nature of that business. With NPRC, we currently expect these distributions to continue, not only for the current quarter but into each calendar quarter of 2019 as well.

Source: Prospect Capital Corporation (PSEC) CEO John Barry on Q1 2019 Results - Earnings Call Transcript

Sources: SEC Filings and bdcbuzz.com.

As shown in the following table and discussed below, there was a previous increase in the yields from its collateralized loan obligation (CLO) residual interests mostly due to the expected resets/refinancings driving higher net interest margins:

"We, as majority investor, can refinance liabilities on more advantageous terms, remove bond baskets in exchange for better terms from debt investors in the deal, and extend or reset the investment period to enhance value. We've completed 24 refinancings and resets since September 2017."

Source: Prospect Capital Corporation CEO John Barry on Q1 2019 Results - Earnings Call Transcript

It should be noted that cash and GAAP yields have decreased slightly from the previous quarter and need to be watched:

Sources: SEC Filings and bdcbuzz.com.

PSEC redeemed $154 million of its 5.00% Notes in September 2018 that were partially replaced by $100 million of 6.375% 2024 Notes and, in August 2018, extended its secured credit facility and slightly reduced the pricing from LIBOR+2.25% to LIBOR+2.20%.

In the September 2018 quarter, we repurchased $154 million of our July 2019 notes as well as $29 million of our program notes. We also issued $100 million of 2024 institutional notes, $26 million of baby bonds through our ATM program. As of September 2018, we had $769 million of program notes outstanding with staggered maturities through October 2043.

Source: Prospect Capital Corporation CEO John Barry on Q1 2019 Results - Earnings Call Transcript

Source: PSEC Investor Presentation

Projecting Dividend Coverage

Projecting dividend coverage is mostly about reading the trends for income and expenses. This includes general sector and specific company trends, watching for portfolio credit issues, changes to capital structure and borrowing costs as well as estimating a range of performance for portfolio growth and non-recurring income. Many BDCs have recently been experiencing higher portfolio yields due to the impact of rising LIBOR on variable-rate investments. Previously, the BDC sector experienced declining portfolio yields driven by competition for "true" first-lien and higher quality assets.

For example, I have assumed continued declines in PNNT's portfolio yield as management is expecting "into the 10% to 11% zone":

Over time given our strategy if that's going to go down into the 10% to 11% zone as we continue to move up capital structure and de-risk the portfolio although we are starting to get some benefit from LIBOR which is nice, so that will mitigate some of that.

Source: PennantPark Investment CEO Art Penn on Q4 2018 Results - Earnings Call Transcript

PNNT has been improving its dividend coverage through share repurchases, reduced management fees, the ability to use higher leverage with SBA borrowings, and rotating the portfolio into higher earning assets from upcoming monetizations (selling and reinvesting) of its equity investments:

With asset yields coming down over the last several years, we're looking to create attractive risk-adjusted returns and our portfolio. We're executing a three point plan to do so. Number one, we're focused on lower risk primarily secured investments, thereby reducing the volatility of our earnings stream. Investments secured by either first or second lien or about 82% of the portfolio. We're focused on -- number two, we're also focused on reducing risk from the standpoint of diversification, as our portfolio rotates, we intend to have a more diversified portfolio with generally modest by sizes relative to our overall capital. Number three, we look forward to continuing to monetize the equity portion of our portfolio. Over time we're targeting equity being 5% to 10% of our portfolio as of September 30, it was 14% of the portfolio.

Source: PennantPark Investment CEO Art Penn on Q4 2018 Results - Earnings Call Transcript

Source: SEC Filings

PNNT has been actively repurchasing shares including around 2 million shares from May 1, 2018, through September 30, 2018, at a weighted average price of around $7.50 per share or an 18% discount to its previous NAV per share. There is still around $15 million of availability for upcoming repurchases that will likely be over the next two quarters, as discussed in the previous report:

We purchased 7.2 million of our common stock as part of the $30 million stock repurchase program which is authorized by our board last quarter. Today, we have purchased $15 million. The stock buyback program is accretive to both NAV and income per share. We are looking forward to continuing this program over the coming quarters.

Source: PennantPark Investment CEO Art Penn on Q4 2018 Results - Earnings Call Transcript

Source: SEC Filing

I am expecting continued share repurchases, given that the stock is trading at over 20% below its $9.11 per share NAV, and the company is preparing to use higher leverage. These purchases will be accretive to earnings/NII per share along with continued portfolio growth and use of leverage that could result in a dividend increase at some point:

We believe that with a generally stable underlying portfolio we should be able to provide investors with an attractive dividend stream along with potential upside as our equity investments are monetized.

Source: PennantPark Investment CEO Art Penn on Q4 2018 Results - Earnings Call Transcript

On November 13, 2018, PNNT's Board authorized the $250 million redemption of its 4.50% 2019 Notes due October 1, 2019, expected to occur in early 2019. This will result in a nonrecurring expense of around $2.5 million to $3.0 million that is not considered when calculating 'Core NII' and was discussed on the call:

Regarding that $2.5 million, $3 million of make-whole premium that you're going to A. "Yes, it's going to be a one-time hit and you're going to see that going as a one-time expense on the on the P&L and it's going to affect March quarter end before doing it in January. As you know, sometimes we announce core NII and GAAP NII. Certainly, it'll impact GAAP NII, but the core it will be below the line from a core standpoint.

Source: PennantPark Investment CEO Art Penn on Q4 2018 Results - Earnings Call Transcript

Source: PNNT Investor Presentation

On November 13, 2018, PNNT's Board approved the application of the modified asset coverage requirements and the submission of a proposal for stockholders to accelerate the application of the 150% minimum asset coverage ratio at the 2019 annual meeting to be held on February 5, 2019. The advisor has agreed to reduce the base management fee from 1.50% to 1.00% on gross assets that exceed 200%. As of September 30, 2018, PNNT's asset coverage ratio was 291%. It should be noted that the company does not necessarily need the lower asset coverage ratio due to already having access to higher leverage through its SBIC licenses.

OCSL management is working to improve dividend coverage through:

  • Redeploy non-income generating investments comprised of equity, limited partnership interests and loans on non-accrual
  • Operating cost savings from leveraging Oaktree's platform
  • Rotation out of broadly syndicated loans priced at LIBOR + 400 or below
  • Benefit from rising interest rates as 83% of debt portfolio is comprised of floating rate securities
  • Realization of lower operating costs from credit facility optimization

Source: OCSL Investor Presentation

Optimal Leverage Analysis

This is a longer-term run rate analysis of dividend coverage that takes into account the potential for portfolio growth with available capital (excluding equity offerings). I typically use stable and lower portfolio yields with minimal amounts of non-recurring income to project dividend coverage with a fully ramped portfolio using "optimal leverage".

For an example, please see the table below from my previously linked article, "Prospect Capital: Expected Dividend Cut Of 20% To 30%", that correctly predicted a previous dividend cut for PSEC (from $0.25/quarter to the current $0.18/quarter). Ultimately, PSEC reduced its monthly dividend from $0.0833 to $0.06 which was exactly the projected earnings during a "worst case scenario" of reduced portfolio yield and lower amounts of non-recurring income as shown in the table below.

Sources: SEC Filings and bdcbuzz.com

Summary and Recommendations

PSEC, OCSL, and PNNT are currently underpaying their dividends likely due to management wanting to retain earnings for improved NAV per share especially, given the high probability of recent book value declines (due to wider rate spreads through 12/31). Over the last four quarter, each of the companies has easily covered its dividends:

  • PSEC average coverage: 118%
  • OCSL average coverage: 110%
  • PNNT average coverage: 105%

A dividend increase is already priced in for OCSL, given its current dividend yield of only 7.7% compared to the current average of 10.4%. PNNT and OCSL clearly have higher quality management which carries a premium.

PNNT currently has a dividend yield of 10.0% likely due to higher oil/energy exposure. Management is in the process of "de-risking" the portfolio, which is invested 47% in senior secured first-lien debt, 35% in second-lien secured debt, 4% in subordinated debt and 14% in preferred and common equity. Management has its "three-point plan" that includes rotating the portfolio into higher credit quality first and second-lien lower yielding debt. There are no investments on non-accrual as of September 30, 2018, and energy, oil & gas exposure previously declined to around 12% of the portfolio (previously around 14%).

Source: SEC Filings and www.bdcbuzz.com

On November 5, 2018, Matlin & Partners Acquisition Corporation (MPAC), announced that shareholders have approved MPAC's merger with U.S. Well Services, or USWS. PNNT's loans will be refinanced and its equity position will be publicly traded and was discussed on the recent and previous earnings calls.

PSEC currently has a dividend yield of 10.4% but also a higher risk portfolio. Some of my primary concerns include portfolio concentration issues, including its top 10 investments accounting for over 40% of the portfolio and the amount of equity investments that continues to increase accounting for over 16% of the portfolio. InterDent remains one of its largest investment and needs to be watched.

Source: SEC Filing

Non-accruals increased to almost 5.8% of the portfolio at cost and remained around 2.5% at fair value mostly due to adding a portion of its investment in Universal Turbine Parts, LLC to non-accrual status during the recent quarter. There were additional markdowns in the previous investments that were on non-accrual, including United Sporting Companies and Edmentum Ultimate Holdings and to a lesser extent for Pacific World and USES Corp. as shown below. It should be noted that non-accruals have been slowly increasing over the last few quarters.

Sources: SEC Filings and bdcbuzz.com

I consider PSEC to have a higher risk portfolio due to the previous rotation into higher yield assets during a period of potentially higher defaults and later stage credit cycle concerns, CLO exposure of 16% combined with real-estate 14%, online consumer loans of 4%, consumer finance of 10% and energy, oil & gas exposure of 3%. S&P Global Ratings also considers the CLO, real-estate and online lending to be riskier allocations that currently account for over 34% of the portfolio.

Sources: SEC Filings and bdcbuzz.com

To be a successful BDC investor:

  • As companies report results next week, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.