- The company had an overly conservative investment mix which changed after the merger with MVC Capital.
- Although there are highest risks associated with MVC's lower-tier loans, credit support agreement and share repurchase plan serve to offset much of the downside risk.
- The company grew its dividend by double-digit numbers during the last three years.
- We believe that the combination of higher-yield investments with the current management actions will create value for the company's shareholders.
I don't know if we have said this in another article as well, but sometimes we are too focused in the REIT sector that we forget about BDCs, which offer a nice capital and income return mix. A BDC that recently came to our attention was Barings BDC (NYSE:BBDC), and today, we will write our views about it.
When we are looking at Barings BDC, we are actually also looking at MVC Capital, a company that was merged under Barings at the end of 2020. The merger was agreed at a specific NAV, which was later overcome by the company, resulting in minor dilution for Barings' shareholders. The management expects that this effect will be temporary and alleviated by the company's growth in the near future. Barings BDC is ventured with other two non-listed companies in an attempt to tweak their allowed activities. For those interested in more details, you can find the relevant article by Ticker Tape Research here.
One thing we liked in this company by looking its financial statements is the very nice geographical diversifications of its investments as well as the risk profile of its loans. As we can see in the graph presented below, 60% of the company's portfolio is targeted to the U.S. middle market while the 12.6% of its portfolio are investments inherited by MVC Capital.
In addition, 8 out of 10 loans (in fair value) are first-lien loans, with another 7% being second-lien loans. The existence of 1.2% of super senior loans means that nearly 90% of the company's portfolio is related to second-lien loans or better. What the merger with MVC Capital actually made was to bring some inferior-tier loans into Barings' BDC balance sheet. In fact, the vast majority of MVC's portfolio was in second lien and mezzanine loans as well as equity. As the president of Barings BDC, Ian Fowler, put it in the latest earnings call:
We believe this portfolio can initially serve as an attractive complement to the Barings' originated portfolio and the acquisition was the unique opportunity to buy a large portfolio at a discount to NAV. As I mentioned before, we have been sizable payoffs of approximately $30 million since the deal was announced and we will continue to drive toward the exit of non-core lower yielding equity investments and increasing core earnings by redeploying this capital into higher yielding assets. Thus far, the portfolio has performed in-line with our original expectations.
So we understand that it is a strategic decision of the company to chase higher-yielding investments. The addition of MVC Capital has increased the total weighted investment yield to 7.2%. What we do see however is that the top 2 of the company's investments belong to MVC Capital and account for 2.5% and 2.4% of the total portfolio value respectively. The first investment is in Security Holdings B.V., and it is 60% equity, with the remaining 40% being senior subordinated loan and bridge loan, both containing paid-in-kind interest (PIK). The second investment is in a company named Custom Alloy Corporation, and it is essentially a second-lien loan with a small part of a revolving credit facility. Both parts contain PIK interests.
It is obvious that if the top 2 investments in your portfolio are of second-lien debt or worse, then this is something that needs to be addressed. This is why upon the merger with MVC Capital, the company signed a credit support agreement with Barings LLC. According to the agreement, Barings LLC is obliged to support Barings BDC with credit up to $23 million to offset any cumulative realized and unrealized loss from investments acquired by MVC or related to them. The agreement is valid for 10 years. Although the analogy of the younger brother playing the tough guy by using his older brother is obvious here, as investors we cannot but like this agreement. It actually gives the company's shareholders more potential yield with limited risk. And we can see how the company will need this support if we look at non-accruals. In 2019 the company had zero non-accruals, which makes sense, given the conservative loan mix described above. After the merger with MVC, the company now has $3 million of non-accruals, or 0.2% of its total portfolio in fair value and at cost. The funny thing is that the company put in a non-accrual status funded with a first-lien loan with PIK interest.
Another thing that we liked is that is the commitment of the company to repurchase up to $15 million of common stock at then-current market prices if Barings BDC's shares trade below 90% of the company's NAV disclosed at the latest filing. As we write this article, Barings BDC is trading at $10.06 per share, and its latest reported NAV per share is $10.99.
The company reported net investment income of $0.19 per share in Q4 2020 and paid a dividend of $0.17 per share for the same period. For the full-year 2020, the company generated $0.64 per share in net investment income, while it paid a dividend of $0.65 per share. The company recently announced a dividend hike for Q1 2021, reaching $0.19 per share. This represents a forward dividend yield of 7.55% which was more than welcomed. Though we cannot judge its sustainability, we anticipate that the company will be able to support it based on the anticipated net investment income increase by the lower-tier investments, combined with the credit support agreement.
Finally, taking a look at the past year's returns, the company has underperformed all its selected peers as well as S&P 500. However, extending the evaluation period, the results are more optimistic, as the company lies in the middle of the total return spectrum.
Source: Seeking Alpha
We chose those peers because they are companies with similar market capitalization. As we can see, Barings BDC yielded 26.08% during the past three years. However, the company has the lowest beta of the three, which suggests more stable stream of returns.
Although the company hasn't provided stellar returns in the past, it has some attributes that make it attractive, in our opinion. The management is shifting towards a more aggressive yield policy while at the same time does well to limit downside risk with credit support agreements and open market common stock repurchase plans. The dividend, which grew by 25% in 2019 and by 20% in 2020, also grew by 12% in 2021 so far. Although the current reported net investment income doesn't suffice to support the increased dividend, we expect the higher-yield investments to provide the necessary funds. Although the company has underperformed its peers during the last year, we believe that it positions itself well in order to provide outsized returns in the future. Always keep in mind that we are talking about a fairly small BDC and it is unfair to compare it to giants in the sector. In our view, this is an investment that will bear fruits in the near future, and the positive interest alignment between management and shareholders will help the company move towards this direction.
This article was written by
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