BDC Market Weekly Review: Breaking Down Shareholder-Friendly Fee Structures

Summary

• We take a look at the action in BDCs through the fourth week of November and highlight some of the key themes we are watching.
• Like September, November is likely to be another write-off for BDC investors. However, the strong price action in October has more than made up for these two middling months.
• We break down BDC fee structures with the key takeaway that investors should focus on more than just the lookback feature, as important as it is.
• Redemptions continue in the BDC bond space which further limit investor options in the space.
• We highlight WHF which we recently added to our coverage in the BDC Tool.
• Looking for a helping hand in the market? Members of Systematic Income get exclusive ideas and guidance to navigate any climate. Learn More »

da-kuk/E+ via Getty Images

This article was first released to Systematic Income subscribers and free trials on Nov. 26.

Welcome to another installment of our BDC Market Weekly Review where we discuss market activity in the Business Development Company sector from both the bottom-up - highlighting individual news and events - as well as the top-down - providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the fourth week of November.

Be sure to check out our other Weeklies - covering the CEF as well as the preferreds/baby bond markets for perspectives across the broader income space. Also, have a look at our primer of the BDC sector with a focus on how it compares to credit CEFs.

Market Overview

The post-Thanksgiving hangover in markets pushed nearly all BDCs to finish the week lower with the majority of the sector facing negative returns for the month.

Source: Systematic Income

From a monthly total return perspective, the sector is facing another monthly write-off - similar to what we had in September when the sector delivered a flat return. That said, a generous October more than compensates for two months of treading water.

Source: Systematic Income

Market Themes

With the market seemingly settling down in recent months from the sharp moves over the last year-and-a-half, investor attention is turning to the more humdrum features of BDCs. One of these is fee structure.

The mantra that many investors have in mind when they think of BDC fee structure is as a binary shareholder-friendly and non-shareholder friendly. And the key, if not the only, determinant of whether or not a given BDC has a shareholder friendly structure appears to be whether or not it has a cumulative total return hurdle / lookback. Clearly, not all investors take this view but it does seem to be prevalent. The reality, as usual, is more complicated.

First, the fee structure is composed of, at least, 7 different features.

Base Management Fee

• base management fee on gross assets (typically in the range of 1.375%-2%)
• base management fee on gross assets above leverage of 1x (typically set to 1% for many BDCs)
• whether the management fee excludes cash & cash equivalents

NII Incentive Fee

• percentage of NII (typically, 17.5-20%)
• hurdle rate (the annualized NII floor rate below which no income incentive fee is earned, typically 6-8%)
• catch-up rate (the NII cap at which point the incentive fee is "caught up" i.e. as though it was earned from NII of zero, typically 8-10%)

Capital Gains Incentive Fee

• percentage of capital gains (typically, 17.5-20%)

Other

• Cumulative total return hurdle / lookback (companies with this feature usually have this set to 3 years)
• Total expense ratio cap

The reason the total return hurdle / lookback rightfully gets a lot of focus is because of both a sense of "fairness" as well as BDC management incentives. The key issue is that BDCs have two types of incentive fees (NII and capital gains) which are calculated separately. This means that a BDC could earn a NII incentive fee on an amount that exceeds its total return due to capital losses in its portfolio. This doesn't seem fair.

What's more worrying is that this fee structure could incentivize a BDC to tilt to higher-yielding riskier assets which would boost its NII incentive fee without bearing the repercussions (at least in its incentive fee profile) for higher credit losses down the road.

The lookback provision is intended to net the two types of incentive fees and ensure that the BDC is on the hook for capital losses as well. In other words, the capital losses are netted against the NII the company generates and it is this net number that goes into the incentive fee number.

Clearly, the lookback provision is important. However, the reality is that, in practice, it is not as essential as it may seem. This is for a few reasons.

First, many strong performers in the BDC space have generated fairly consistent returns in excess of NII which means that, for them, lookback provision is more theoretic than practical. For these companies, the lookback incentive to keep portfolio quality adequate is not very relevant. They are incentivized to keep portfolio quality high by the desire to grow the company's asset base as well as maintain a reputation for being prudent investors.

Secondly, some BDCs without the lookback provision have tended to waive fees anyway to reflect capital losses.

Thirdly, a BDC with a record delivering consistent capital losses will find it very difficult to outperform the sector even with the benefit of the lookback provision.

The key takeaway here is that investors should pay as much, if not more, attention to the base management fee as well as the hurdle rate. Ultimately, the lookback provision is just part of the puzzle - yes, it's a nice feature to have but it's not something that can exclusively render a given BDC fee structure as shareholder-friendly or not, at least not on a holistic basis.

Market Commentary

There were a few redemptions of BDC bonds with WhiteHorse Finance (WHF) redeeming their 6.5% 2025 notes and the First Eagle Alternative Capital BDC (FCRD) redeeming their 6.125% 2023 notes. The coupons on these are so high that the redemptions are far from a surprise. Recent senior unsecured issuance in the sector has been closer to 2-4%, even if these two issuers have historically been on the higher end of the sector bond yield range.

There has been a steady drip of redemptions in the BDC baby bond sector which is a shame on the one hand as it reduces the number of bonds in the sector - down to around 20 by our count.

On the other, it's less of a big deal since the sector has not really offered a lot of value for a long time. For example, the median YTW of the sector is a touch above 3% and FCRD 2026 bonds are trading at a 3.51% YTW and this from a BDC that has delivered negative total NAV returns for the last 3 and 5 years on its common shares.

Separately, this dynamic is actually big plus for investors in common shares as a drop in interest expense provides a significant boost to NII. For example, WHF refinanced its 6.5% bonds into 4% bonds and, though the size was fairly small, the big rate differential has a significant impact on NII – driving it higher by about 3%. In an environment where yields have been grinding lower for some time, any NII tailwind is very welcome.

Speaking of WHF, we added the company to our BDC Tool. In our view, it is worth a look as a low-equity allocation option for investors. It has a very impressive historical NAV return of around 14% over the last 5 years – well above the sector average.

Source: Systematic Income BDC Tool

Its most recent performance has shifted lower and it has underperformed the sector in the last 4 quarters.

Source: Systematic Income BDC Tool

This is not unexpected given its lower equity allocation stance but it still bears watching. Non-accruals have moved lower and are at around the sector average of 1.3%.

Source: Systematic Income BDC Tool

Net new investments are holding up well while portfolio quality is improving. Regular dividends have been steady and the NAV is at a record high. Valuation is at 99% which is about 10% below the sector average and a touch below the median valuation.

Stance & Takeaways

As far as our allocation stance is concerned, we are using the recent weakness across the broader income market to improve the yield profile of our High Yield Income Portfolio. A simple starting point for identifying potentially attractive BDC additions at current levels is highlighted in the chart below - composed of three metrics from our BDC Tool.

The y-axis shows the RSI - an indicator of recent price strength or weakness. The x-axis shows the current valuation or the price / NAV ratio. The subset of BDCs in the chart is also limited to companies that have delivered 3Y total NAV returns above 8% - this is a quick-and-dirty way to avoid potential value traps.

Source: Systematic Income BDC Tool

The highlighted part of the chart are those BDCs that have seen recent price weakness and have reasonable current valuations. In this subset we like the TCG BDC (CGBD), the BlackRock TCP Capital Corp. (TCPC) and the New Mountain Finance Corp. (NMFC).

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CGBD, TCPC, NMFC either through stock ownership, options, or other derivatives. 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.

Comments

[BartAtTheRanch]

@ADS Analytics

Thanks for the article. As always, important to look across the sector and glad to have the addition of WHF but might be good to describe the effects of their recent secondary, which proved to be a good buying opportunity despite the lethargy (at best!) of the sector recently

WHF has been a name we have returned to frequently and which might be in yet more demand given (as you describe) that the sector may be cooling for greater equity holding names (see BDCBuzz's recent article on PNNT)..

WHF's non-accrual rate may be near sector average, but might be worth looking at their cumulative realised gains and losses for those considering a longer term investment.

In the short term it is difficult to see where the best opportunities lies for trading shares - are any of four names (OCSL, CGBD, NMFC and TCPC) you clearly show as in the "sweeter" part of the sector by valuation and RSI and three of which you hold thought by you as "trading positions"? Are there any that (in that sweeter area or not) that you consider longer-term holds? If so, which ones?

Bart

[BartAtTheRanch]

@BartAtTheRanch

PS Might be similarly useful to compare credit quality in a similar way across the sector (and beyond just the mention of an approximate average of 1.3% of non-accruals, though that is a good starting point.)

Do your "averages" come from the "BDC universe" you include in the graphic showing month-to-date returns?

[ADS Analytics]

@BartAtTheRanch I don't make a distinction between "trading positions" or longer-term holds. I highlight what I find to offer attractive risk/reward and some people treat that as a trading position and other as a long-term hold.

In terms of realized gains/losses my view is that if you look at total NAV returns that takes everything into account i.e. imagine you found a company that appeared to have high realized losses but it also had a relatively high total NAV return - would you avoid it? At the end of the day the company delivered very strong book returns and realized losses were offset by a high level of dividends and possibly unrealized gains. Realized losses are just part of the picture. There is an argument to be made that a company with nil realized losses is not taking sufficient risk.

My sense is that people focus on realized gains/losses because it's harder to put together a total NAV return profile so they use that as a proxy of whether a given BDC burned capital or not.
ADS

[BartAtTheRanch]

@ADS Analytics

In either case (cumulative realised g/l or total NAV return) my search is for companies that do well (preferably in both) over a significant time period. since such companies are likely to have that very hard to define quality of "good management" (that's why I mention cumulative realised gains).While those stocks might be the better long term holds, this should not prevent you from trading in and out of a name which is a reasonably good prospect in the short term even if it only seems to have "average" quality management. WHF might fit that role.

Do any of the BDCs you hold seem to you to have such management?

Thanks again for the survey of the sector!

Bart

[papaone]

I invest exclusively in BDC's using BDCBUZZ as my authority plus my review.
Presently, I'm completely out of the market. I would like to see what actions the Fed will take and when.
Inflation is most certainly here. and the good news-- BDC's mostly have a floating rate portfolio, combined with a low cost of capital.
It now looks to me like a January reentry buying my favorites.

[Basil6]

@ADS Analytics Thank you for this. These graphs are very useful.