How To Evaluate Business Development Companies

Summary

• BDCs are some of the highest-yielding investments available to income investors in the current market environment.
• In this blog post we discuss the features our new BDC Investor Tool and its benefits.
• Take a 2-week no-obligation trial of Systematic Income to check out the BDC Tool and more - we maxed out the discount to 20% through the weekend.

Last week we discussed how investors can think of BDCs in income portfolios and, in particular, how BDCs compare and contrast with other leveraged loan instruments such as CEFs. In this blog post we highlight how investors can follow the BDC market and select individual investment opportunities using our recently launched BDC Investor Tool. This Tool joins our suite of CEF, Preferreds and Baby Bond Tools for a holistic view of the broader income space. 

Where's the Beef?

Before we get going, an obvious question is why shouldn't individual investors just go with "expert" advice - following the BDC recommendations of the many contributors on SA or elsewhere. This is obviously easier than having to roll up their sleeves to dig into the various sector metrics. There is no one right approach to investing and many investors will be happy following third-part buy and sell recommendations.

However, in our view, there are important caveats for investors to keep in mind when allocating to BDCs based on "expert" advice. 

The first caveat is that explicitly following someone else's advice makes the assumption that the investment style of the analyst is the appropriate investment style for all the investors who follow the analyst's advice. This  obviously doesn't work for everyone - some investors will be more tactical in their style while others will be more strategic. Some will be going for higher growth / higher risk exposure while others will want to focus more on the downside or defensive positions. 

Secondly, a lot of the analysis tends to take the form of, what we call, "screenshot porn" which is simply taking whatever information is presented by the BDC with minimal evaluation and context. This sort of analysis, which, in our view, tends to be dominant, clearly doesn't add any value as it doesn't touch on what the given company chooses to ignore. 

Thirdly, much of the analysis is presented on a standalone basis, what we call  "snowflake analysis" with no cross-sector comparison. It's easy enough to say that a 150% price / NAV ratio seems high - but how high is it to the average and median and is that a high historic number for the company or not i.e. is the spread to the sector high or low right now? It's also easy to say that the dividend yield of a given BDC is 8% - but is that high or low relative to the sector and how many other BDCs feature even higher yields? Of course, the reason analysis tends to be of the "snowflake" kind is that collating metrics across the entire sector is hard to do and it's much easier to throw a few snapshots together instead. 

The BDC Investor Tool is designed to put the power back in investor hands and empower them to follow their own investment style, check and question the analysis they see from other contributors, explore issues left unaddressed as well as easily compare a given BDC to the rest of the sector. 

BDC Investor Tool

In this section we highlight only a few of the features of the BDC Tool - as the full description would fill many thousands of words. 

The Returns Section of the Tool shows both total price and total NAV returns. for the 25-name universe in our coverage. The key point here is that total NAV returns are not discussed elsewhere because they are quite hard to put together. 

Rather, we often see historic price returns (which ignore valuation changes i.e. the BDCs with the strongest price returns are those that are also the most expensive) and we occasionally see net NAV returns (which ignore dividends). To state the obvious neither really gets to the heart of the matter which is how much total return has the company delivered on its investments. You can quibble about the lack of consistency in valuing assets across the sector and it's a real issue but so long as people point to price / NAV ratios as half-sensible metrics, total NAV returns are important.

The reason you don't see these is because they are a pain to put together. Unlike CEF NAVs, BDC NAVs are not available by data providers under a special ticker. What is available are historic dividends and NAVs, typically backdated for splits (i.e. a company with a $10 NAV in 2019 that had a 2:1 split in 2020 would actually show as a $20 NAV in 2019 in various sources). So, to construct the total NAV return you have to unsplit-adjust the NAVs and then compound the returns using historic dividends. This is not Nobel prize-winning work but it's tricky which, again, why you tend not to see it. Instead, contributors have to jump through hoops by either using net NAVs (NAVs excluding dividend returns) but then qualifying these by saying, well, these three had big special dividends which is why their net NAV return looks unusually low so ignore those and then these have a low regular dividend which is why their net NAVs are overstated which is an inconsistent mess, to say the least. 

The Valuation Section shows various price / NAV metrics which can allow investors to gauge absolute and relative attractiveness of the pricing available in the sector. 

The Dividends Section shows dividend levels, trends and coverage

The Yields Section shows various key yield metrics.

The Performance Section shows various key performance metrics such as operating expense ratios, return on assets and equity ratios, operating margin and more. 

Other sections include Income Dynamics (how various income drivers are changing), Market Risk (drawdowns, volatility etc), Credit Metrics (leverage, non-accrual, PIK, etc), Quality Metrics (e.g. asset allocation in first-lien vs second-lien etc), Fee Structure and more. 

We also collate all these metrics into a rating for each BDC. 

Outside of this database, there are a number of scatter plots which summarize the sector across different pairs of metrics. One of our favorites is the total 5-year NAV return vs. valuation to gauge attractively priced BDCs with strong historic returns.

Another section of the BDC Tool allows investors to drill into an individual BDC. Power users can take a look at a number of key balance sheet and cashflow metrics.

Investors can also look at various metrics such as valuation relative to the sector.

the net yield margin and its drivers

key dividend and income metrics

historic dividend trajectory and a comparison to the sector

and much more. 

We have already discussed FDUS in our introductory article on the sector using the metrics in our BDC Tool and have upcoming articles on another 2 BDCs. 

Thanks for reading.

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