October 10, 2011: It’s that time again: almost. We’re talking about earnings season for the Business Development Company (“BDC”) industry. Companies have been issuing press releases setting dates and times of earnings releases and the attendant conference calls. In a few weeks there will be a deluge of new data as most of the thirty BDCs we track come clean about their results through September 30, 2011.
Given that this will be the first quarter after the great turnaround in market sentiment, which reached dramatic proportions in August and September, and continues unresolved, this earnings season appears to be unusually important. Since the last earnings were reported, virtually all the BDCs have gone from trading at or above NAV to significant discounts (in many cases anyway) from book value as investors became spooked about the prospects for the economy. Analysts and investors will be looking for clues about the future direction of the market from what companies will be telling us.
So what are we likely to hear and could surprise to the upside or downside as the talking heads on CNBC like to say? Here are a few prognostications:
- Net Asset Values will drop. Anyone who was invested in this industry back during the Great Recession will remember what happens to asset values when there is a stock and credit market crisis. Yes, investment assets get written down sharply and this should be no exception. We’ve already seen drops in market prices for high yield bonds and liquid senior syndicated loans, and BDC assets should be no exception. After all, BDCs are required to mark their portfolios to market, which means prices will have to reflect September 30 values.
The biggest losers on paper should be the upper middle market focused Business Development Companies such as Apollo Investment (AINV), Ares Capital (ARCC), Solar Capital (SLRC), American Capital (ACAS)and BlackRock Kelso (BKCC). Their valuations will be pegged to prices on the relatively liquid market for larger transactions, and we’d expect values to drop by 8-10% at least. Investments in mezzanine and subordinated debt should take the biggest hits, as well as some equity positions.
However, there will probably be lower valuations amongst the rest of the BDC pack, even if they operate in the less liquid, but also less volatile middle and lower middle markets. Prices are often set on leveraged buy-out comparables, and values have dropped with the general market confidence in recent weeks. Every company’s valuation method is slightly different so expect a wide range of NAV changes.
- Non-Performing Loans Will Not Change Much. Despite all the activity in investment values, we don’t expect any material uptick in non-performing loans to show up in BDC portfolios…yet. In the last few quarters, there has been a great cleansing by BDCs who were active before and during the Great Recession of their under-performing loans. Some companies that were not paying their lenders have been able to resume payments. Many other non-performing companies were either sold or filed for bankruptcy. In numerous cases, BDCs took control of troubled borrowers and recapitalized their balance sheets (usually converting debt into preferred and/or injecting additional capital). As of June, most of the BDCs that were in business in 2008 boasted portfolios with few or no troubled loans. Companies such as Hercules Technology (HTGC) in the technology area, PennantPark Investment (PNNT), Fifth Street Finance (FSC), Gladstone Investment (GAIN) and the afore mentioned Apollo Investment and Ares Capital are examples of BDCs which have largely cleaned up their portfolios. The most impressive credit turnarounds have come from Kayne Anderson Energy (KED) and NGP Capital (NGPC): both of which are in the energy sector. [For the record, KED is not strictly speaking a BDC, but only made the switch recently for technical reasons and continues to operate pretty much as they did before de-electing BDC status]
Add to these names the several BDCS which have been launched in the past two years and have not had time to get themselves into trouble: Golub Capital (GBDC), THL Credit (TCRD), New Mountain Financial (NMFC) , Fidus Investment Corporation (FDUS), Medley Capital (MCC), Pennant Park Floating Rate Trust (PFLT) and Full Circle Capital (FULL) all had zero non-performing loans in June.
There are a few exceptions: BDCs that are still struggling with loans booked during the good old days of 2005-2007. We worry that it’s these BDCs which will be most impacted INITIALLY by any weakness in the U.S. economy, and by a tightening in the capital markets. The top candidate for trouble ahead appears to be MCG Capital (MCGC), still digging itself out of a strategy of buying control investments in a relatively small number of companies and feeling the impact when some of those deals turned sour. Likewise American Capital (ACAS) has a Smithsonian Museum collection of loans booked in the halcyon days of old. The company has made progress selling off and restructuring the portfolio, but there’s more to be done. Plus, ACAS has major exposure to the European leveraged buy-out market through its wholly owned subsidiary ECAS, and that market is in the dumps. Prospect Capital (PSEC) has been doughtily adding lower risk, senior assets in the last couple of years but still has 8 non-performing loans, virtually all of which have been on the books since 2007-2008.
Nonetheless, if there are new credit problems developing in the BDC sector’s portfolios we’re unlikely to see actual non-performing loans announced yet in earnings season. If history is any guide it takes several quarters for portfolio companies to go from paying to defaulting in any number. If we do see a significant jump in NEW non-performing loans that will be a very bad sign. That would be an October surprise and unwelcome.
- Loan Books Should Increase. In the past two months, new deal activity in the very large buy-out market has crawled to a stop, as the headlines will tell you. The only deals getting done are transactions that were very far along when the market crisis began to bite. The banks (and a few BDCs involved) are forced to stand by their underwriting, but newer deals will not be so lucky.
Thankfully, BDCs operate under the news radar, and activity in the middle market tends to be less cyclical. We’ve been tracking new deal announcements in August and September and found that there have been hundreds of millions of new deals announced across the industry. Moreover, when Conference Calls were being held in early August for the June period, management reported very robust new deal activity before the current crisis set in. From memory: Apollo Investment, Ares Capital, BlackRock Kelso, Fifth Street Finance and Prospect Capital (amongst others) indicated new loan activity was on the upswing.
Moreover, the loan refinancing boom that has been a feature of the BDC market for the past year at least, had begun to slow down even before the summer. Now with a permanent pall of uncertainty in the air, refinancings will probably slow down sharply, even in the middle and lower middle market. This protects BDCs loan books from shrinking. When you add in the new business coming on, most BDCs will probably show higher assets.
- Debt To Equity Will Increase. BDCs are limited in the amount of the debt that they can carry versus their equity. In the Great Recession this was a major problem as debt approached or exceeded regulatory limits. In the last couple of years, with BDCs raising equity at a feverish pace, the problem has inverted. BDCs have been under-leveraged while trying to patiently and conservatively put their new equity capital (and often new debt capital) to work, while avoiding the excesses of the not-so-distant past.
As we’ve covered above, depreciating loan values will hit the fair market value of BDC’s equity, just as their debt outstanding increases from booking new investments. Thankfully BDCs are nowhere near their regulatory ceilings so the impact in this quarter should be muted. We don’t expect to see BDCs being forced to sell off assets to stay in compliance or defaulting under their debt agreements. Partly that’s to do with the substantial margin BDCs have left themselves against the limits, but also with the type of debt that they’ve taken on since the end of the Great Recession and the beginning of the Mild Expansion. By loading up on medium term unsecured Notes, Convertible debt and loan agreements with covenants that do not tie asset values to fair market value but to actual performance (see what Ares Capital, Apollo Investment, Fifth Street Finance and TICC Capital have done), BDCs are in far less danger of waking up one morning and finding they have crossed a line thanks to negative developments in the broader credit market.
Then there are the numerous BDCs that have raised 10 year subordinated debt from the Small Business Investment Corporation (SBIC), and don’t have to worry about mark-to-market accounting in the same way as they would if they were financing themselves with a Revolver from a bank lender. Hercules Technology (which has two Revolvers but does not use them), Triangle Capital (which only just added a small Revolver after maxing out its capacity at the SBIC), Main Street Capital (ditto) and PennantPark have successfully used this long term capital to avoid being hostage to loan valuation vagaries. No wonder there’s a long line of applicants for more borrowings from Uncle Sam.
- Earnings Will Increase. Ironically, we should see earnings increase because of the increase in total loans booked, which will raise interest income and fees received. There may even be a premium to be received by the BDCs for lending money in this difficult environment that might slightly expand gross yields, and transaction fees.
At the same time, the depreciation of existing asset values discussed previously will reduce or moderate the rise in BDC expenses for externally managed funds. BDCs pay their managers according to the fair market values of their assets (usually averaged over a couple of quarters it’s true) so management fees could be positively affected (from a shareholder’s viewpoint).
No wonder that analyst consensus estimates for many BDCs have not budged much in recent months although there is a constant upward and downward revision in a narrow band going on. In the short term BDC earnings are not in danger. Earnings will drop when and if non-performing loans increase.
We should point out that dividends and earnings also peaked back in early 2008 just before the Great Recession caused substantial hardship to most of the BDC players at that time, and a slew of dividend reductions in the year that followed. Past, though, is not prologue, and we don’t raise this point to be alarmist. On the contrary, if the U.S. economy avoids actually shrinking, BDCs will probably not see a material uptick in bad loans. Even if the U.S. economy goes nowhere (a la Japan), BDCs should muddle through even if earnings and cash flow at their portfolio companies are flat for a long period. Sympathy should go out to the owners and employees of the portfolio firms who will be caught in a form of financial purgatory, unable to create much value.
We started out by saying that this earnings season will be an important one but we don’t want to overstate the matter. Changes in credit quality and portfolio performance take many periods to play out, and we’re only in the first couple of innings. This could still go either way. A few weeks or months from now from now the European debt crisis could be “resolved”, the U.S. economy could establish a firmer footing and all the issues investors will be worrying about as the BDCs report their third quarter results could seem overblown. Or Europe and the global economy could go to hell in a hand basket, and the third quarter of 2011 will look like the good old days. Welcome to the “new normal”.
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We have positions in all the BDCs mentioned except MCGC, KED, GBDC and NGPC.