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BDC Common Stock Market Recap: Week Ended April 13, 2018

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BDC COMMON STOCKS

Which Way ?

One of the problems of using the UBS Exchange Traded Note with the ticker BDCS as a measuring stick for how the BDC Sector is performing are the quarterly dividends.

This week, BDCS paid out $0.442 per share in distribution, which dropped the stock price in the aftermath to $19.39.

Compared to the prior week’s BDCS price of $19.97.

However, adjusting for the distribution, the “real” price was $19.83.

That suggests the BDC Sector was down on the week, but only modestly.

Still, that’s the first reversal in an uptrend for BDC common stocks that began March 1, 2017 when BDCS was a two year low of $19.05 at closing.

The obvious question – at least to us – is whether the BDC Sector is in a short term bounceback, which is already petering out, but still headed downward or is this just the pause that refreshes before prices move higher ?

Unclear

Unfortunately the data is very mixed.

We certainly had an unedifying week if we look at the number of BDC stocks up in price.

Just 11 stocks were in the green out of 46.

(We’ve added KKR’s public BDC with the ticker CCT to our universe of stocks tracked).

Moreover, 22 BDCs are trading above their 50 Day Moving Average, 1 down from 23 last week.

Down Below

In addition, we like to look at how many BDCs are trading within 5% of their 52 Week Lows, a datapoint that we capture in our internal spreadsheet.

Last week there were 13, and this week 16.

New Law. Same Result

If investors were enthused about the ever growing numbers of BDCs electing to adopt lower asset coverage (codeword for much higher leverage) limits there was no reflection in price levels.

For example, early adopter Apollo Investment (AINV) – which waved off warnings about being downgraded by S&P – continues to trade very close to the bottom of its 52 Week price range: just 4% off the lowest price.

Constantly Updating

We’re keeping a list of which BDCs have jumped at the chance to boost assets, borrowing and risk.

So far, about a quarter of the BDC universe has raised its hand, but we’re expecting many more to follow.

Questioning

Maybe investors are not jumping on the purported opportunity to boost BDC earnings by leveraging up because they agree with the BDC Reporter that the 100% debt funded increases don’t result in any accretive gains to EPS ?

And vastly increase credit risk on a per share basis, in theory.

Or maybe investors are just waiting till the new leverage – and the resulting higher income and Net Investment Income Per Share – becomes reality.

In most cases that’s not going to happen till next spring.

Or, investors are waiting – as we are along with  S&P and Fitch (which came out this week with a wishy washy first response to the new BDC rules) – to see the individual plans of the BDCs involved.

Test Case

We’re especially intrigued by how Ares Capital (ARCC) – which is managed by a publicly traded asset manager whose fiduciary duty is to boost management fees – will navigate this complex issue.

The BDC has announced its intention – as has been their mantra all along – to use the extra leverage to invest in “lower risk” loans, and thus (presumably) not affecting its risk profile.

Besides the fact obvious to everyone but BDC managers that all non-investment grade loans can default and result in losses of income and principal, there is the question of accretive benefit.

Lower risk means lower yield assets, and after debt service, Management and Incentive Fees and incremental operating costs of having more loans on the books are taken into account,  how much drops into the pocket of the shareholder ?

As we’ve shown now on three occasions in tedious detail with AINV, FSIC and OFS the answer is likely to be: very little.

On the other hand – and with all due respect to “lower risk assets”, which are actually mostly BB or B credit rated assets – the risk of credit loss will materially increase for shareholders (less so for managers) from the first minute those new assets hit the books.

Ulysses Tied Himself To His Mast

ARCC have always held themselves out as a beacon of reasonableness in the BDC Sector, but with a Board that does not push back (a universal and shameful phenomenon in the BDC Sector); a management contract which includes no liability by the Investment Advisor and a corporate structure which leaves shareholders with little power but to consent to what the insiders want (how many dissident shareholder challenges can you remember not funded by a multi billion “activist” ?), the temptation to grab those extra fees from leveraging up the balance sheet might be irresistible. That’s especially the case as the damage to the balance sheet that might occur is somewhere down the road when credit conditions worsen and critics will never be able to distinguish which future loss was the result of adopting the new rules and which not.

If it’s any comfort – and we accept that it’s probably not – the BDC Reporter will be keeping an eye on ARCC and all the other players both in the short and long term.

Ready To Be Convinced

We’re keeping an open mind and hoping to be shown how ARCC or others can “square the circle”.

There Is Another Way

Otherwise, the only real recourse BDC investors have if BDC Managers end up going down a “shareholder unfriendly” path is to vote with their feet.

It would be ironic if the new law passed by Congress – touted by some as a possible fillip for BDC prices after a year plus of price declines – ends up having the opposite effect.

If you believe in an “efficient market” a failure by BDC Managers to use the new laws to generate incremental risk-adjusted benefits for shareholders will ultimately result in lower prices.

There’s a lot of ifs, maybes and perhaps yet to go through and this will take many quarters to play out.

Winners And Losers

The Good News – if there is any – is that the BDCs that handle this subject appropriately may gain a greater following amongst grateful investors, while those who do not may be hard pressed to raise any new equity ever again.

Maybe a year or two from now we’ll be left with some very successful BDCs using leverage in a shareholder friendly way and growing through continuing equity offerings and some highly leveraged “zombie” BDCs, bulked up by new assets bought with extra leverage but unable to access the equity markets.

Roll just a few years forward and we can imagine what will be happening to distribution levels and stock prices.

As we’ve said before, the new law is the most important development in the BDC space that we have had to contend with since we first bumped into a stock called American Capital back in the year 1999, and began to learn the idiosyncrasies of the sector.

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