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BDC Common Stock Market Recap: Week Ended May 11, 2018

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BDC COMMON STOCKS

Get Out Your Rally Monkey

Halfway through the week the signs became so clear that the BDC Reporter was impelled to alert readers: a BDC rally is on !

For those of you who missed the missive, here’s the article.

By the end of the week, the regular marker we use – the stock price of the UBS Exchange Traded Note with the ticker BDCS – was up to $20.09.

That’s up from $19.63 the week before and $19.50 the week before that.

Or, in other numbers: up 2.3% on the day, and 3.0% over a fortnight.

However, the lowest price on a year-to-date basis was $19.050 for BDCS.

Currently the sector is trading 5.5% off that bottom.

Off The Bottom

Another data signal that caused us to come running about a BDC rally was the sudden and dramatic change in the number of BDCS trading within 5% of their 52 Week Lows.

This is one of our favorite metrics as bargain hunters – when those denizens exist – tend to swirl around the stocks with the lowest prices.

On Thursday, the number of BDCs “at the cliff’s edge” had dropped from 21 to 7 in what seemed like the twinkling of an eye.

By Friday’s close, the number had dropped again: to 3.

Worst

There are so few we can name the tickers:

MCC, HCAP and TCRD.

All three reported poor IQ 2018 results. (We discussed Medley during the week, and have more to say next week).

More Ups Than Downs

Another regular data-set that we use is looking at how many BDC stock prices are up on the week, and by how much.

We arbitrarily use a 3.0% move in either direction as “meaningful”.

This week, according to Seeking Alpha data, 42 of 46 BDCs were flat or up in price and only 4 down.

Troubled

The Biggest Loser was (and this will not be a surprise) MCC, which was down (15.8%).

We’d been projecting a dividend cut at the highly troubled BDC for months- and many investors had been pulling out as well – but the news still caught some investors flat footed.

The BDC Reporter has a feeling MCC will continue to stay in the news through the summer.

Nearly A Third

On the plus side, we count 14 BDCs up 3.0% plus, including 3 up by double digits. In 5 business days.

Those are OCSL (12.2%), CMFN (11.3%) and ACSF (10.2%).

ACSF benefited from news of its imminent liquidation at close to par, when the stock was trading well below book.

The other two BDCs jumping up in price are benefiting from that change in sentiment which characterizes a rally.

Not Convinced

We’ve spent some time with the results of both OCSL and CMFN and not been particularly impressed with the turnaround at either.

OCSL’s slight increase in Net Investment Income Per Share for the IQ 2018 was predominantly due to a reduction in outsized professional fees from the IVQ 2017.

At the portfolio level, Oaktree Capital – despite much self congratulation on the Conference Call – still has 8 loans on non-accrual and a slight increase in Unrealized Depreciation reported.

Book value per share dropped for yet another quarter.

However, the wily Investment Advisor – after allowing the dividend to drop to $0.085 last quarter from $0.125 the quarter before – upped the pay-out in the IIQ 2018 by 1 cent to $0.095.

Investors lapped it up, pushing OCSL to a 3 month high, as this chart shows:

Moving Along

Finally, the number of BDCs trading above both their 50 Day and 200 Day Moving Averages has spiked.

39 BDCs are trading above the 50 Day average, and 14 above the 200 Day average.

That second metric leads us to our next point, which is that the rally underway still has plenty of room to run.

With the benefit of short term hindsight, we’ve been in a sharp uptrend for only 7 days, since a recent low on May 2, as this chart illustrates:

Plenty Of Room

BDCS is still down (3.2%) on a 2018 YTD basis and (17.6%) off the March 2017 high.

According to our data – and we admit we’re still inputting the flood of new numbers – only 10 BDCs are trading above book value out of 46.

That’s up from a half dozen, but leaves room for further improvement.

Reasons Why

Of course, we can’t guarantee that this “rally is for real” and will continue its upward trend.

However – as we mentioned in our mid-week article – a mixture of a temporarily improving credit quality picture and the (probably false) promise of higher returns from the new leverage rules may continue to cause investors sentiment to improve.

Returning To An Old Theme

A positive catalyst for earnings – but not necessarily for long term credit performance – would be some sort of backing down by S&P about its threat to slap a “junk” rating on the debt of any BDC that adopts the new law.

We continue to believe that some sort of compromise will be coming down the pike which will allow many of the larger BDCs that have (reluctantly) held back from adopting the lower asset coverage to change course.

No bell will ring. There may not even be a press release on the subject but individual BDCs will work out some modus vivendi.

Frustration

Just read the discussion of the subject on the FS Investment (FSIC) Conference Call to get an idea of how conflicted the big cap asset managers are, given the years they’ve been lobbying for just this loosening of the rules only to be blocked by the rating group at the last minute.

Calculating

(The BDC Reporter continues – in the background – to undertake pro-forma calculations for every BDC to determine if extra leverage will be materially accretive to shareholders – both before and after eventual bad debts are figured in.

So far, only 1 in 4 BDCs that has expressed interest in the extra leverage could make a reasonable case that return on equity will materially- 20% or more – improve from the potential doubling of their leverage).

Unstoppable

Moreover, BDCs continue to load up on debt through SBIC subsidiaries and Joint Ventures pushing actual leverage (versus regulatory) well above the 1:1 debt to equity threshold, while still preparing to increase their on balance sheet debt.

Even sensible managers cannot resist the siren song of ever bigger balance sheets without needing to raise fresh equity capital.

Not Tied To Any Mast

PennantPark Floating Rate (PFLT) announced the following on its latest Conference Call:

We are pleased to announce that we have doubled our PSSL joint venture with Kemper Insurance. In addition, Capital One in a syndicate of lenders has doubled the PSSL credit facility as well. As a result, PSSL has buying power of $630 million, consisting of a $420 million loan facility and $210 million of notes and equity. PSSL has enabled us to be even more responsive to our middle-market, private equity sponsor clients as well as generate an attractive ROE to help grow PFLT’s income.

At the same time, the Board of PFLT has also given the green light to adopt the new higher leverage rules as well.

Of course, every manager considers themselves sensible, reasonable, “highly selective” and capable of handling the extra firepower.

(There’s a dangerous parallel with what happens in a bar late at night when your friends are ordering shots. We know this only from what we’ve read and seen on television shows).

Insight

Here is a revealing quote from Art Penn – the CEO of PFLT (and PNNT too) – from the latest Conference Call, which reflects the thinking process of many of his BDC peers:

And we’ve got the Board approval [of the new leverage rules ] just to give us the runway for 12 months. Hence as we evaluate all the different options, talk to our shareholders, talk to our bondholders, talk to our lenders and assess what exactly we’re going to do. But as we said — and then, as we said for the last years is this law was being evaluated. We think the assets in PFLT could judiciously be leveraged more than one to one and still operate prudent risk-adjusted return for our shareholders. And certainly, our operation at PSSL would so far — by the year-end, it has been very smooth. Our relationships with our lenders have been good. We doubled the credit facility in PSSL. We had an oversubscription; we had to cut lenders back. And I think that’s because lenders see, number one, the quality of the collateral that we have, first lien senior secured floating rate loans, and they also see that the track record over the last seven years that we’ve had investing in this asset class. So, should we decide in the coming months to go to more fulsome, up to two to one leverage, as an overall firm we’ve been operating at, we think it could prudently be done, and we do think we could get capital. We haven’t firmly make decision. So, we’ll keep everybody appraised along the way. We do want to hear from all of our stakeholders along the way. As this law has been [Technical Difficulty] the last 10 years, we’ve said to people, hey, we think these assets could prudently be leveraged more than one to one, and no one has disagreed with that, not a rating agency, not a bondholder, not a shareholder. So, we feel good about the support, should we decide to do it.

Exceptional In Every Way

We are amused that the only BDC that seems to have firmly concluded – after initially heading in the other direction – to stick with the old leverage rules is Prospect Capital (PSEC).

This still huge BDC has long been derided by analysts and some investors for pushing the envelope on risk taking.

Yet on the last Conference Call CEO John Barry was holding out PSEC as an example of leverage rectitude (to coin a phrase) compared to other BDCs that have jumped on the Small Business Credit Availability Act bandwagon:

What we’re seeing I think here — now, we have the benefit of a month and a half or so from the new building passed and rating agency reaction is same; what I see — what we see is a bifurcation market between folks interested in being relevant to the bond market which generally tends to mean staying at 200% assets coverage, and folks that are focused or shifting their model towards focusing on secured financings.

I would encourage folks to think about it’s not just the amount of leverage but the type of leverage that matters, and we intend on — of course, we have our bank revolver but we intend upon being quite relevant and managing our risk prudently and demonstrating that with the bond market and view that as a less risky place to be in the late endings of the business cycle approaching some sort of economic slowdown recession most likely in the next couple of years. If you’re 100% dependent on secured financings and the significant bills and whistles that go — come along with that, you have other risks that come into play and we saw that occur during the last cycle, and we of course were a significant beneficiary of that as a consolidator in the industry.

So short answer again is, 200% we plan on staying at that level for asset coverage and continuing to be a relevant and leader for institutional and non-institutional term debt issuance.
Behind The Scenes
The BDC Reporter did not just fall off the turnip truck.
We know that even within the 200% asset coverage strictures, PSEC has loaded up on credit risk in a variety of ways that would make other BDCs blush.
There’s the huge exposure to CLO equity tranches, sitting at the most junior level on vehicles that are themselves leveraged eight to fourteen times.
Then there are the portfolio Control Companies in finance, real estate and consumer lending which are themselves highly leveraged with third party borrowings.
You do not achieve a 12.9% yield on your investments – as is the case with PSEC – without taking on plenty of risk.
Even that average yield does not tell the full story.
Drawn From The Portfolio List
Just trawl though PSEC’s quarterly filings, as we do periodically, for useful illustrations.
Here are a few from the March 31, 2018 10-Q:
Credit Central Loan Company – a consumer finance business – pays 20.0% on its Subordinated Loan (10% in cash and 10% in Pay-In-Kind).
First Tower Finance – also in consumer finance – pays 17.0% (10% cash and 7.00% PIK).
MITY Inc – a wholesale supplies company- pays 20.00% on its Secured Secured Note B (10% in cash and 10% in PIK)
National Property REIT – real estate and consumer lending – pays 16% on Senior Secured Loan E (11% cash and 5% PIK).
We could go on but we won’t as those examples should speak for themselves.
(By the way, these are not isolated situations or small borrowers. On the contrary, just the 4 names we mention above and the CLO investments account for over 40% of PSEC’s total investment portfolio).
Tying Up
We mention all this to make three points:
One, looking at debt to equity in a table or press release tells you very little about risk. Digging down to the granular level is necessary to ascertain a BDC’s real “risk profile”.
Two, BDC managers of all stripes are drawn to use leverage to make their returns work. Investors have to keep an eagle eye on what the trade-offs are for those extra few cents of earnings.
Third, commercial lending is a very cyclical business and the business model can work for years till it doesn’t. Or in other words, when a recession comes along a decade of good results can be wiped out in a quarter or two.
While we navigate what seems to be a revival in market sentiment for BDC stocks, it’s important to keep an eye on those credit rocks lying just beyond the horizon.
The Best And The Brightest
Ironically, we worry most about the BDCs that have performed well in recent years and may believe themselves immune to credit losses.
It was hubris that caused crafty Odysseus to take ten years to return home from the Trojan Wars.
We hope that the more successful BDC leaders will not “sin against the Gods” by taking on excessive risk  just when conditions are improving.
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