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BDC Earnings Season So Far: Three Observations

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VIEWS

Ten BDCs have already reported quarterly earnings, at the time we write this article on May 3, 2018.

(By the time you read this another round of releases will have occurred).

See the BDC News Table for links to every earnings press release, and a brief summary of highlights from the BDC Reporter.

In addition, most of the reporting BDCs have filed their SEC mandated quarterly reports, and have held Conference Calls.

The BDC Reporter is wading through each in turn, and updating our database.

Measuring Stick

Moreover, we are comparing the first quarter results against our 2018 earnings projection for most every name.

(We don’t have a projection for Triangle Capital).

Returns Are Easy. Risk Is Hard.

We also compare portfolio credit performance against our own short term and long term expectations for every BDC.

That’s a much more involved process than comparing and contrasting earnings per share.

We look at every investment in each BDC’s portfolio in turn, both performing and non-performing.

Where the latter are concerned, we gather as much public information as possible to provide context.

New (Related) Subject

This quarter, we’re also paying close attention to what each BDC is saying and doing about their approach to the Small Business Credit Availability Act.

Overwhelming

And we’re still less than a quarter of the way through earnings.

Given that we can’t immediately undertake and publish an in-depth review of every BDC and all the issues mentioned above, we’re going to share a few general findings.

Opinion Piece

Plus, throw in some commentary because this is a Views article.

Remember, though, that this is a work in process and only 48 hours have passed since the deluge of new data began.


1.Performance Is In Line With Expectations

You’ll see headlines on earnings releases about this BDC or that meeting, matching or exceeding median analyst expectations.

We’re less concerned about a penny here or there, either up or down.

Nor do we spend much time contemplating a few cents change in book value.

Instead, we seek to determine if BDCs performance – defined broadly – is consistent with our expectations, and 1 year and 5 year projections.

We can report that – almost universally – all the reporting BDCs have performed as we – and the market – might have expected.

The Best Surprise According To Holiday Inn

There have been very few surprises in either reported earnings, or credit quality or strategic approach or whatever.

This is reflected in the stock prices of BDCs that have already reported.

A few have done slightly better than the more skeptical investors might have expected and seen a mild bump in their price (ARCC,NEWT and OXSQ are three examples).

Others have done slightly worse in one or more key categories and seen a mild drop in price.

(HRZN and BKCC come to mind).

However, there have been no wild swings 10%-20% up or down in a short period as has often been the case in the past.

That may yet occur with over 30 BDCs still getting ready to report.


2. Investment Advisors Continue To Subsidize Earnings

BDC investors do not like to see distributions cut.

BDC Investment Advisors are well aware of this BDC Fact Of Life.

With many BDC earnings running close to or below their recurring distribution level, managers have been waiving fees left, right and centre to maintain their pay-outs.

Despite higher yields from LIBOR shooting up, this remains a challenge in the IQ 2018.

BDCs that are artificially boosting earnings by offering TEMPORARY waivers (or are all waivers essentially temporary ?) include the following:

ARCC, BKCC,GLAD, and TCRD.

Shareholders are presumably happy that the Investment Advisors are throwing dollars their way to maintain dividends.

So what’s the problem ?

Giveth And Taketh Away

Unfortunately – as we said – these are usually voluntary waivers or formulas written into Incentive Agreements with a finite life.

At some point these cost reductions will go away and pay-outs will be threatened.

Or, additional income will be generated but be completely channelled to the Investment Advisors so they can receive their full compensation due.

We’re not talking about small amounts here, in many cases.

The existence of the waiver or temporary Incentive Fee reduction is sometimes a major component of reported earnings.

This means some BDCs may see higher income in the future but shareholders will not see any of the increase.

Or managers will have to cut the distributions if they are to be paid in full.

This issue affects BDCs of all sizes including ARCC, GLAD (which deliberately and openly waives fees every quarter to meet the distribution) and BKCC.

Moreover, there are many BDCs in this same boat that have not yet reported.

Most notable is AINV, which has been waiving fees for two years now.


3. Most BDCs Are Opting For Higher Leverage.

The Small Business Credit Availability Act has given BDC Boards the option of adopting the new higher leverage rules and waiting a year to implement.

Or, gaining shareholder approval and being immediately able to double the amount of debt on the balance sheet.

Or do nothing.

No BDC Left Behind

So far, there have been no BDCs who’ve emphatically plumped for sticking with the traditional 200% asset coverage / 1:1 Debt To Equity.

Admittedly, every BDC has a different approach to the Act.

We won’t go through all the permutations we’ve seen so far, but we’ll tackle a couple of trends we’ve noticed below.

At The Drafting Board

Just be assured that just about everyone is drawing up plans to lever up in one way or another.

Counter Intuitive

Unfortunately – but not surprisingly – some BDCs with very high loan yields are making the argument that the extra leverage will be accretive for them.

After all, if you’re charging 14% or 15% for your loans, some of that is going to end up in shareholders pockets even after expensive borrowings, compensation, costs and incentive fees.

The Elephant Left Out Of The Room

Left out of the argument is that mid-teen yields also come with substantially higher credit risk and the potential for outsized Realized Losses.

So what might be gained in higher incremental earnings might be lost – and more – when borrowers fail to pay down the road.

Short term thinking can be a dangerous thing.

Define “Safe”.

Other BDCs are proposing to take another tack: investing the extra leverage in lower risk-lower yielding assets than has been their norm.

This is based on the unstated assumption that leveraged loans yielding 6%-10% (we’re never told exactly what is the target yield) barely ever record credit losses.

Being Direct

This is clearly untrue.

These are still mostly BB or B equivalent loans (and sometimes CCC).

Their credit histories as a group may be better than loans made at yields between 10%-15%, but that’s hardly a fair comparison.

We Are Witnesses

Over a full economic cycle, these so-called “safer” loans can readily result in losses of 10%-20% of funds advanced, even if they’re labelled “First Lien” or “Senior Secured”.

We have yet to be challenged in our assumptions by any BDC spouting any long term credit performance data that would contradict us.

Does Not Compute

Most of the time – as we’ve now shown over and over again – borrowing to invest in loans does not work in the BDC model.

The cost of borrowing  – even for the “safest” collateral is pushing well over 4.0% when interest and unused fees and front end fees are included.

Then there’s the Management Fees at 1.5%-2.0% in most cases and incremental operating costs associated with all those new loans of 0.5% to 1.0%.

Then there’s the 20% in Incentive Fees.

And last – but by no means least but often left out of the argument – are those eventual credit losses.

What We Want To Hear

On paper, leveraging up to invest in “safer assets” and get the same or better return than at the moment ,but with less risk, sounds attractive.

In reality, that arbitrage between what you can earn and what you have to pay does not work nine times out of ten.

Contradiction

The irony is that the same managers  who are arguing for leveraging up the BDCs that they advise, but often invest very little in themselves,  continue to complain about market conditions.

As reading virtually any of the Conference Call transcripts that have come out so far will show, BDC managers repeatedly moan about  extreme competition; loosening covenants; higher acquisition and debt multiples in the debt markets.

This applies to upper middle market, middle market, lower middle market and specialty sectors.

Here’s an extract from the ARCC transcript when CEO Kipp deVeer was asked about market conditions, which will serve as a typical example:

We’ve seen just all-around … weaker underwriting. So more covenant light, lower quality, earnings being financed, value loss adjustments being financed to high multiples, structural loosening of all sorts of provisions and documentations, provisions for restricted payments that we haven’t seen before, capital structures that allow for layering of debt, covenants that actually don’t decline, if they exist. So people — that will give you a 9 times leverage covenant forever, which is a new invention in today’s market, so just all sorts of things that we don’t think represent particularly sound underwriting metrics.

Earlier in the call, Mr deVeer quantified how few attractive transactions were out there in the marketplace:
We currently are only closing on about 3% to 4% of the transactions we review for new companies and we continue to stress-backing our strongest incumbent borrowers. For example, in the first quarter, we reviewed more than 330 new portfolio company transactions, and we closed 12.
That’s a fascinating stat – and not unlike numbers given by other BDCs.
Whereto ?
The BDC Reporter would only point out that even if Mr deVeer and his team have managed to identify the best 12 deals in the market, that leaves 300 transactions deemed unattractive getting done somewhere else.
Probably by one or other of the other 45 BDCs out there, all touting themselves as being “highly selective”…
Final Question
Is this really the time to be embracing taking on more assets – and thus more risk – even if the nominal economics by some Minor Miracle are marginally accretive ?
The answer will be crystal clear if we get a recession any time soon but harder to determine if the positive credit environment we’ve enjoyed for several years just continues.
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