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BDC Common Stocks Market Recap: Week Ended August 3, 2018

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BDC COMMON STOCKS

Enthusiastic

Just as second quarter BDC earnings season was about to begin, the signs were mixed about the state of the BDC rally.

We discussed as much in great detail in our Market Recap ended July 27.

However, the BDC Reporter plumped for an optimistic reading of the market, as exemplified by this quote:

“This suggests to us – and there are as many ways to read these tea leaves as there are readers – that a strong vein of optimism remains amongst investors”.

That was definitely confirmed this week as a host of BDCs – big and small, famous and infamous – reported results.

The UBS Exchange Traded Note with the ticker BDCS, which we use as a sector proxy, ended at $20.86, up from $20.63 the week before.

As the YTD chart shows that brings BDCS back to a level not reached since January 3 of this year:

Rally Numbers

The Wells Fargo BDC Index indicates the total return in 2018 is 7.5%.

This rally, which began March 1, 2018, has now moved up 9.5% in price terms alone.

Wait A Minute

Will that trend continue ? We’ll get back to that at the end.

All This Research Has To Go Somewhere

First, let’s look at some other confirmatory data points.

On the week, 33 BDCs were up in price versus 21 last week.

Moreover, and using a slightly wider frame, we note that over the last 4 weeks – using Seeking Alpha data – 34 BDCs are up and only 12 down.

When you have three-quarters of the BDC universe up in price in this way that suggests a relatively broad rally.

Untroubled

Our other favorite BDC Reporter data point – drawn from our own huge database – shows now only 4 BDCs trading within 5% of their 52 Week Low, versus 5 last week.

Just as important 10 BDCs are trading within 5% of their 52 Week High and another 12 between 5%-10%.

Last week, there were 8 BDCs in the 0%-5% category and just a few weeks ago half that number.

The Big Mo’

Looking at momentum numbers 31 BDCs are trading above their 50 Day Moving Average and 35 above their 200 Day Moving Average. 

That last statistic lets us know most clearly whose been left out of the Good Times in the BDC sector.

Questionable

There are just 5 names who are 3% or more behind: MCC (24% down), ABDC (15%), MVC (6%), TCRD (6%) and HCAP (3%).

Not surprisingly all these under-performers are contending with major question marks about their credit performance.

Moreover, all but MVC – which reported quarterly results through April – have yet to release IIQ earnings.

Investors may have a “strong vein of optimism” running through them, but not for any BDC company, and not without getting a look at the books.

That suggests this is not yet a “red hot” market.

As Anticipated

Helping the rally this week was that BDCs that did report earnings mostly met expectations.

There were a few whose numbers were a little lower and a few little higher than what the median analyst may have projected, but we’re talking pennies of differential.

The BDC Reporter itself has begun to project out earnings per share and dividends in one year and five year time frames for every BDC we track, and comparing quarterly results against those far away numbers.

Of the 15 BDCs that have reported results in the week ended August 3,  10 met expectations, 3 were above and only 2 were below. 

Yet Another Projection

We’ve also taken – as a useful exercise to determine earnings momentum – to project earnings over the next 12 months on a rolling basis.

For what it’s worth, we expect higher earnings from 10 of the 14 in the next 4 quarters than for 2018 – halfway finished already – as a whole.

Likely Outcome

The prospect of higher earnings begs the question of an increase in distribution levels.

Most BDCs who’ve been around for awhile are loath to raise their regular distributions lest they should have to cut back in the future, always a sign of weakness and a signal for investors to sell,sell, sell.

Instead, several BDCs including Goldman Sachs BDC (GSBD), Gladstone Investment (GAIN)  and TPG Specialty (TSLX) have kept their regular distribution level untouched and resorted to frequent “Special Distributions“.

That seemed to be the way all three aforementioned BDCs were leaning when the subject came up on this week’s Conference Calls.

Ares Capital (ARCC) went its own way, raising its quarterly distribution by one penny. Nonetheless – because of BDC regulations – we expect a “special” payout as well.

Under Pressure

However, with ever more BDCs adopting the higher leverage rules allowed under the Small Business Credit Availability Act and planning big boosts in portfolio size, pressure will grow to reset the regular distribution.

Candidates for an increase – over the next 24 months (!) – are ARCC (again), GSBD,TSLX, GAIN,GLAD,MAIN, NEWT and TPVG.

(We’re just counting from amongst the BDCs that have already reported).

Still struggling to match up earnings with their distributions – and mostly for credit reasons – are BKCC, FDUS, HTGC, HRZN, KCAP and OXSQ. 

Frankly, we’re worried only about two of those strugglers as we’ll discuss in a soon-to-be-published Dividend Outlook review.

Adopted

As we’ve said, part of the likely reason for higher earnings going forward is the fast and broad adoption of the new asset coverage rules by BDCs of all sorts.

We’re on the record as expecting almost every BDC to eventually succumb to the temptation of lower asset coverage and higher debt capital.

That was mostly confirmed this week as 11 of the 15 BDCs that reported have chosen to be governed by the new limits.

Quantifying

The BDC Reporter has taken to calculating what the likely increase in assets/debt over the current level might be for every BDC that has adopted the Act.

We listen to the “Target Leverage” each BDC is imposing on itself to guide our calculations.

When no guidance on “Target Leverage” is given we make common sense assumptions based on current practice by the BDC involved.

To date – according to our records – 29 BDCs out of 46 have already signed up for higher leverage, whether by action of the Board or the shareholders or both.

Big Number

We estimate that this will result on a pro-forma basis when “Target Leverage” is met in $14.8bn in new asset and debt formation.

To put that into context – using Advantage Data‘s excellent database – public BDCs have $55.1bn in assets at fair market value.

(We’ve deducted out the value of a number of smaller public BDCs that we don’t cover).

This suggests that at this stage just the extra assets from the BDCs that have committed themselves to the new rules will grow the sector by 27%.

Harder To Prove

The BDC Reporter has predicted in the past that the final number will be at least $20.0bn, and maybe even higher.

Even at $20bn, the BDC sector will have grown by more than a third and will exceed $75bn in balance sheet assets.

When all the off balance sheet debt which BDCs utilize in Joint Ventures and in wholly owned finance companies – and which rating groups and many investors seem to forget about – total public BDC assets are likely to far exceed $100bn.

On The Podium

Obviously that’s a huge number but observers may say that pales in comparison to the $1.0bn syndicated leveraged loan market (which just hit its own record high in July ) or the $1.1 trillion U.S. high yield market.

Here’s an interesting article in the FT which discusses both “leveraged loans” and “high yield”. (Sadly, no mention of BDC lending which continues to be little understood and under-appreciated by financial journalists).

However, when you adjust for a few key items to ascertain the risks involved the gap between BDCs and its two other non investment grade cousins is much smaller than total amount of investments outstanding might suggest.

First – at least on paper – BDC loans and equity stakes are far riskier from a credit loss standpoint than the large syndicated leveraged loans to huge borrowers.

As this data from LeveragedLoan.com (an endless source of useful data), the current average yield on these bigger loans to bigger borrowers is 5.94%.

Further Along The Spectrum

A yield under 6.0% is almost unheard of in the world of BDCs, where average loan yields tend to be in the low double digits.

We keep a list of yields at each BDC on income producing investments. We’re still filling in some blanks but the range of yields is between 7.2% and 14.4%.

85% of the 29 BDCs we’ve gathered data on so far enjoy yields above 10.0%.

Some of the differential between syndicated leveraged loans and BDC equivalents can be accounted for by the liquidity of the former, which are bought and sold daily like any other security.

However, most of the differential – which is probably 5% in toto – reflects the likelihood of greater credit losses over time.

Even when BDCs invest in lower yielding, larger cap “safer” loans they are typically at the higher end of the risk range (with yields above 7.0%) and are pushed into joint ventures which are then “leveraged up”.

Obviously that increases the risk involved down the road.

One also has to realize that several BDCs between them  have invested billions of dollars in the equity tranche of CLOs – vehicles often leveraged at 10: 1.

The latest phenomenon which many BDCs are getting into is acquiring controlling stakes in finance companies and leveraging them up as they see fit as there are no regulatory limits thereon.

Often this means the companies involved have third party debt equal to 2, 3 or even more times the junior capital which the BDCs have committed.

Let’s Not Forget

Finally, we’ve only been giving you the numbers for PUBLIC BDCs.

Once again drilling into Advantage Data’s tables, we find that there are 32 “non traded” BDCs with $33.1 bn of balance sheet assets.

These entities – usually sharing the same Investment Advisors as their public counterparts – also utilize off balance sheet vehicles to enhance their size and are subject to the Act.

Count Risk. Not Assets

If one throws in all the BDCs – both public and private – and weight the credit risks  – we’ll probably find in the Next Recession that the risks of loss in absolute terms may be much in line with their nominally bigger syndicated loan and junk bond brethren.

Very Big Picture

To date, this government- and its predecessors – have largely left BDCs and their asset manager sponsors to regulate themselves.

Regulators – fighting the last war – were mostly intent in the last nine years  on getting banks away from the risk of leveraged buy-outs.

They have largely succeeded in that regard, as bank exposure to these “highly leveraged transactions” broadly defined has dropped dramatically.

However, that’s mostly been achieved by pushing those credit risks into the syndicated loan, high yield and – to a degree probably not understood by many in Washington D.C. – into the BDC market.

Chances are that laissez faire attitude – for ideological and pragmatic reasons – will continue even as the BDC sector grows ever larger in the years ahead.

“Systemic risks” are usually caught only in the back view mirror.

At some point, though, BDC managers and shareholders may have to contend with both the rough and the smooth of the sector’s quiet but inexorable growth in the form of greater regulation.

Let’s Be Realistic

Unfortunately, that’s likely to occur only after one of those once-in-a-decade financial meltdowns that is baked into the global economic system.

Apres Nous Le Deluge

In the short term, though, we expect investor enthusiasm – barring any catastrophic results being announced by a heretofore respected BDC – to remain high.

Higher earnings – even if associated with higher risks – tends to draw in more capital.

With the impetus of the asset growth brought on by the Act and the possibility that BDCs will be once again included in the major indexes and the benefits of a growing economy on borrower performance, the BDC rally is set to continue.

As always there will be ups and downs, but we’ve been in an upward trend for 5 months.

Moreover, BDCS would have to rise 15% just to match the sector’s 2017 high.

Our prediction is that BDC investors will make hay while the sun is shining and will worry about all the issues the BDC Reporter has mentioned above somewhere down the road.

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