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BDC Preview: Week Of December 17 – December 21, 2018

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Focus:  This week – as in all recent weeks – the focus of most market participants will be on the gyrations of the markets. The week ended December 14, 2018 was not a pretty one for either BDC common stocks or Fixed Income, with both hitting new lows as we expounded on at length in our stock and debt Market Recaps for the BDC Reporter’s now shell-shocked Premium subscribers. BDC common stocks are now in the red in 2018 on a total return basis and at multiple new record lows. The median BDC debt price is now under par – albeit by only $0.05 – for the first time.

Looking ahead for the week ended December 21 – and downward – the next major number to look out for is the price of the UBS Exchange Traded Note with the ticker BDCS – which we use as a quick sector proxy – and which closed Friday December 14 at $18.67. The all-time low for BDCS is $17.31, set in February 2016 following a similar market meltdown. The very fact that the BDCS price would have to drop as much as 7.3% to match that nadir speaks to how relatively well the sector has held up in the current environment – the 10%+ drop from the August 30 2018 BDCS high notwithstanding. However, that sort of implosion would not be uncharacteristic for this highly volatile sector.

Not helping is a news environment for non-investment grade debt laden with prophecies of disasters to come. As a result, the high yield market – from an issuance standpoint – has ground to a halt. For the first time since 2008 no new “junk” has been issued in December so far. Over in the larger leveraged loan market, investors are pulling monies out of Exchange Traded Funds and mutual funds at a frenetic pace. LeveragedLoan.com leads with the following:

U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011. This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.Mutual funds were the catalyst in the latest period as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.

For the full article – and many more miserable metrics – click here.

Then there’s the sudden realization about ten years into the process that leveraged lending is on the rise; overall assets involved are growing and banks are being replaced by non-bank lenders. A hot off the press example is this December 17, 2018 Bloomberg article by Sally Bakewell and Christopher Cannon with the longish title “Investors Are Piling Into Loans That Banks Have Avoided Since The Crash”. The authors have discovered what every new BDC prospectus has been touting for years as a selling point: opportunities to lend to private companies, as the banks pull back. Here is a stat:

In the past 10 years, private funds that lend directly to companies have raised almost $500 billion, according to data compiled by Bloomberg. Another $100 billion has been amassed by publicly traded lenders known as business development companies, giving even small-time stock investors a chance to get in on the action. Altogether, an industry group has estimated that the market would hit the trillion-dollar mark by 2020.

We’re going to review and annotate this article shortly to place some context around the breathless prose for any of our readers interested in a different perspective by one of us on the frontlines, but the message here and as in so many other similar screeds is that risks are highly elevated and the chances of a 2008-2009 mortgage-crisis led like crash are high. (Nobody ever seems to be able to look more than one recession behind. Let’s not forget the relatively mild 2002-2003 recession in which lenders fared pretty well). No wonder then that debt investors have either bolted the leveraged lending complex, or are waiting anxiously around the exits, eyeing what others are doing.

However much wood you pile together, it still takes a match and some kindling to create a fire, and that’s one of the missing ingredients in this would-be financial disaster. As another article – this time by CNBC and whose fear inducing headline was “A $9 trillion corporate debt bomb is ‘bubbling’ in the US economy’ ” – conceded that its lead notwithstanding  Fitch Ratings projects 2019 junk bond defaults at their lowest level since 2013 and those of leveraged loans the lowest since 2011. Our own more modest – but comprehensive – journey through the latest portfolios of over 70 public and private BDCs found little change in credit quality, and very few new names being added to our Watch Lists. When you’re lending at yields in the double digits – as most BDCs do – there are always going to be some under-performers, but there has been no sign in the quarterly valuations and in the flow of news about over 3,000 companies that we track every day that suggests anything different is happening than was the case one, two or even five years ago.

That could change if the U.S. and global economies slump – but credit will hardly be the only victim and we’re not likely to get any definitive insights this week. Instead, we’ll just be keeping an eye on the much harder to assess confidence levels in the markets.

New Lows: As we noted in last week’s Preview, this lack of confidence – only 14 weeks after the BDC sector was at a 2018 high – is translating into many more BDCs hitting new 52 week lows in price. On Friday alone we counted 13 names making that move ! Again, that’s a subject covered in great detail in our Premium coverage during this last week and many weeks before. In the week ended Friday December 14, a very large number of BDC common stocks reached new 52 week, multi-year and even all-time lows. Those included just about every individual BDC we called out in the Preview as being at risk of further price declines. Going by tickers alone, those included BCSF, FSIC, CCT, GARS, and MRCC. Many more were added to that unenviable list. As the week begins, 31 of the 46 BDCs we track are trading within 10% of their 52 week lows and 38 are trading below book. Drilling further down, 21 of the 38 are priced at least 20% below book value. We expect – barring one of those drastic u-turns by the markets that make investing so frustrating for some and exhilarating for others – more record lows to be set this week.

Looking Up: However, our focus will be less on the bottom end of the table – which still mostly consists of BDCs that have been under-performing from a fundamental standpoint – but on what happens to the “better” BDCs, as we discussed last week. Currently there are still 9 BDCs trading within 10% of their 52 week high, including 8 trading above book value. However on Friday last Golub Capital (GBDC) dropped to a new 52 week low. So did Barings BDC (BBDC), with its spanking new, low risk loan portfolio and deep pocketed and highly committed sponsor. If even the most respected and best performing BDCs are going to take be affected by a mass evacuation by shareholders, the whole sector could take a leg down. We’ll be keeping an eye on five names, which have been excelling in different segments of the leveraged debt market of late to see if alarm bells will be ringing. These are Ares Capital (ARCC) in the large cap, sponsor driven market for transactions that compete with the highly liquid syndicated leveraged loan market; TPG Specialty (TSLX), with its focus on complex , one off larger transactions, often with an asset based feature; Capital Southwest (CSWC) given the BDC’s growing earnings, principally from the lower middle market and WhiteHorse Finance (WHF) and Stellus Capital (SCM) ; both of whom are currently enjoying almost trouble free credit portfolios in the middle of the middle market.   We’ll posit that how goes these 5 names, so goes the wider BDC market. We’ll check in next week and see how that theory held up in practice.

Activist: Away from watching our screens, the BDC Reporter will be curious to see if FrontFour Capital Group’s challenge to the pending Medley Capital (MCC) merger with two sister companies will pick up any steam. An open letter to shareholders – like the one published last week by this leading MCC shareholder is all very well, but still begs the question: what next ? MCC is pretending not to notice and no response has been filed. Till we see anything else, we’ll assume the merger – and the potential loading up of Sierra Income (which will swallow up MCC and the business of Medley Management) with both the assets and the debts of its related entities – will occur sometime in 2019. We provided an annotated version of FrontFour’s letter in a premium article on December 13, 2018.

Merger Complete: According to the official filings – and barring a last minute hitch – Corporate Capital Trust (CCT) will merge into FS Investment (FSIC) this week on December 19. That will result in a new name and ticker for FSIC – which will become “FS KKR Capital” and the ticker FSK. (Nobody can claim large asset managers are very creative when it comes to naming their BDCs. Still better than “TCG BDC”, whose ticker is “CGBD”. Not one vowel could be spared by Carlyle). For the BDC Reporter that will mean – shortly having had to adjust for a 3 for 1  reverse stock split by Apollo Investment (AINV) that gives investors not paying regular attention that the BDC has shot up in price, when the contrary is in fact true – reducing our BDC coverage universe down to 45. However, the size of the public BDC sector in terms of assets only continues to grow. With the likely Sierra deal, total assets and total book value will only increase.

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