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BDC Preview: Week Of February 11 – February 15, 2019

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Here is our preview of the most important developments likely to occur in the  BDC sector in the coming week.  Pretty much everything highlighted in last week’s report came to pass. This week may be a little less frantic, as we explain below. However – as always – the BDC common stock market remains in a volatile state as investors – who just a few weeks ago – were bailing out have bailed back in, but now face what to do next. BDC Fixed Income investors have a more propitious environment than at any time since November 2018. 

Medley Merger: As we anticipated in last week’s Preview, the dogfight about the future of Medley Capital (MCC), as well as Medley Management (MDLY) and Sierra Income, dominated the BDC news headlines. The BDC Reporter wrote three (!)  more full length articles on the subject during the week for our Premium subscribers, the most recent over the week-end. We won’t repeat all the twists and turns of the week past. However, this is where we are right now: MCC and Sierra have rebuffed the NexPoint offer to serve as the Investment Advisor of the two merged BDCs. Also, MCC, Sierra and MDLY have set a new date for a shareholder vote for each entity: March 8, 2019. Plus, MCC’s Board has changed some of its by-laws to maintain control over when and by whom shareholder meetings are called. NexPoint has offered some very harsh criticism of the management and Boards of the Medley empire. Oh, and we’ve learnt about several lawsuits underway which MCC and MDLY have to contend with by disgruntled parties, including FrontFour.

So what’s next ? Of course, anything could happen but this week might be less tempestuous than those that have come before. NexPoint remains on the sidelines and can do little else than complain to Medley and reach out to shareholders on the hope that a No vote on March 8, 2019 might bring them back into the picture. Likewise for the several unhappy MCC shareholders who’ve been vocal in their criticism of the merger. We might see more diatribes delivered by press release but the main arguments have been made. Which is not to say the Medley companies won’t be pumping out communications to shareholders asking for a FOR vote in a few weeks. We might get some developments in the court room, but typically there’s a lag between filing and resolution and this has been a relatively brief courtroom fight. All sides will be preparing for the vote – and what might happen if shareholders vote against this most controversial of transactions. We expect this week to be relatively quiet, but this subject remains red hot and will continue to be so for at least the next month.

As always when a transaction is at the mercy of constantly changing facts, the stock prices of the two public entities involved – MCC and MDLY – will tell us much about which way the market winds are blowing. Last Friday, both MCC and MDLY were down 3.0%. However, there may be a substantial divergence between how the two stocks perform as the week – and month – progress. The more likely the merger, the more probable MCC’s stock price will drop. As we’ve explained in our myriad articles, even a rejection of the merger does not necessarily mean NexPoint – or MCC shareholders against the three-way merger – will get to celebrate. The Medley insiders may lose the merger battle but still remain entrenched in all 3 entities and may do…nothing. For those interested in historical parallels see what happened when TICC Capital (now Oxford Square Capital or OXSQ) sought sell the Investment Advisory contract to the BDC to a third party. Much opposition arose and the deal didn’t happen. Instead, the insiders have just renamed the BDC and continued with business as usual and challengers and would-be buyers have dropped by the wayside. The BDC Reporter wrote many articles about that subject too – we’re fascinated by corporate governance challenges as they offer up a view into the inner workings of the BDCs.

Earnings: By our reckoning, the only public BDC releasing earnings this week is Ares Capital (ARCC). If we’ve forgotten anyone we apologize in advance. No great surprise is expected from the ARCC results, but this is the biggest BDC out there and it’s results are always instructive. The drop in asset prices in December might cause – if ARCC chooses to reflect that reality fully – book value to be impacted, but most everyone has discounted that development by now. Helping out is the fact – as other BDCs have reported in recent days – that leveraged loan prices have recovered most of their unrealized losses in recent weeks. More interesting will be seeing if ARCC – which has signed up for the bigger balance sheet allowed by the Small Business Credit Availability Act – has made much progress growing its portfolio, either on its main balance sheet or through its joint venture with Varagon, or both. In a related manner, we’ll be interested to see if ARCC’s earnings materially increase and if shareholders receive a dividend increase. We expect a hike in distributions, but the timing is still unclear. This quarter, or several quarters from now when and if EPS grows from that growing balance sheet ? This is a complex subject related to the type of earnings ARCC has realized and its preference for the form of pay-out. BDCs are spending a good deal of time crafting dividend strategies that support their stock price. Have a look at what Capital Southwest (CSWC) and Main Street Capital (MAIN) announced last year in this regard, moving in opposite directions.  Gladstone Capital (GLAD) spent a long time on its latest Conference Call discussing the subject in response to a direct question. Here is a link to GLAD’s transcript. Go to the final question and read Bob Marcotte’s – GLAD’s President – revealing answer. How ARCC chooses to address its dividend policy in the face of potentially higher earnings brought on by “leveraging up” under the new rules will be watched by many other larger BDCs with a similar business model and a similar challenge in the future.

The key question: How will shareholders react as assets – and risk and manager compensation – grows 20%, 30% or 40% – if the “regular” dividend remains unchanged ?

We don’t expect a definitive answer from ARCC this quarter, but the subject is worth watching.

Markets:  We had a not inconsiderable 3.0% pullback in BDC common stock prices – and a similar wobble throughout the credit and broader markets –  last week. That’s not surprising after a 6 week rally from the depths in December 2018. However, there is no guarantee that the incredible rally of January will continue. Unless we get an out of the blue crack up, this week will not provide a definitive answer to the question: Is the rally over ? However, another pullback may dent investors confidence. Is this early 2016 and an early stage of a multi-month rally ? Or is this as good as it gets ?  We don’t know the answer but it’s a question that needs asking. We’ll be especially intrigued to see how investors treat the BDCs that have already reported IVQ 2018 earnings last week. Even more specifically, we’ll be looking at how the most popular names fare. To be specific that includes Golub Capital (GBDC), Capital Southwest (CSWC), PennantPark Floating (PFLT) and Gladstone Investment (GAIN). Nothing much new emerged from their  earnings results. Will investors push up their prices nonetheless ?

On the Fixed Income side – as we’ve just discussed in our weekly Market Recap – prices have settled down, just 1% off prior highs. A return to the levels of last summer are not a given, but the public market seems open to new debt issuance. Last wee, Fidus Investment (FDUS) launched Baby Bond Number Two. We wouldn’t be surprised if other BDCs did not launch new issues of their own this week and in the weeks ahead. At this pricing level, and with the over-predicted surge in long term rates headed in the opposite direction to what the pundits were saying a few weeks ago, the environment is favorable to issuers. If the many BDCs with their eyes on the SBCAA prize are to succeed in greatly growing their portfolios, more unsecured debt will be an essential ingredient. We expect more and more news like that of Fidus.

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