New York Minute

Even since the BDC Reporter wrote the BDC Common Stock and Fixed Income Recaps over the weekend, the landscape has changed dramatically.

Both in the broader political and economic environment, and amongst investors in the public BDC space, there appears to have been a marked change in mood.

Not There

In terms of BDC news between the close of Friday and Tuesday there is nothing of substance to report.

At most, we’ve noticed – as you’d expect – a large number of Form 4 disclosures showing insider purchases of stock at ever lower price points.

Bleak

What has being going on, despite multiple interventions from the White House and Congress is an ever worsening sense that Covid-19 is going to cause unprecedented hardship.

That will itself result in the end of the Great Expansion – which has lasted 11 years – and bring on a recession.

Thinking The Unthinkable

Even a few days ago projecting a recession was still a rarity.

If such an outcome was projected, terms like “V shaped recovery ” or “short, sharp shock”  was appended.

Just in the past 48 hours, though, the economists at the top firms seem to be competing for who can predict the greater contraction in GDP.

Tonight, the Treasury Secretary is getting in on the trend, warning of 20% unemployment if senators don’t go along with the latest “rescue plan”.

Here in California, we are moving closer to the entire shut-down of the state.

Affected

BDC investors – and rightly so – have been caught up in this drastic darkening of the national mood if the change in sector prices is any indication.

Just since Friday, the ETF which tracks BDC sector performance – ticker BIZD – has dropped from $12.38 to $9.93.

Rounding, that’s a (20%) drop in two days and brings the total percentage drop of the BDC sector since February 20, 2020 to (42.5%).

Latest Metrics

As we’ve been discussing periodically on the BDC Reporter’s News Feed through the trading day, BDC prices have been reaching new 52 week lows constantly.

Just on Tuesday – and after breaking through this particular barrier many times previously since February 20 – 24 BDCs reached new lowest points.

Now there is no BDC trading above book value where there used to be 20 and even 2 as of last Friday.

The highest price to equity level is 89%.

The average of the 45 BDCS is 54%.

The market capitalization of the BDC universe has dropped to approximately $25bn, while investment assets at FMV are just north of $80bn.

Nothing Certain

Notwithstanding the devastation to BDC prices that has already occurred – and as investors are finding out every day – BDC prices can always drop further.

As we’ve done previously, let’s compare how much Ares Capital (ARCC) has dropped in price this time round:  (38%) versus in the Great Recession (85%).

At least that latter price downturn took 1.5 years, and a series of historic reverses before occurring.

Fast

This time, we are still in the earliest stages of the pandemic – and still getting rosy economic backward looking reports on the economy from the pre-virus period – and have already lost nearly half the sector’s value.

We wouldn’t be the first – or the last – to say that the crisis we are in is unprecedented.

This Changes Everything

That means for BDC investors that the old shibboleths of what to expect from the sector and its participants no longer hold true.

We are all going to have to take a new approach towards the BDC sector because the way business has been done for the past decade is going to change.

In the quarters ahead every BDC’s current earnings and dividend is going to be subject to challenge.

Many/most  distributions will be cut or suspended.

Unreliable

That steady income which investors have come to rely on (“ka-ching”) is going to become much more erratic.

We track the dividend paying track records of every BDC and there are players who’ve been paying the same regular payout since 2009.

This last quarter not a single BDC cut its dividend.

That Was Then

That’s going to change, and very shortly.

A similar phenomenon occurred during the Great Recession.

We remember counting 21 surviving BDCs at the time and only 4 were able to maintain their distribution.

Many of the others – including many fine firms – suspended distributions altogether to rebuild capital accounts devastated by unrealized – and then – realized losses.

In a few cases these dividend-free times went on for years and included paying shareholders with stock rather than cash.

Fine Print

After all, tucked into every BDC Prospectus is a disclosure that the BDC’s Board may choose to distribute profits in the form of paper.

Shareholders, though, will have to pay taxes thereon with cash, as the IRS will have it no other way.

Impactful

Nor – if the experience of the Great Recession repeats itself – will BDC managers be too certain of what future profits are likely to be.

Bad debts don’t all happen and get resolved together but occur over a long period, impacting book equity; earnings and distributions for years.

Well into 2011, many BDCs were still “working out” credit problems dating back to 2007-2009.

This time investors will find out “who is swimming naked” – as Warren Buffet famously said – but that may take some time to play out.

Almost Forgotten

BDC liquidity – too – is likely to become a subject of concern again.

Back in the Great Recession, many secured revolver lenders which had financed BDCs bolted during the hard times or greatly tightened advance rates and other terms.

Many a conference room was filled with BDCs and their lenders negotiating their way out of financing agreements that had been booked with great enthusiasm just months before.

We may see defaults occur as the value of assets pledged on secured debt facilities dip below funds advanced by lenders given the drastic change in valuation that is occurring.

There may even be defaults under Baby Bond indentures in a few cases, starting with Medley Capital (MCC) and its Israel-placed unsecured debt.

Shrivel Up

If things get bad enough, new debt issuance – both secured and unsecured – will get placed on the back burner and many players will be unable to take advantage of the lowest rates of all time.

Also at risk is the AUM growth of the BDC sector, a trend that’s been going on since the Congress generously allowed a doubling of leverage and a reduction by a third of asset coverage of regulatory debt outstanding.

By our count, a third of BDCs at 12/31/2019 were already close to or above their “target” debt to equity leverage.

Add to that – from the IQ 2020 on- a reduction in portfolio values that could go to 20% or more – that number will likely increase.

Moreover, some BDCs – till they successfully take evasive measures – will see asset coverage levels drop below the regulatory requirement.

Consequences

When that happens the BDCs in question are not allowed to borrow any more funds (which seems prudent) or pay out any cash dividends.

Just try selling your leveraged loans into a market loaded with troubled debt and unhappy lenders after a downturn begins.

It’s not pretty and buyers can sometimes not be found at any price.

If they can, even faster and more drastic net asset erosion is likely to occur, if past is prologue.

Who’s Who

Likely to change drastically as a result of all the above will be the composition of the industry.

It’s likely that theBDCs that under-perform – especially the smaller players – will disappear as fast as the Antarctic ice shelf.

There could be liquidations; portfolio sales or mergers.

That’s what happened last time around, with Patriot Capital being bought out early, Allied Capital later and American Capital much, much later.

We expect that a couple of years from now the roster of BDC players will have greatly changed.

Locked Out

Also challenging will be raising new equity – possibly for years – and the recent popular strategy of public BDCs acquiring their sister non-traded BDCs at book value.

Equally difficult will be taking any new BDCs public, following a slate of famous new names that have joined the sector in recent years.

Maybe, like last time,  BDCs that launch from a standing start (i.e. all cash) will be more popular than those with much battered existing portfolios while in private hands.

Popularity Contest

Or, maybe, investors will be so disillusioned by what’s happened to BDC prices to shun anything with those three letters for a very long time.

After all, if you’d both the UBS Exchange Traded Note with the ticker BDCS back in April 2011 on its launch, you’d have lost more than half your investment today.

Most of that evaporated in just the last few days.

You could understand if investors were sore and turned their back on the industry, at least for awhile.

Pie Cutting

This crisis MAY result in more of a debate between shareholders and managers about compensation.

At the moment there is a huge range of fees charged; ranging from 2%/20% of management and incentive to 1.0%/17.5% and much in between.

Then, there are BDCs that agreed to abide by a “Total Return” qualification where incentive fees are concerned and those that did not.

The result: some BDC managers will be receiving incentive fees in the quarters ahead even if book values are dropping like the proverbial stone.

Others will be paying out that money to shareholders as part compensation for losses to book value.

That will drastically change ROE and both investor perceptions and preferences.

So, whether prices go up in the days ahead or go down, the BDC sector is about to go through a once-in-a-generation transformation, not unlike the one America faces.

Optimistic 

In no way are we suggesting that the BDC model will crumple under the pressure or that we will have a slew of BDC bankruptcies, even though we are at a stage when seemingly anything can happen.

In fact, the BDC Reporter believes the ability of BDCs – under the rules in place – to retain earnings until asset coverage heals will be a great boon.

In fact, we’d suggest that all BDCs immediately suspend distributions and deploy earnings back onto the balance sheet to rebuild what is likely to be lost from credit losses.

(That’s a suggestion unlikely to be heeded but would be in the general interest).

Unsecured

We also expect that the heavy reliance on unsecured debt with virtually no covenants that BDCs have developed in recent years will result in far fewer challenges on the liability side of the balance sheet than last time around.

Also, the ability and willingness of BDC managers to undertake debt for equity swaps and take a long term view will benefit shareholders as the economy revives, even if portfolio cash yields suffer.

The presence in the background of deep pocketed asset manager parents should also serve as a calming influence and provide BDC investors – rightly or wrongly – the sense of being supported.

Best In Breed

Hard to quantify – and not a universal phenomenon – is the undeniable professionalism; experience and seriousness of purpose of the BDC managers themselves.

Generally speaking,  investors can expect reasoned judgement; thoughtful credit decisions and effective long term work-out of troubled credits from the professional staff at most BDCs.

The best of them are more likely to turn lemons into lemonade given enough time and may even – in a few cases – emerge stronger than before.

Survivor

As a general rule the best place to be in private credit right now is with the public BDCs rather than many of the private funds that have been assembled in recent years.

Many of the private funds do not have the financial resources; depth of management or market power that the public BDCs possess.

We Hold These Truths 

All of which to say is that we believe the public BDC industry will survive this very real test, but the proof of the pudding might take two or more years to play out.

Helpless

What our readers – and the BDC Reporter – will find most frustrating is that we are not going to be able to tell for several months yet how big the obstacles are that BDCs will have to climb.

We are so early in the drastic change in the U.S. and global economy that estimating – even very roughly – what the impact will be on BDC earnings and ROE is impossible.

No Man’s Land

As we said at the top, all our prior assumptions are no longer valid and new assumptions cannot yet be made given the extreme range of possible economic outcomes.

That leaves BDC investors – and everyone else involved in the sector one way or the other – serving more as spectators in this unfolding environment than anything else.

For the BDC Reporter,  the likely result will be that we’ll providing “News,Views & Analysis” on a broader range of subjects than has been the case in recent years.

Moreover, we expect that the pace of new developments will be greater than ever before, keeping us and our readers busy.

Furthermore, we expect that there is going to be more than usual that will be unclear and requiring ever greater amounts of research.

Job 1

That will especially be the case where credit is concerned.

Based on current prices, the market seems to be suggesting that one-third of BDC assets are at risk of being lost in the years ahead as a result of the Covid-crisis.

With several thousand companies being financed by BDCs that will result in a huge jump in the sheer number of troubled credits from the 400 or so we’d identified through year end 2019.

Different

How each BDC tackles the expected upsurge in under-performing portfolio companies in the next 24 months is likely to be the deciding factor in their success or failure for the decade ahead.

Exactly which portfolio companies will need working out; the methods involved; the time frame and the likely losses along the way – and which BDCs will succeed or fail at the task – is unknown.

We’re keeping an open mind and will keep our readers apprised of what we discover as the situation develops.

For the BDC Reporter, the sector and our readers the years ahead promise to be challenging; fascinating and bear little resemblance to what has preceded.