BDC COMMON STOCKS

Instructive

The week ended May 8, 2020 was the second week of this quarter’s earnings season, with a deluge of BDC reports.

Investors learned a great deal.

Much had been previously telegraphed, or sussed out by investors and analysts, but there were plenty of surprises as well.

Broad

This is reflected in the wide dispersion of price movements.

We had 29 BDCs increase in price or remain unchanged and 26 that dropped.

The biggest percentage increase on the week was 10.8% up (PTMN) and the biggest decrease (33.1%) for CPTA.

Overall, 17 BDCs were up 3.0% or more on the week and 11 were (3.0%) or more down.

Those numbers are similar to prior weeks, suggesting that investors are still making and unmaking their minds about individual BDCs.

Overall, the sector – as measured by BDCS – was up 4.5%, the best performance in 4 weeks.

Downers

There was no obvious pattern in the BDCs that dropped in price.

Some were BDCs that had reported disappointing results, while others have not yet pulled the curtain back.

We can only imagine BDC investors are – in the case of the latter – positioning themselves in anticipation of soon-to-be-announced results.

After all, with every BDC earnings release we get a clearer picture of what might lie ahead for the players who have not yet reported.

Up To Date

However, amongst the BDCs increasing the most in price, the top 11 have already announced their IQ 2020 performance.

(We include in that list Golub Capital (GBDC), which has made many preliminary disclosures due to its soon-to-be-completed Rights Offering).

Those price increases come from all the relieved investors finding things not as bad as they feared.

Notably, long time venture-debt favorite Hercules Capital (HTGC) was up in double digits and 30% over the last month.

Ares Capital (ARCC) was up 9.6% and 16% over 4 weeks.

And so on.

Surveying

Nonetheless, none of the above should be taken to suggest that a great deal of damage has not been done to BDC sector prices, balance sheets, earnings and distributions.

First, let us update where the BDC sector stands – using the price of BDCS at the moment compared to February 20, 2020, the day before the markets awoke to the Covid-19 risk.

BDCS is (38.6%) down.

That’s better than the (59%) drop registered intra-day on March 23, just 6 weeks ago.

In the interim, we’ve had three rallies and three pull-backs, but the former have outstripped the latter and the sector has been stabilizing.

Flattening

A month ago on April 9, BDCS reached an intra-day high of $12.95.

As of Friday’s close, BDCS was at $12.61.

In the intervening weeks, BDCS has never reached beyond $13.13.

Way To Go

At this point, only 3 BDCs are trading above book value. These are MAIN, HTGC and TSLX.

That number used to be 7x higher.

Still, a few weeks ago no BDC had that honor and for a few weeks MAIN was alone in this category.

(Of course, the lower NAVs reported, as much as higher prices, account for the improvement).

Snowflakes

Reviewing the 27 BDCs that have reported first quarter results so far, we cannot stress enough how very different each of their approaches has been to a common catastrophe.

We’ve sought to enumerate some of those discrepancies in the Key Metrics Table we published at the end of the week.

Paying Out. Or Not. 

Take dividends, as an example:

Some BDCs have proudly maintained an unchanged payout, even in the face of lower earnings, as if nothing was awry.

At the other end of the spectrum, others have suspended any dividend for the coming quarter, just in case and in advance of being aware of specific troubles.

Then there are the BDCs that have followed the lead of Great Elm Corporation (GECC) several weeks ago and will be paying out 80% of their distribution in the form of stock rather than cash.

Benevolence

Not mentioned in our already crowded table were what concessions the external managers of BDCs offered up to their bewildered shareholders who, in the period of a few weeks, have lost half their market value or more.

Some were lavish in promising fee waivers to mitigate the impact on their shareholders, even if ever so little in the bigger scheme of things.

Others were mum.

Big Brother

Some managers were able and willing to tap the abundant resources of their asset management parents to support BDC liquidity and some did not feel the need or had the need and did nothing.

Even those who did intervene did so in widely different formats; amounts and terms.

Some of the half dozen rescue packages thrown together on short notice were priced at what we’ll call “market terms” while others were more “BDC shareholder friendly”.

In all cases, BDC shareholders will have been glad of the support at a difficult time.

However in each case a reckoning will need to be undertaken because the Rights Offerings, unsecured debt issues; below NAV share issues; dividend suspensions; medium term fee waivers and the like will have a long term impact on shareholders total return.

Different

In some cases BDC balance sheets have been drastically impacted, both in terms of assets and liabilities and equity.

Those changes will not show up till the next quarter’s results, and all the consequences may take a longer time to play out.

Schooled

Even harder to suss out at this stage – but also likely to affect BDCs for years to come – will be what lessons BDC managers believe they’ve learnt from this still ongoing episode.

Will most every BDC swear off junior investments (second lien, last out debt, preferred, equity) because of their volatility and higher credit losses ?

Is that even possible to achieve “acceptable” returns ?

Will joint ventures – already being wound up in many cases before Covid-19 – be seen as more trouble than they’re worth ?

What about leverage levels ? Some BDCs are relatively close to breaching asset coverage requirements and some are out of compliance with bank covenants related to net worth and leverage.

Another step-down in loan values and many BDCs could yet be defaulting under both BDC regulations and those of their secured lenders.

Down the road will that cause even more conservatism from the many players whose target leverage was 1.25x-1.50x (or higher) before the crisis and got caught very close to tripping the wire ?

Possible

We believe one of the key lessons most every BDC will take away is to rely less on secured debt (both revolvers and on balance sheet CLOs) and more on unsecured borrowings to finance assets.

Most of the BDCs that are current investor darlings and are pressing ahead in this environment in that “business as usual” way are those with large slugs of unsecured debt, and less reliance on secured debt.

So while many BDC peers are locked in conference rooms or in Zoom meetings with their secured lenders negotiating waivers; amendments, higher interest rates, their peers with a different liability management philosophy are free to forge ahead.

This could boost the Baby Bond market for the smaller and mid-sized BDC players, and the private placement of unsecured debt for the larger ones.

Too Soon

All of that will have to wait till the crisis ends.

As we saw with FS-KKR Capital’s (FSK)  unsecured debt issue this week the cost of money at a time of stress can be as high as 10.0% (8.0% if investment grade).

Interim Score Card

Looking down the list of BDCs that have reported so far, 15 have – in the BDC Reporter’s estimation – handled the Covid-19 challenge appropriately and 12 less so.

Getting it right involved both measures taken in advance and after the virus struck.

The cause of the current crisis is “unprecedented” more or less (Spanish flu of 1918 notwithstanding) but the financial impact is not.

We’ve had recessions before and this crisis is not altogether different from those that have become before in its severity and how its playing out for lenders and companies.

Like An Eagle Scout. 

One of the key jobs of BDC managers is to prepare for the unexpected.

Most of the challenges some BDCs have faced in recent weeks comes from avoidable practises like overleveraging prior to the crisis or not maintaining enough cash reserves for every eventuality.

Then there are more arguable issues like having a portfolio mix laden with too many highly volatile investments or concentration in too few companies or in certain industries.

In some cases, BDCs had recognized the risks they were taking prior to the crisis but thought they had more time to adjust portfolios.

As Blackrock Capital (BKCC); Apollo Investment (AINV) and Capitala Finance (CPTA) – amongst others – have found, turning round oil tankers happens faster than BDC portfolios.

After The First Inning…

So far there has been no permanent BDC casualty from this combination of sudden crisis and being not fully prepared.

Yet, these remain the early days.

We have still not heard from a third of BDCs and even amongst those we have a handful will struggle to remain operational in the long term.

It Comes Down To This

Much will depend on what happens in the credit area over the rest of the year and into 2021.

Very high losses could impact weaker BDCs enough to both erase any prospect of meaningful long term returns and pressure financing arrangements.

Sanguine

With that said – at the moment –  the credit picture is improving somewhat.

Yes, there are dozens and dozens of companies seeking capital infusions; requesting amendments and the like.

Many others cannot even hope for those intermediary measures and have filed or are preparing to file for Chapter 11.

The numbers in both categories are huge but so are the unrealized losses booked by most every BDC out there.

At one point virtually every BDC portfolio company was being written down to underperforming status.

Two Roads Diverged

Now a triage process is occurring as lenders begin to distinguish between companies and industries that have been in the bullseye of the crisis and those that have not.

Many, many companies/industries have been deemed “essential businesses” in these difficult times and quietly continued operating throughout.

Their financial results may have been impacted but not in the same manner as companies who sent everybody home and padlocked the doors.

Thank-You U.S. Government

Furthermore, smaller companies have been accessing the Payroll Protection Program (PPP) in large numbers according to what we’ve heard on the two dozen BDC conference calls we’ve listened to.

The amounts received may not be large in the greater scheme but are sufficient to make a material difference for a few weeks for thousands of companies.

(As we’ve noted before, the Federal Reserve’s tri-pronged Middle Market while well meaning has not even gotten up to the plate yet).

As We Speak

The gradual re-opening of the country to business activity – barely underway as we write this – should also serve as a fillip.

Also, a great deal of sudden belt tightening is occurring at companies around the country.

As happens in every recession, company managers are finding creative ways to stay afloat.

Most have not even yet reached the stage – at the end of April – where they needed to call upon their equity owners or lenders for assistance.

Although this crisis feels like it’s been going on for an eternity, the impact on day-to-day business is less than twelve weeks long at this point.

If a business is not actually closed down, chances are they can limp along without needing to resort to court protection or a drastic restructuring.

Quantifying

Anecdotally from the 10-Qs we’re reading – and speaking in broad stroke terms – there’s an 80/20 situation developing in BDC portfolios.

About 80% of companies are keeping their head down and getting through the crisis so far without need for any assistance from their owners or lenders.

The other 20% are in varying degrees of trouble.

Hard Up

Worst off are – as you’d expect – the companies that were already seriously under performing before Covid-19.

If they happen to be a “non essential business” or in one of the industries most directly in the line of fire (like travel, energy, certain healthcare segments etc) the odds of credit survival are poor.

Think of names like Neiman Marcus and J.C. Penney; or any number of E&P oil and gas operators or service companies like Oasis Petroleum.

Companies in industries forced to shutter like restaurants have folded very quickly. See the stories of TooJay’s and Garden Fresh Restaurant Holdings.

Law Of The Jungle

In these cases, both the equity sponsors and the lenders – in most cases – seem to be prepared to allow the companies to fail.

In a few cases BDCs are preparing themselves for a write-off and to walk away.

In many other instances lenders are preparing to be owners and keeping their capital dry for a new structure, and the prospect of doubling down.

The equity sponsors – facing the new order of things – are throwing up their hands and accepting the inevitable.

Good Time As Any

The Covid-19 crisis may be seen by both owners and financiers as an opportune time to divest themselves of perennial underperforming companies caught with outdated business models or facing the spear tip of technological change.

This house cleaning is well underway as we can see from the daily list of “people familiar with the situation” warning of possible bankruptcies.

The BDC Credit Reporter’s regularly updated “Weakest Links” list of companies expected to become non performing shortly is up to 31 and an aggregate FMV of $1.4bn.

Those companies will be joining – if we’re right – the 135 companies already on non accrual with an FMV of $2.4bn.

What Matters

The critical issue for the future of the BDC sector is not whether the companies already on the brink fail.

That’s almost a given under every conceivable economic scenario in the next few months.

The question is whether the even greater population of companies that are strained by the current crisis – many of which we are just moving from the ranks of “performing” to the upper ranks of the underperforming scale – are going to slip further.

That is not a given for a host of industries such as manufacturing; food processing; food retail; software; IT; defense; construction, etc.

We count $7.0bn of BDC portfolio company assets in our CCR 3 category, spread over nearly 200 entities.

(Candidly, the number of companies and dollars will end up being much bigger but reviewing each and adding them to our database takes time).

If Only

Should the credit deterioration of this category of company be stopped the damage to BDC balance sheets – while severe – should be better than what investors have expected.

This will depend on the success of the re-opening of the U.S. economy.

If that proceeds apace, BDCs  may end up contending with an initial burst of bad debts, but a rapid tapering down thereafter.

If the broader economy does not recover for whatever reason, the risk is that there will be a seemingly unending stream of troubled companies lining up.

How that plays out – and we’re just as unable as everyone else to tell – will determine if BDC capital structures will weather the crisis or whether some will not.

Big Picture

Undoubtedly, whether the economy comes back or not, most BDCs will survive.

However, the BDC Reporter’s prior prediction that all BDCs will avoid bankruptcy will depend on whether credit stabilizes from here or takes another step down.

We’ll know that by the time the next BDC earnings season rolls round.

So far the credit downturn has been tenable where the BDC sector is concerned.

We can only hope that continues.