Preamble

Seeking Alpha has summarized some of the conclusions of Keefe, Bruyette and Wood’s (KBW) report about the condition and outlook of the BDC sector just before earnings season takes hold.

KBW’s Ryan Lynch – who prepared the report – is a Managing Director of Equity Research at KBW, and a regular presence on BDC conference calls. 

There’s a lot to unpack here which is likely to be of interest to our readers so we thought we’d annotate the SA article, adding BDC Reporter’s own thoughts on the subjects discussed:

• “Keefe, Bruyette & Woods is previewing a good fourth quarter for business development companies, due in large part to the tailwinds the companies saw in Q3 as well.

BDC Reporter Notes: We track pretty every public BDC out there (44 by our count) but don’t undertake quarterly earnings projections, but do project dividend levels over a rolling 5  year time horizon. In any case – on a more anecdotal basis than KBW – the BDC Reporter is also expecting a “good fourth quarter”.  Last quarter – as you can see on the BDC Performance Table where we rate every BDC’s results as GOOD,FAIR or POOR, 32 were in the top category and 9 in the second. Only three were POOR: BKCC, GECC and PFX. Without getting into calling out matters BDC by BDC, we expect a similar outcome in the IVQ 2020. 

• That includes more rising loan prices and tightening credit spreads lifting book values.

BDC Reporter Notes: It’s no secret to anyone that the broader loan market has been in the grips of a mighty revival of prices after the massive drop-off in March. As S&P Global Market Intelligence and others chronicle every week, loan prices have returned – and in some cases – exceeded the pre-pandemic levels. Even the average underperforming company has seen its value increase. This continues in 2021 and should show up in BDC asset values in the IVQ 2020. Here’s a telling quote from a report by S&P from a few days ago:

“The average bid of the S&P/LSTA Leveraged Loan Index hit 97.49 as of Jan. 21, which has not only erased the fallout from the onset of the pandemic, but marks the highest level since May 5, 2019. Moreover, the share of loans bid at par or higher is at roughly 50%, up from 12.5% at the end of December”.

The key question is how much longer this can go on as we’re very close to record levels. For now, though, lenders – including BDCs – should benefit in the form of higher fair market values.

• Also, middle-market activity rose “significantly” in the quarter, analyst Ryan Lynch says – likely “making up” for the dramatic deal flow shutdown in the spring and summer, and which should bode well for portfolio growth and/or fee income.

BDC Reporter Notes: We’ve been watching the output of Kelly Thompson at Direct Lending Deals, who seemingly chronicles every new leveraged loan being booked. Just looking at the flood of results is exhausting and underscores that new financing activity is wild. It’s not surprising given that the Fed cut the cost of borrowing last year by lowering the Fed Funds rate, which brought LIBOR down sharply. Although many lending professionals and their credit committees are stuck at home, the business of lending has marched on in a remarkable way. This may last some time as different borrowers have different time frames for refinancing and M&A activity is very hot, which will continue to bring new transactions to the market. Furthermore, the CLO market – left for dead by some less than a year ago – has revived and managers are desperately looking for new product. 

• If there’s a negative, it’s that valuations have already reset to pre-pandemic levels, he says: in-line on a price/book value basis, and about a 10% premium on a price/earnings basis. But that’s still reasonably attractive vs. the broader market.

BDC Reporter Notes: What is “reasonable” at these price levels is in the eye of the beholder. The BDC Reporter has been comparing the latest prices against their 2020 post-Covid highs and found – as we’ve reported before – that almost every BDC is close to or above that bogey. We had a fresh look for the purposes of this article and found only two BDC stock prices that were more than (10%) off their post-Covid 2020 highs: FCRD (11%) and GECC (37%). That suggests – except for those two exceptions to the rule – a very “hot” market. That’s good for those who hold BDC stocks, but makes the market pricey for new buyers. In our own “Expected Return Table” which we use to project likely returns over a 5 year period, the number of common stocks seemingly offering the opportunity of superior returns (15% plus per annum)  is down to a handful (5). That’s the sparsest we’ve seen since early 2020.We also note that 12 BDCs are trading above book value. At the height of the last pre-pandemic rally that number was 21. We read that as meaning we’re much closer to a top than anything else.

• While loan prices have increased, some struggling industries are still at risk for writedowns, Lynch says, but he expects credit metrics overall to keep improving – and for book values to rise 1-3%. (Two companies have announced such changes so far: Golub Capital (NASDAQ:GBDC) in the +1.6-2.1% range, and Owl Rock Capital (NYSE:ORCC) +1.8%).

BDC Reporter Notes: Yes, book values will increase in IVQ 2020 and for the reasons given. However NAV Per Share is also being boosted in many cases by BDCs being parsimonious in their distributions because of the environment we’re in, which boosts their equity but will eventually have to be released to shareholders. Investors would do well to investigate on a case-by-case basis why a BDC’s net asset value per share might be increasing. There are multiple variables involved and looking at the bottom line outcome might send the wrong message. 

• And middle market activity looks to be returning to a “normal” pace, Lynch says. Institutional volume was up both quarter-over-quarter (by 66%) and year-over-year (by 31%). Leverage and purchase price multiples are rising, and yields on primary institutional loans fell to their lowest level since 2018 (6.6%).

BDC Reporter Notes: For BDC investors in March and April 2020 looking forward to new loans being booked at wide spreads and higher yields 2020 has been a disappointment. The loan market has gotten back to its expensive ways (good for borrowers, bad for lenders) almost immediately. Even in the prior quarter many BDCs were complaining that their peers – never themselves – were unreasonably driving down margins and terms in a pre-pandemic way. This has been doubly hard on BDCs: contending with a much lower LIBOR – which dropped from 2.5% to 0.17% currently and with razor thin loan spreads. Thankfully, there has been some offset afforded by lower borrowing costs – an ongoing process – and the presence of LIBOR floors, mitigating some of the reference rate drop. 

• Overall Lynch is raising targets on the entirety of the coverage, due to higher multiples sector wide,, and is raising estimates on Ares Capital (ARCC; to $0.44 from $0.40) and cutting on Horizon Technology Finance (HRZN; but raising 2021-2022 estimates there due to strong net portfolio growth).

BDC Reporter Notes: Everyone has their own valuation methodology. Analysts tend to have investors who are shorter term focused and are keeping an eye on what everyone is valued at when deciding what is “under-valued” or “over-valued”. For our part, as a long term investor,  we’re less concerned about market values and more about absolute returns and seeking to achieve them over a long period. As we’ve made clear above the ongoing market enthusiasm has taken the bloom off the rose for potential returns. However, if we hear anything on the upcoming earnings season that causes us to increase our projection for future dividends our price targets for some BDCs might get moved up as well.

• The top ideas going into earnings are PennantPark Investment (NASDAQ:PNNT) and Hercules Capital (NYSE:HTGC) – “which should experience a significant increase in book value from strength in select equity investments” – and Ares, whose “very robust” Q4 portfolio activity should benefit NOI.

BDC Reporter Notes:  We’ve spent a lot of time struggling with whether PNNT represents an opportunity or not. In fact, we even mistakenly sent out a draft article we’d been writing about the subject to our readers. (We hit the wrong button !). Then and now our analysis has proved inconclusive. Yes, PNNT seems poised to benefit from several equity stakes getting sold off at substantial gains, providing cash to be re-deployed into yield bearing investments. On the other hand, the BDC continues to be saddled with large, poorly performing energy and other investments which generate little but trouble for the manager.  Investors have sharply bid up the stock price, which takes away most of the potential benefit of higher earnings should everything turn out well. We’ve shrugged our shoulders and stayed away, but KBW might be right and PNNT could move even further up in price.

We’re long HTGC and have been for some time. However, at a 48% premium to book the BDC is hardly good value. HTGC is trading at 2% above its post-Covid high and only (7.7%) beneath its 52 week high, set ominously on February 21, 2020 – the very day the markets began to react to Covid. 

We’re also long ARCC and have been for some time. The same trepidation prevails as with HTGC because the BDC is trading 1% above its post-Covid high, (9%) below its 52 week high and (slightly) above book value. Our model indicates a prospective 10.2% annual return if held over half a decade – similar to what HTGC pencils out at – which is not rich enough for the BDC Reporter’s liking but might be okay for others. 

CONCLUSION

At the end of the day, the BDC Reporter agrees with most everyone of KBW’s conclusions about likely sector performance in the fourth quarter 2020.

We don’t even differ widely on the specific BDC investment ideas proffered.

The only material difference we’d point to – and which we expect is as subjective as whether “Manx” is Oscar-worthy or a waste of time – is regarding whether to be a buyer in this market.

KBW seems to be suggesting that high valuations should not be a deterrent.

For our part, the numbers just don’t add up.