BDC COMMON STOCKS

“The US private equity industry is storming through 2021, smashing records as investors take advantage of a bullish climate and remain undeterred by the possibility of inflation and interest rate hikes. Our Q3 US PE Breakdown, sponsored by Liberty GTS, CohnReznick and Stout, tracks all the trends defining US private equity in what is shaping up to be a year to remember”.

• US PE dealmaking through Q3 has already broken 2019’s annual record for deal value, at over $787 billion.

• Exits are on an astounding run; year-to-date value has topped $638 billion—more than 50% above the previous high.

• Fundraising is proceeding at a rapid clip, and Q4 is expected to close the year on a strong note“.

Everyone’s Invited

We don’t want to be the voice of doom, but what invariably happens when capital is so abundant and valuations so high is that many would-be borrowers emerge.

Many are solid companies with long track records; tried and true management and sensible strategies.

However, there are also numerous entities that would previously have not been of interest to the PE buyers or the leveraged lenders because of their weak balance sheets; unreliable business outlook; inexperienced managers and so on and so on.

These companies are the future credit disasters we’ll be talking about either in late 2022 or 2023, and thereafter.

Of course, every BDC will tell you that they look through hundreds of potential transactions and only pick a tiny percentage to fund, and will avoid the future credit disasters.

We often hear BDC managers on conference calls tut-tutting about the risks their (always unnamed) peers are taking, while reassuring their shareholders that their own underwriting processes remain as solid as ever, unaffected by the hurly burly of the markets.

We say “from your lips to God’s ears”, but our experience is that this is rarely the case because competition for deals forces even the most serious minded lenders (and there are a lot of them) to have to cut corners in their due diligence; loosen protections in their documentation and accelerate the closing process to remain a meaningful player.

In this situation weak borrowers creep into portfolios even with all the credit goodwill in the world.

Left Guessing

It’s impossible for investors to really determine how good an individual BDC’s underwriting standards are while these deals are being added. We just have too little information, and even if we did, parsing out who will succeed and who will fail years down the road is a hopeless task.

Signs, Signs, Everywhere Signs

However, we will be worrying more about BDCs that launch into new market segments during this time; or are booking an inordinate amount of deals. Winning all your mandates is something of a poisoned chalice in this environment.

More anecdotally, we are keeping our ear to the ground when talking to borrowers, PE groups, other lenders and the BDCs themselves about what they’re witnessing about current deal doing. Years ago when Medley Capital, Fifth Street Finance and Triangle Capital were booking deals at a frenetic pace we did hear from “anonymous sources” that the rigorousness of their underwriting was questionable. Not very much later, those BDCs – now acquired by new managers – began to record an appallingly high number of new troubled credits.

As many of our readers know, we also publish the BDC Credit Reporter, where we write about underperforming and non performing companies that BDCs have financed. Frankly, of late there has been little raw material to write about and our attentions have been directed elsewhere.

However, we’re pretty certain that will not be the case for all that much longer.

At the moment – as we’ve shown above just about every BDC – judging by their prices – is faring well as all boats are lifted. As noted, we expect that to continue in 2021 and into 2022.

For Long Term Investors

However, how well BDCs today underwrite new credits will be the key determining factor of their success or otherwise if we look a little further out. Historic BDC credit performance has shown that there has been a huge variance in performance between the 42 players in this market.

Just take a look at the BDC NAV Change Table, and the column which calculates how NAV Per Share has performed since IVQ 2017 to IIQ 2021 for every BDC . The range of change in percentage terms is very wide: a positive 27% on one hand to a (68%) loss on the other. That’s over just three and a half years.

Differing credit performance is also at the root of the wide variance in BDC total returns for shareholders – calculated by Seeking Alpha – over longer periods. The SA table for 5 years shows shareholders achieving a gain as 239% over the last half decade (Capital Southwest), but also a loss as great as (62%), which relates to PFX.

At the moment, with all BDCs registering higher prices in 2021, investors might feel that whatever stock you pick is going to result in a positive. That has been true – and may continue for awhile. In the longer run, though, that has never been the case and will not be in the future.

As in any good capitalist system – and leveraged lending is very much one – there will be winners and loserrs, and the differential between them is likely to be substantial.