BDC COMMON STOCKS

Week 31

Staying Strong

We have just completed Week Two of the IIQ 2022 BDC earnings season, with 26 of 43 players already reporting.

As we’ll discuss below, the overall results – at least in earnings and dividend terms – have been favorable.

Not surprisingly then – especially as the broader markets also continue to be sanguine – BDC stock prices have continued to rally.

Six Of Seven

Since the BDC sector reached its lowest point of the year on June 16, we’ve had six weeks out of seven with prices ascendant.

This week, BDCZ – the UBS sponsored Exchange Traded Note which owns most BDC stocks – was up 1.8%.

That other signpost we use – the S&P BDC index, calculated on a “total return” basis – increased 1.5%.

Better

Both BDCZ and the S&P BDC index were well ahead of the venerable S&P 500 index, which booked a 0.4% weekly gain.

BDCZ has out-performed the S&P 500 all year, as this chart makes clear:

Week’s Metrics

This week, 33 out of 43 BDC stocks moved up in price, including 7 by 3% or more.

Change Is Good

Far and away the biggest mover was Apollo Investment (AINV), up 13.6% on the news of a major make-over of the BDC by its external manager which will change its name, ticker, capital base and business strategy.

The changes involved were discussed at length in an article we wrote on August 2, 2022.

Investors were clearly delighted by the news – which also included an aggressive lowering of compensation costs – which pushed up the stock price.

Still, for all those thumbs up by investors, the stock still traded by week’s end at a (16%) discount to net book value per share.

More “proof in the pudding” might be required to get AINV to trade above book like 17 of its peers.

In The Red

The biggest percentage price loss of the week occurred to TriplePoint Venture Growth (TPVG), but for a good reason.

The stock price fell back (3.2%) after the ambitious venture debt BDC announced its intention to undertake a secondary stock offering.

As happens in these situations, TPVG’s stock price dropped but only modestly.

Where We Are

At this stage, BDC prices are neither very low – as they were in mid-June – or very high – as they were in late April.

At the bottom, 41 BDCs were trading within 10% of their 52 week lows and none were within 10% of the highs.

At the high point, there was only 1 BDC trading within 5% of its 52 week low price and 33 within 10% of the high.

Right now, there are only 2 BDCs still trading within 5% of their 52 week lows, and another 10 between 5%-10%.

However, there is also only 1 BDC within % of its 52 week high (MAIN) and another 9 between 5%-10%.

YTD in 2022, 34 BDCs are still in the red despite all the recent rallying.

All to say that BDC investors have some way to go before being able to boast of superior – or even normal – returns in this peculiar year but have moved away from the abyss that loomed back in June.

Going Well

It’s fair to say, though, that BDC earnings season has been encouraging for the bulls.

We’ve been keeping records as best we can:

More Data

Premium Subscribers: See the updated BDC NAV Change Table for five new columns where we compare actual EPS achieved against analyst expectations as well as changes in Net Asset Value Per Share. We also review whether credit metrics – using the BDC Credit Table – have gone as as expected, gotten worse or stayed the same.

We also provide an update on whether reporting BDCs have maintained, increased or reduced their “regular” distributions – a useful measure of financial health.

Finally, we’ve compared the analyst consensus for the next quarter against the IIQ actual results to see for each reporting BDC whether EPS is expected to increase, decrease or stay the same. Admittedly, these last numbers are subject to constant revision, which we’ll be doing periodically.

Results

First off, 19 of the reporting BDCs actual EPS exceeded what the analysts were expecting, another 3 were as expected and only 3 fell short – and not by much.

That might say as much about analysts famously tending to set earnings expectations low for a host of reasons not worth discussing here, or reflect the upward drift of investment income from the multiple rate increases that occurred in the period. As we’ve noted in the past, just knowing the rate increases is only a starting point as those h higher yields work their way through every BDC’s P&L in different and unexpected ways.

Bigger

9 BDCs managed to announce a higher regular distribution and the remaining 17 kept their payouts to shareholders unchanged.

Not one BDC in this supposedly difficult environment reduced its dividend.

Long term BDC investors will recognize that this degree of dividend increases is unusual in a sector where typically payouts remain the same from quarter to quarter.

Shrinkage

The BDC bears, though, will point to the almost universal drop in BDC net book value per share -24 of 26 are in the red for an average of (-3.9%).

That wipes out the last three quarters of overall NAV gains, and leaves only a minority of BDCs 917) boasting higher net book value per share metrics than before the pandemic.

We also calculate that only 4 BDCs out of 26 are showing higher net book value per share at mid year over their level at the end of 2021.

The bulls might reply that these “losses” are just paper calculations and could just as easily head in the other direction with any change in the economic atmosphere.

Unclear

Both bulls and bears can point to the early data gathered in the BDC Credit Table, and summarized in the BDC NAV Change Table, to make their respective points:

Yes, there are 10 new non accruals booked so far (8 net of reversals), but the overall the level of non performers – and their value in BDC portfolios – remains at a historically low levels, both in aggregate and by most players individual track records.

Even looking at underperforming assets more broadly – using what data the BDCs themselves offer up when evaluating their portfolios – is not determinative.

Some BDCs have seen total underperforming assets increase, some even decrease.

A few have underperformers that exceed 15% of their total portfolio, which we consider a level to start worrying about, but there have been no major changes in this regard, and no clear cut trends.

Successful Exiting

To further complicate the picture – albeit not captured by the BDC Credit Table – many BDCs have seen increases in the valuation of their equity investments, including a host of realizations.

At a time when the public markets were sometimes in free fall, there’s been a flurry of M&A activity in the private markets, benefiting a number of BDCs, especially in the lower middle market.

Money Magnets

Even more confusing is that we’ve learned in the last two weeks that many BDCs in recent months have been successfully raising new equity through At The Market programs just when you might have expected investors to turn away.

The just announced secondary stock offerings by ARCC and TPVG are just the most visible part of a broader capital raising trend that has quietly been going on in the second quarter and beyond.

In fact, we’d guess that more BDC equity has been raised of late than has been bought back as lower BDC prices triggered share repurchase arrangements.

A few BDCs have managed to both issue new shares and undertake repurchases in the same period !

Expanding Universe

Likewise – as the BDC Credit Table shows – rather than shrinking BDC portfolios have been mostly expanding in the second quarter.

18 of the 26 BDCs who’ve reported results have larger portfolios in June 2022 than the quarter before, even after taking into account lower asset values.

In a few cases, portfolios have increased by double digit percentages in those 3 months. See TRIN and HRZN, for example.

Plenty Of Fish

That’s mostly because investment opportunities have not shriveled away as many expected in the face of a recession, but been maintained or increased in the different market segments that BDC operate in.

We knew already that venture debt was a red hot segment in this regard and that large cap deals were still getting done.

Of late, BDC reporting indicates both the lower and the middle market remain active, and the BDC participants are finding plenty of opportunities to put capital to work.

Seesaw

All the above notwithstanding – and probably because certain groups of non-bank lenders have pulled back in recent months from making new loans – repayment levels are on the low side.

This is fueling the growth of portfolios almost across the board in BDCs of all sizes and in all segments.

This is good news for the bulls, especially when that AUM growth is married with ever higher yields from higher reference rates as far as the eye can see.

Coming Together

Many BDCs made clear on their conference calls that whatever EPS boost they received in the second quarter was nothing compared to what would be occurring in the third and fourth quarters as higher rates lock in.

With credit seemingly unaffected, this is a recipe worthy of Goldilocks for much higher earnings in the second half of the year (and something we’ve been bleating about for months because the math is inescapable).

You’ve got increasing assets; higher reference rates; wider spreads/fees on new loans and only modest increases in offsetting expenses thanks to most BDC borrowings being fixed and the only increase in compensation costs being in the incentive fee. Even that is partly offset by lower management fees due to lower asset values.

Short Term Future

Have a glance at analyst earnings projections for the next two quarters as we are beginning to do.

ARCC’s EPS is expected to increase by 9% by the IVQ 2022 over the mid year level; HTGC 16%;and CSWC 6%.

We expect further revisions upward as analysts re-calibrate their models with the most recent rate increases and financial information.

Earnings and dividend in the second half of 2022 should be the juiciest we can remember, exceeding an already bountiful first half of the year.

On paper, at least, that momentum should continue into 2023…

Rough From The Smooth

What we’d worry about, besides the obvious issue about credit losses mounting and wiping out some or all those earnings gains, is a sudden freeze-up of the markets that would cause asset values to drop.

With so many BDCs already at full target leverage (we estimate two-thirds of the universe), an unexpected drop in the value of their assets would cause a catastrophic drop in net asset value.

This would cause the BDCs affected to be unable to make much in the way of new loans and might cause them to raise expensive new equity or sell off existing investments at a discount to meet their leverage standards or those of the BDC format.

Unperturbed

We have to say – and speaking in broad terms – there’s a certain hubris in the air as we hear from the Masters Of The Universe about the risks that might lie ahead.

Famously AINV’s CEO said he was not losing any sleep, and he has much company in this regard amongst his peers.

Based on the current data we understand BDC managers self confidence but it’s what might be around the corner which is what needs fretting about.

Taking Precautions

To date, we’ve heard from the BDCs that they’re aware of the risks and are doubling down on new investment selection and reviewing their portfolios for potential weak spots.

This is all well and good, but not very different from what lenders do at all times.

Enough Already ?

There has been little in the way, though, of material defensive actions such as shrinking portfolio size or leverage; selling off riskier loans and staying away from new investment activity.

If anything – as we’ve seen – the BDC universe has been headed in the opposite direction. For example, this week Oaktree Specialty Lending (OCSL) announced its intention to INCREASE its target leverage.

Divergent

For BDC investors, if that proves to have been the right move, we should see much higher earnings, dividends and returns on equity for many quarters to come and – if the general fear factor in the markets dissipates – the prospect of BDC prices reaching higher than their April peak.

If the BDC managers are seriously wrong – and get caught flat footed by one or more crises that we can’t yet name – investors will suffer from the vulnerability of being so exposed just as conditions changed.

Generally speaking, we have great confidence in the risk management of BDC managers, but nothing in this world is certain and markets are famously fickle.