PREAMBLE

We are re-publishing an article from our sister publication – BDC Best Ideas. The article is itself in response to an article about the attractiveness of investing in the BDC sector that was recently published in that venerable financial publication – Barron’s. As you might expect when a specialist publication comments about a generalist, there are going to be a number of differences of opinion. However, we don’t regard this as a matter so much of “he said, he said” but an opportunity to have a useful dialogue of sorts about the nature of the BDC sector; its recent and future growth; what a recession might bring and – to a lesser degree – how best to value its public stocks. Because this was written for our Best Ideas audience we even offer some advice – something the BDC Reporter usually tries to stay away from.

De-Constructing Barron’s Article On The BDC Sector

BDC Best Ideas responds to a wide ranging article in Barron’s about the advisability of investing in the BDC sector right now.

INTRODUCTION

A reader sent me a copy of a recent article by Andrew Barry at Barron’s entitled “BDCs Sport Lofty Yields, But the Risks Are Growing. Time to Steer Clear“. We could say that all you need to know about the author’s thesis is in the headline and leave it at that. Instead, we thought it might be interesting to de-construct the article from this influential publication and determine what value an in-depth discussion can have for our readers.  As we often do, we are annotating the article with the BDC Reporter’s insights and we’ll close with a conclusion. We’d also like to offer a shout out to John Cole Scott at CEF Advisors who contacted us out of the blue wondering if we were going to write about this piece. (At that point, we were 80% done and suggests Mr Scott may have psychic powers). He sent me his own – highly quantitative thoughts drawn from his databases – some of which are quoted below.

Barron’s – November 25, 2022

BDCs Sport Lofty Yields, But the Risks Are Growing. Time to Steer Clear.

“Business development companies lend to midsize private companies at high interest rates. They have proven popular with retail investors in recent years by offering dividend yields of around 10%. Total industry assets have doubled to about $260 billion since late 2020.

BDC Reporter Comments: We sympathize with Barron’s trying to generalize about what has become a very diverse sector that defies easy categorization. BDCs lend not only to “midsized private companies” but also to lower middle market and large cap borrowers, as well as a significant number of public companies. And foreign companies. Etc. In many cases BDCs do not even lend to companies but invest in their equity, all the way up to taking controlling positions in imitation of a private equity firm. This variety makes rendering any wide ranging conclusions – like the one in the title – problematic.

Leading BDCs include Ares Capital (ticker: ARCC), Owl Rock Capital (ORCC), FS KKR Capital (FSK), and Blackstone Secured Lending (BXSL). The largest BDC is the nontraded Blackstone Private Credit fund, known as Bcred, which has grown to $22 billion in net assets since its inception in January 2021, more than twice the size of Ares Capital, the largest public BDC.

BDC Reporter Comments: As our readers know, we track 43 public BDCs, but there are more public players besides investing mostly in venture equity. Like with Bered, there are also a host of “private”, or non-traded BDCs. According to Advantage Data (now Solve), there are 72 of these, with an FMV of $138bn. The entire BDC sector – still according to AD – has a value of $252bn. Barron’s has fixated only on the top public names, and within that group those that target the bigger borrowers. No word on lower middle market (LMM) lenders/investors like MAIN, CSWC or SAR. Or venture debt BDCs like HTGC, TPVG and HRZN. Or BDCs with hybrid strategies like SLRC or GECC.

The bullish case for BDCs has been that they allow individual investors to invest side by side with institutions in the booming market for “private credit,” and benefit from what have been historically low loan losses. Most loans have floating rates tied to short-term interest rates. This has allowed BDCs to capitalize on the sharp rise in rates to a recent 4% from near zero at the start of 2022. A high percentage of loans go to companies acquired in leveraged buyouts by private-equity firms.

BDC Reporter Comments: All true. Worth mentioning but unsaid is that most BDCs are doubly benefiting thanks to fixing much of their own borrowing costs with unsecured notes – something that leveraged loan funds may not be doing. The arbitrage when loans are paying 12% and only paying 3% or 4% on your unsecured notes is a remarkable  phenomenon. Not only does this boost profitability but ensures much more stable balance sheets than in times past.

Yield-hungry investors ought to steer clear of the sector, however, now that the economy looks to be on the verge of a downturn. For one thing, BDCs are investing in highly leveraged companies. Generally, there are no credit ratings on their illiquid loans, as they tend to target smaller private companies valued at $3 billion or less.

BDC Reporter Comments: “Smaller”  –  $3bn or less” ? Barron’s is spending too much time writing about the likes of Tesla. Companies valued under $3bn employ most of the people in this country and contribute most of the GDP. Anyway, many BDC borrowers do have investment grade ratings. (By the way, so do many BDCs themselves).  Moreover, every single investment – we’re talking thousands – get valued by every BDC – and often by a third party valuation firm – every quarter. BDCs are not black boxes.

If BDCs’ portfolios were rated, they likely would average single-B, deep in the high-yield, or junk, category. BDCs often make loans to companies whose debt equals six times annual cash flow, as defined by earnings before interest, taxes, depreciation, and amortization, or Ebitda. Investment-grade companies typically have leverage of three times Ebitda or less.

BDC Reporter Comments: We don’t disagree about the single-B comment. However – once again – Barron’s is only considering BDCs involved in lending to the very largest companies with EBITDAs well north of $100mn. Even then a 6x debt to EBITDA is rare. Many, many loans in the LMM, middle market and even the large cap market are made at much lower multiples : 3.5x -5.0x covers most of the waterfront. Then there are the venture debt companies where EBITDA is irrelevant and rely on cash raised from equity investors. Then there is an increasing cohort of asset based loans on many BDCs books. Etc.

BDCs, too, are leveraged, magnifying risk, as most carry more than $1 of debt for every dollar of equity. Costs are steep, with most charging a 1.5% base management fee and an incentive fee of 17.5% or 20% of investment income, subject to hurdle rates, or minimum rates of return ranging from 6% to 8%.

Without such leverage, BDCs wouldn’t be able to offer such lofty dividend yields, given the fee structure. BDCs can collect incentive fees, even if their portfolio values decline, as long as income levels are unimpaired.

BDC Reporter Comments: We’re not here to defend BDC manager fees – always too high from a shareholder’s standpoint. However, there are plenty of BDCs charging far less than 1.5% on the MF (GSBD at 1.0%, BBDC at 1.25%, etc). Then there are the many BDCs who do not charge an Incentive Fee when net asset values drop. Not to mention the many BDCs that over time have voluntarily waived fees, sometimes for years. As always, there is a huge difference between players. Compare BXSL and PSEC…We would not describe BDC compensation as excessive given the difficulty – and cost – of finding these smaller loans – a much harder process than lending to the very largest leveraged companies  which closed-end funds focus on. Plus, BDCs can and do invest in the equity of these sort  of companies, opening up another avenue of returns than CEFs do not explore much.

As to leverage, John Paul Scott calculates that average debt to equity stands at 1.16x, way below the 2.0x allowed under BDC rules. Furthermore, remember that much of the BDC leverage – as mentioned above – is in the form of long term fixed rate unsecured notes, virtually devoid of all covenants or principal repayments for many years to come. This is not your father’s BDC that was previously almost completely funded with secured, floating rate debt and based on an availability calculations subject to shrinkage when loan values dropped.

Many BDCs have made only minor reductions to the value of their portfolios this year, despite the selloff in the junk and leveraged-loan markets. The portfolios effectively are black boxes, meaning there often are no public prices and limited liquidity on the loans, and no public financial results on the companies.

BDC Reporter Comments: HY ETFs and closed end funds really are black boxes but – as we’ve discussed earlier – that’s not the case for BDCs, which are constantly re-evaluating their investments and supplementing the data with quarterly commentary  on earnings conference calls. We never know enough about BDC portfolio companies, but if you read the BDC Credit Reporter which tracks the underperformers, we know a great deal.

The private credit market boomed in the past decade as BDCs and others rushed to fill a lending void created by an exit of banks from leveraged lending. Returns generally have been strong, helped by a bull market in stocks and historically low interest rates. That favorable environment is changing, which raises the question of whether future returns will be as good as those in the recent past.

BDC Reporter Comments: No word from Barron’s here about the large number of BDCs increasing earnings and dividends in 2022 and expected to do more of the same in 2023. More subtly, no recognition that with Fed Funds rate unlikely to go back to prior rock bottom levels that this could be a long term phenomenon. The “favorable environment” is not in the past, but – arguably – in the future as new loans are being booked by BDCs on far better structural and financial terms than ever before.

Investors seeking high-yielding assets ought to opt instead for open- or closed-end funds and exchange-traded funds focused on junk bonds or loans to large, leveraged companies. These include the closed-end Nuveen Credit Strategies Income ETF (JQC) and BlackRock Corporate High Yield (HYT). They carry similar yields, but have more conservative portfolio values than BDCs.

BDC Reporter Comments:  We have no opinion on JQC and HYT but Mr Scott does. This is what he wrote:

“We would say that neither are good sustainable income options are the moment:

JQC has a 3-year average of paying 50% Return of Capital uncommon for a bond fund that is earning its yield in our opinion. JQC has a 10 year NAV total return of +4.23% vs  +7.8% for our BDC index and HYT has 10% of RoC on average the past 3 years and only 70% earnings coverage vs 110% to 125% for most BDCs (after the current increases) and a 10 year NAV TR of +5.88%”.

Our skeptical take on BDCs is at odds with the prevailing view on Wall Street, where most analysts recommend the stocks. Ares Capital, at $19.69, trades for a 6% premium to portfolio value or net asset value (NAV), and has a market value of $10 billion. The stock has 14 Buy ratings, one Hold, and no Sells.

BDC Reporter: ARCC at $19.69, though, is trading (14%) below its 52 week high and less than 9x its projected 2023 earnings. All to say that BDC prices are hardly “hot” – middling at best.

BDC executives tell Barron’s their valuations, which average about 90% of NAV, are appropriate, based on the high quality of their loan portfolios, the financial performance of borrowers, historically low credit losses, and the benefits of higher rates, which have lifted yields on their portfolio by as much as four percentage points this year, to about 10%. Dividends could be headed higher as higher short rates are reflected in portfolio yields.

BDC portfolios tend to be widely diversified. The Ares portfolio has loans to more than 400 companies.

“We continue to have very strong credit performance and almost no losses, and higher rates are flowing through to the bottom line,” says Craig Packer, the CEO of Owl Rock.

He says Owl Rock cherry-picks less economically sensitive sectors, including software and healthcare, for its lending activity. “We lend to high-quality, recession-resistant businesses,” Packer says.

BDCs regularly say they have plenty of cushion, since private-equity firms have substantial equity in the borrowers. Still, areas like software, a popular industry for BDC lending, have started to feel the effects of a weaker economy. Many publicly traded software stocks are down 50% or more this year.

BDC Reporter Comments:  Software stocks – because they are so profitable – ran up in value more than many other industries and had further to drop. More importantly, there’s no sign that the software sector – or any other industry for that matter – is showing any unusual sign of credit stress after many months of difficult economic conditions.

“If we’re going into a recession, even a mild one, it will hit BDC stocks meaningfully,” says Ryan Lynch, an analyst at KBW. “When credit is deteriorating, the stocks don’t work well. If we don’t go into a recession, BDCs will be a great place to be.”

Lynch says the stocks “could easily trade down to 70%” of NAV in a downturn. Investors are showing some caution already, as many BDCs trade below stated net asset value.

Lynch says he has grown “more cautious” on the sector, although he has Buy ratings on Ares, Owl Rock, and others. The companies now are in a sweet spot: Rates are rising and credit quality generally is good, but financial troubles are surfacing at some borrowers, and could worsen in 2023.

BDC Reporter Comments: Clearly Mr Lynch does not believe – as yet – that “we’re going into a recession” or he would not have all those BDC Buy calls. Nor do most investors, judging by where prices sit – not as bad as in September when the mood was darker but not as optimistic as in April when prices reached their 2022 high. As to “financial troubles are surfacing”, we’d like to know what Barron’s is referring to.

Ares Capital, Blackstone Secured Lending, and Owl Rock have experienced declines in NAV of just 2% this year, while leveraged loans—more liquid, floating-rate loans made to larger companies—are down about 5%. If BDCs had similar performance to the leveraged-loan market, many BDC NAVs would be down close to 10%, given their own leverage.

BDC Reporter Comments: Barron’s – and many others – do not understand how fair market value accounting works. The “more liquid, floating-rate loans” bigger discounts than BDCs do not necessarily reflect underlying performance but just that the two sorts of loans are valued differently.  The former relies much more on market quotes and at a time when debt investors are nervous that results in bigger discounts. The latter – in the absence of such price quotes – looks to a series of other calculations more tied to company performance to determine. Frankly, as someone who looks at these valuations every day, neither method is entirely satisfactory, but no one has come up with a better methodology. The valuations are more broad estimates, as reflected in the fact that two BDCs can hold the same debt and come up with quite different values. Depending on either method to give you a “true” sense of the value of an investment either right now or years in the future is a mug’s game.

Many closed-end leveraged-loan funds have experienced a 10% drop in net asset values this year, and their shares are down 15% to 20%.

“Private credit isn’t as volatile as public markets,” says Lynch, adding that investors can debate whether that’s appropriate.

“It is not a hidden secret that BDCs do not like to mark down their books aggressively,” says Eugene Grinberg, the CEO of Solve, a bond-data platform that analyzes BDC loan prices, based on publicly available information. “One school of thought is that they can hold on to these investments for longer periods of time and hence they do not mark their books down.”

Business development companies don’t pay taxes at the corporate level, and pay out 90% or more of their taxable income. Due to their tax status, their dividends generally aren’t tax-advantaged.

The risk/reward profile of BDCs looks unfavorable, in part because most have taken minimal write-downs of their portfolios, while open- and closed-end funds that focus on liquid loans and securities have taken meaningful reductions.

BDC Reporter Comments: This is silly. Because open and closed-end funds have taken bigger discounts than BDCs  does not make their values more conservative. Anyway, investors don’t buy these investments on a book value basis alone. There are many other factors that go into valuing risk and return. Like return for one.

Take Ares, which has one of the sector’s stronger records, having generated an 11% annualized return over the past 10 years, against 3% for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). Ares has marked down its NAV by just 2% this year. Yet, it has a riskier asset mix than peers, with just 45% of its portfolio in first-lien senior secured loans, the highest-quality BDC asset, while Owl Rock has 72% in that category and Blackstone Secured Lending, 98%. Ares has nearly 20% of its assets in riskier preferred stock and equity.

Barron’s spot-checked some of the larger Ares holdings using Bloomberg price data and found that several had experienced declines since quarter end, including loans to Zywave, a software company, and CoreLogic, a financial-data provider. The CoreLogic loan is down more than 15% since the end of the third quarter and the Zywave loan is off about 5%.

Several BDCs, including Ares, have exposure to the preferred stock of Citrix, a recent leveraged buyout whose debt prices are down sharply. Yet the BDCs are carrying Citrix’ preferred stock at close to face value.

BDC Reporter Comments: As our readers know, the BDC Credit Reporter just completed a full fledged review of ARCC’s 458 company portfolio, which we analyzed in the BDC Reporter. Here was our conclusion:

By no means is ARCC immune from making credit missteps. There are several companies in our database to which the BDC has made large advances that are carried at big discounts and significant realized losses are known to occur. It’s an impossibility with a portfolio of this size. Overall, though, our credit review shows ARCC performing very well. As a rough rule of thumb, we don’t worry too much as long as underperforming assets are under 15% of the portfolio and ARCC’s number is only one-third of that standard and holding stable in 2022. Non accrual levels are consistent with a low level of credit stress and prospective recovery rates – using FMV to cost percentages – are normal. There is a slight pickup in new potentially troubled companies in 2022, but nothing drastic. It’s no wonder that ARCC’s CEO on the latest conference call seemed unperturbed about potential credit risks going forward, with roughly 95% of assets and 90% of companies performing to plan nine months into this difficult year.

Lynch likes Ares, calling it one of the “most tried and true” BDCs that has performed well through economic cycles. Ares, like other business development companies, uses independent valuation providers to evaluate its portfolio. “We believe our portfolio continues to deliver healthy overall performance and is well positioned to weather future market challenges,” said Kipp deVeer, Ares CEO, on an earnings conference call in late October.

Blackstone Secured Lending has a portfolio similar to that of the larger Blackstone Private Credit Fund. It trades around $24, a 6% discount to its NAV, and yields 10%.

Bcred and Blackstone Secured Lending have lower fees than other BDCs. Brad Marshall, the CEO of both companies, said on Blackstone Secured Lending’s conference call in November that the company has “some of the best credit metrics” and is positioned to be “a net winner” in coming quarters.

FS KKR has taken a bigger hit to its net asset value of 7% this year, and its shares, at $20, trade at a 22% discount to that value.

A better alternative to BDCs are closed-end leveraged-loan and junk-bond funds. “The fund discounts across the sector are at the widest levels of the past decade,” says Eric Boughton, co-manager of the Matisse Discounted Closed-End Strategy (MDCEX). He notes that discounts on both groups are around 10%.

Investors can buy these funds at a discount to portfolios that already have been marked down. Closed-end fund fees are lower, leverage is less, and portfolios are more liquid than BDCS.

“This is one of the best opportunities since the financial crisis,” says Scott Caraher, who runs Nuveen’s leveraged-loan funds. He favors higher-quality loans that now offer yields of about 8%. Unlike BDCs, which tend to invest in obscure companies, Nuveen owns loans from companies such as Restaurant Brands International (QSR) and Tenet Healthcare (THC).

BDC Reporter Comments: Of course,  Mr Caraher is going to promote his own funds, as he should. Note, though, that quality BDC loans are paying out 10%-12% currently thanks to Chairman Powell – substantially higher than the 8% quoted above. Moreover, whether a company is “obscure” or not is unimportant from an investment or credit perspective. Just for the record, though, there are plenty of “famous” companies on BDC books. Now we sound like a proud father…

In a year when stock and bond markets have come under pressure, business development companies largely have been immune, based on their reported portfolio values. The risk is that, with a weakening economy, BDCs may be forced to take markdowns in coming quarters as some of their loans sour.

Shares of leveraged companies making highly leveraged loans might not be a good play in a downturn.

BDC Reporter Comments:  We agree with Barron’s that a weakening economy will likely cause BDCs to take markdowns. The BDC managers themselves – typically the most sanguine of folk – admit credit conditions are likely to worsen in 2023 if we get a recession and as debt service costs increase. We all know this. What is unclear is whether the markdowns will translate into material losses of BDC capital and permanently decrease their earnings power.

Our argument has been all year that permanent credit losses will be relatively mild – way lower than the last time we had a rooting tooting recession like in 2007-2009. To oversimplify that’s because in the last 13 years the sector has drastically changed the nature of the assets in its portfolios – now heavily weighted towards the top of borrowers balance sheets. Moreover, most of the players are managed by the biggest and best asset managers out there – versus a much more mixed bag back in the day – who have huge resources to deploy when conditions darken. These include those strong balance sheets; plenty of liquidity; the ability to trade debt for equity or to advance more funds if needed and more. The cherry on the cake is that even the recession that might be coming down pike is likely to be less dire than the Great One of 13 years ago.

Finally, this possible recession is likely to feature interest rates much higher than in the past thanks to the Fed.  The result is likely to be that BDC earnings and distributions will gain more from higher rates and widening spreads than they’ll lose from higher levels of non accruals.  Yes, BDC net asset values are likely to drop but their earnings – and thus their Return On Equity – should climb higher. A sector offering the promise of rising earnings and payouts in the midst of a recession. You don’t see that every day.

Conclusion: At the end of the day we have no view about whether investing in public BDCs or in “open- or closed-end funds and exchange-traded funds focused on junk bonds or loans to large, leveraged companies” is better or worse. Our market knowledge only extends to the former.

Furthermore, we concede what both Barron’s and KBW suggest: BDC prices could go much lower than they are now in a recession, or even the promise of one. That holds true for just about everything but BDCs do have – unfortunately for investors seeking to sleep well at night – a history of high price volatility. Long term investors remember the drastic price drops of 2007-2009 and in March 2020. There were less drastic – but still gut wrenching – price drops in 2011, 2016 and 2018 just on the possibility of economic trouble ahead. Currently, we’re living in one of those dire periods of uncertainty which tend to foster articles like the Barron’s one. The long term BDC investor has to have nerves of steel and the market timer has to hyper-alert because prices usually swing back up very fast.

Where we differ with Barron’s is using net book values to determine where to invest. The author’s assumption seems to be that the bigger the discount taken, the better bargain. Ah, if things were that easy…The long term earnings/dividend power is what ultimately matters in our view – and that of many others – and BDCs are well positioned in this regard, even if a recession occurs.

Still, to quote Alexander Dumas: “All generalizations are odious – even this one“. Given the varied nature of BDCs – from size, to strategy, to years in business, etc – one has to pick and choose carefully. (Yes, this is an argument for subscribing to the BDC Reporter but also happens to be true).  Recessions do tend to separate the wheat from the chaff and there are a number of weaker players amongst the BDCs we track who might not survive in their current form. We’ve never had a BDC go bankrupt but plenty have been forced to recognize that their business model was not working. We can think of a dozen right off the bat.

All in all – and even with all the drama associated with a recession still to come – our big picture, long term view is that the sector’s enormous AUM growth in recent years – mentioned in the Barron’s article – is primed to continue. More controversially, we believe BDC earnings are going to reach – and maintain – record heights for years to come. Our unsolicited advice: Don’t get distracted by the noise and miss out on a sector where annual total returns are likely to be in the mid-teens or higher.