BDC COMMON STOCKS

Week 12

Funny Peculiar

Just two weeks ago, the BDC sector panicked – as rarely before – about the Silicon Vally Bank (SVB) crisis, which then metastasized into a full-blown banking crisis.

In Week Ten, BDCZ – the exchange-traded note which owns most BDC tocks and serves as one of our measuring sticks for sectoral price performance – dropped by (10%).

Since then, we’ve learned about the failure of Signature Bank; the asset-liability mismatch across the banking sector (but especially with regional banks); witnessed the disappearance of Credit Suisse into UBS, and seen the markets shiver about the outlook for global banking giant Deutsche Bank.

Even as we write this, data is out showing that billions of dollars of deposits have been fleeing small and mid-sized banks for the regulated safety of the very largest institutions.

Just Said No

Treasury Secretary Yellen – apparently with the tacit support of Chairman Powell and President Biden – dismissed a request by a consortium of regional banks for a blanket – albeit temporary – FDIC guarantee of ALL deposits.

Instead, the powers that be are relying on special funding measures that keep smaller banks from “doing an SVB” and failing in a very short period, while still leaving them at risk of gradually seeing much of their deposit base melt away.

Stay Calm Etc

There seems to be some hope from Yellen/Powell et. al. that the markets and businesses with deposits over $250,000 will “calm down” in the days and weeks ahead and move on to some fresh concerns elsewhere.

Our Own Greek Drama?

To editorialize for a minute – which we typically don’t like to do because there’s too much of that going on everywhere you go – this could be a tragic mistake.

This crisis – if nothing else – has made clear that many of our banks – if GAAP fair market value accounting was applied normally – would be far less well capitalized than their balance sheets show, or are even insolvent.

Furthermore, the real estate sector is likely to be the next victim of the breakneck change in the direction of interest rates, potentially bringing about further losses to the banks – especially the regionals.

We’ve had a bank crisis without any talk of “bad loans” and the like but that’s unlikely to last.

As well, some other commentators are looking in the direction of leveraged finance and predicting varying degrees of credit bloodbaths to come.

Clean Hands

The government – so eager not to be accused of a “bailout” – is taking the risk of allowing a full-blown banking collapse to take root.

Maybe Ms. Yellen calculates that without a bona fide disaster getting Congress to agree on anything in a bi-partisan way is impossible anyway.

She might be calculating that to even try – and fail – would be to invite the very crisis of confidence she is trying to avoid.

Not Enough

Whatever the reason, the measures taken so far by the authorities here and globally do not fill us with confidence that all will be well.

Other shoes could yet drop as the cliche goes, and at any time, without the benefit of wider-scale support.

What Me Worry?

The irony in all this is that both the stock market and BDC investors – after an initial tremor – are “whistling through the graveyard” – unperturbed by the BREAKING NEWS and endless parade of developments on their screens.

This week, the S&P 500 increased by 1.4%, the same percentage as the week before.

BDCZ increased by 2.0%, with 36 of the 42 BDCs we track in the black.

Of those 36, 9 increased by 3.0% or more, as investors rushed to take advantage of perceived bargains.

The number of BDCs trading at or above net book value per share increased to 8, from 5 the week before.

On a 2023 YTD basis, the S&P BDC Index – calculated on a total return basis – went from break-even to a 2.3% gain in 5 business days.

As always, the markets are running ahead – apparently having bought into the “worst is behind us” scenario.

Winner

In fact, one could make a case that the damage done to regional banks’ balance sheets and the coming credit pullback which Chairman Powell seemed to heartily anticipate (and which permitted the Fed to “only” increase its reference rate by 25 basis points this week) is a long-term benefit for the BDC sector – and private credit generally.

Less regulated, funds with no fleeing deposits to worry about should be in a position to tread where regional banks and other regulated institutions will now fear to go.

A similar argument could be made where venture lending is concerned and throughout the world of leveraged finance, the outlook for wider spreads and tougher terms shines bright.

This is all true, and we share the belief that “non-bank lenders” like BDCs will be long-term beneficiaries and private credit’s market share will accelerate from here.

Yes, But…

In the short run, though, anything might yet happen to the financial system.

This is admittedly a subject way above our pay grade.

We do know, though, from harsh experience that when doubts arise about the viability of our financial system BDCs suffer terribly.

We have the scars to prove it.

How This (Doesn’t) Work

That’s because the debt markets seize up as everyone is either watching or panicking, depending on their exposure.

Loan values can drop precipitously and – thanks to fair market value accounting – this can result in huge unrealized losses on BDC books.

Just think what a (30%) write-down of a portfolio can do to a BDC leveraged at 1.5x equity: a (75%) drop in net worth, and in a very brief period.

Your assets might be completely problem-free but your net asset value will be in shambles until the crisis is resolved.

Cruel To Be Kind

That results – under BDC rules meant to protect shareholders – that no cash dividends can be paid out until asset coverage is back over the regulatory limit and no additional borrowings are permitted.

(An elegant solution available to the government is to suspend the application of fair market value accounting – as the banks successfully lobbied for – but that can’t be counted on).

Solid

It’s all very silly in a way because BDCs are invested in long-term assets (5-7 year loans) which pay out interest (and a little principal) monthly or quarterly and use a very modest amount of debt themselves compared to a bank.

That BDC debt – as we all know – is largely medium-term and fixed rate in nature, with only a fraction of funds at risk of defaulting or not being accessible in a crisis (bank Revolvers mostly).

Given that no bank lending to a BDC has ever lost any money, we doubt that their revolver advances will be a great concern at JP Morgan, Bank America, etc. in any crisis.

One Crucial Flaw

The BDC structure is very safe compared to the banks but its Achilles Heel is the very element that was meant to protect shareholders – the quarterly revaluation of its assets.

(Some BDCs tried to get around this in the GFC by writing down the value of their debt to “market”, which had the effect of boosting net worth. However, the SEC has blocked this methodology, leaving only the assets subject to the prospect of a sudden sharp devaluation even if all loans are performing normally).

Worrisome

Through 2023 and into 2023 the debt markets held up remarkably well – until the last few days.

At the moment, the high-yield bond market is in deep freeze where new issuance is concerned (March issuance was the lowest since the beginning of the pandemic three years ago).

The Wall Street Journal warns that the leveraged loan sector is also under pressure, quoting a market participant:

John McClain, a fixed-income portfolio manager at Brandywine Global Investment Management, said the biggest risks lie in the leveraged-loan market. Roughly $300 billion in loans are coming due over the next three years, according to PitchBook LCD, and refinancing will be difficult. 

“It’s going to be a triple whammy for the leveraged-loan space. Companies’ interest costs go up, the economy is ticking down so their earnings are going down, and the main buyer in that space, CLOs, may or may not be around,” said Mr. McClain, referring to the collateralized loan obligations that are a major source of demand for risky company loans.

WSJ – March 24, 2023

Our Point

By no means are we suggesting that the capital markets have reached dire levels yet. In fact, judging by stock prices as we said, the consensus appears to be that an improvement lies ahead.

We are saying, though, as explicitly as we can, that the door has been opened since the SVB/Signature failure for a system-wide failure.

The measures taken to date do not guarantee a return to normality.

If the Treasury, Fed, Biden Administration, and the stock markets have under-estimated the problems that face us and we get a full blow-up after all, chances are very high that BDC sector prices could implode, if the experience of the GFC, European crisis, and the pandemic are anything to go by.

Ending On A Positive Note

On the other hand, if our banking system is “sound” as promised by our leaders, BDC prices – even in the face of weaker economic conditions – are likely to continue rallying back.

A lot of ground was lost two weeks ago and many BDC investors will not be able to stay away with many yields in the mid-teens, just as risk-free rates are dropping.