BDC COMMON STOCKS

Week 10

Deja Viewed

We know it’s a bore to lead with the same observation (almost) every week, but we call them as we see them – even when repeated.

Once again, in the week ended March 8, 2024, the BDC sector and the broader markets – represented here by the S&P 500 – headed off in different directions where prices are concerned.

BDCZ – the UBS-sponsored and admittedly thinly traded exchange traded note which owns virtually all the public BDC stocks, moved up 0.8% while the S&P dropped (0.3%).

As BDC earnings season winds down – with only 5 BDCs left to report their IVQ 2023 results and 38 already in the hopper – investor enthusiasm for “private credit” in a public wrapper remained strong.

Sort of.

Twice as many BDC stocks (29) went up in price or remained unchanged as dropped (14).

Two BDCs reached new 52-week highs: Blackstone Secured Lending (BXSL) and MidCap Financial (MFIC).

These are two quite different BDCs but both have caught the market’s fancy.

As of last Friday, 13 BDCs are trading at a price within 5% of their 52-week high and another 17 are 5%-10% from their price peak.

By contrast, there is only one BDC whose price is within (5%) of its 52-week low and that’s newbie Palmer Square Capital (PSBD) which is also close to its 52-week high and doesn’t really count.

That leaves just Prospect Capital (PSEC) and TriplePoint Venture Growth (TPVG) hovering (8%) off their lowest price levels.

As to the number of BDCs trading at or above net book value per share – another useful indicator of market enthusiasm – the number remains 17, close to the best level we’ve seen in this long-winded BDC rally.

Shiver

However, let’s get to the ominous “sort of” comment we made above.

Investors may be paying up for BDC stocks – BDCZ just broke into the black again in 2024 and is only (5%) off its own 52-week high peak – but they are discriminating.

As we anticipated in last week’s Market Recap, several BDCs reported relatively poor IVQ 2023 performance this week and were punished by Mr Market, as we feared might be the case.

Worst

The biggest casualty was venture-debt BDC Runway Growth Capital (RWAY), whose price dropped (13%)

The BDC Eeporter was moved to review RWAY’s performance and gave the BDC a rating of only 2 on our newly introduced 1 to 5 scale.

Despite management putting on a brave face, flat earnings, a lower NAVPS and new credit challenges caused many shareholders to throw in the towel.

On Friday, the volume of shares changing hands shot up to 8x-10x their normal volume.

Unrelenting

Maybe this was a singular over-reaction but the evidence elsewhere suggests not.

TPVG, which also reported poor results this quarter, fell (9%) in price this week and is off (22%) in the past year even as the BDC sector generally boomed.

Thanks to a deluge of credit reverses that began in 2022 and accelerated in 2023, the venture-debt oriented BDC lost one-third of its NAVPS in eight quarters.

TPVG’s stock price has dropped (42%) since the underperformance began.

Naturally enough, analysts and remaining investors want to know when this is all going to end, as reflected in this plaintive question on the most recent conference call:

Brian J. Mckenna JMP Securities LLC, Research Division – VP & Equity Research Analyst

Okay. Great. So you had well over $1 per share of net realized and unrealized losses in the quarter. And that drove an 11% decline in NAV, bringing a year-over-year decline of 23%. So I guess, is there a way to think about future losses across the portfolio moving forward? Are we getting near the end of these write-downs and losses? And I’m just trying to think through the trajectory of NAV from here and ultimately when you think it will start to inflect higher.

TPVG IVQ 2023 Conference Call

Not Alone

Unfortunately – and a little shocking to us – there are many other BDCs in the same underperformers boat.

For a long time now the market has recognized that Prospect Capital (PSEC) has intractable credit challenges, causing the stock price to drop (40%) since late 2021 and (25%) in the last year – the worst BDC performer by that last metric.

This quarter – as we instituted our grading system for BDC performance – we couldn’t noticing that there were many other BDCs in trouble – some maybe only for a brief while and others that may be entering a long winter.

We suggest having a look at the not-yet-world famous BDC Summary Results Table for the IVQ 2023 where our ratings are published.

You’ll find that 11 of the 38 BDCs that have reported so far received a low score where their overall performance is concerned.

We cross-checked those names against a Seeking Alpha table that shows stock price performance in 2024 YTD and found 10 of the 11 were in the red this year.

By the time BDC earnings season is over and we put away our grading pencil it’s likely that as many as 14 BDCs will be in the poor performance category.

That seems high. It may be because our grading methodology is too demanding, but we don’t think so.

There are plenty of objective criteria that we employ to support the low scores.

Not In Our Stars

Maybe BDC managers – and the rest of us – have been lulled into complacency for the last two years by the high earnings and increased distributions gushing out of the sector.

Over at our sister publication – BDC Best Ideas – we spend a good deal of deal filling our so-called Expected Return Table with the annual distributions paid out by the 41 BDCs we track.

The latest data suggests the sector saw 30 BDCs increase their distributions in 2023 over 2022,; 5 were unchanged; and only 6 dropped

Even then, only half of the BDCs cutting their payout did so because of weakening earnings. The others are due to booking lower realized gains in 2023 – a very episodic metric.

Cracks

Also, we didn’t get the recession and broad-based credit problems in 2023 that most everyone expected but that doesn’t mean there has not been some less dramatic but still material damage done to portfolio values in more than a few cases.

With earnings peaking in the second half of 2023 as SOFR plateaued and spreads on new loans beginning to drop back towards more normal levels, some of the credit weaknesses in the BDC sector are beginning to be felt and materially decreasing earnings and net book values.

Unfortunately, things are mostly going to get harder for BDCs from here. Interest rates will drop, pressuring earnings. Spreads will continue to shrink in every segment of the market as lender confidence returns. (The syndicated loan market is back already). Companies already in credit trouble are mostly likely to continue to deteriorate in value and often achieve little in the way of recoveries.

Bright Spot

All of this containable and may take many quarters to play out. Moreover, we continue to be impressed how few new underperforming companies are popping up.

Many companies on non-accrual, or about to land there, have been underperforming for some time and large reserves for potential losses already booked.

Zeitgeist

We worry, though, that the changing tenor of what’s happening at the BDCs may result in more severe reactions in the market than we’ve seen so far.

Any long-time BDC observer will tell you that investors can be very unforgiving when there is blood in the water.

So far, the BDC dam has held up but with the sector close to a high and after many months of “rally this” and “rally that”, we worry that the market mood might change as investors and analysts absorb the lessons from the most recent data and look to the future.