BDC COMMON STOCKS

Week 28

Delighted

This was the week that the June 2024 Consumer Price Index (CPI) came in negative – dropping (0.1%) versus May.

That’s very good news on the inflation front, even if subsequently slightly spoiled by a higher-than-anticipated Producer Price Index (PPI) the following day.

However, the markets, the economists and everyone else are now all but certain that the war is won and – most importantly – the Fed will be reducing rates in September.

Bloomberg even reports that some on Wall Street now believe the first cut will be (0.50%), rather than the (0.25%) most presume.

We’re not saying the certainty of some sort of Fed Funds rate cut is wrong but just a few weeks ago the zeitgeist was just as certain that there would be one cut very late in the year or NOTHING at all.

Anyway, the markets lapped up all the “good news”, with the S&P 500 up 0.5%, the NASDAQ 0.3% and the Dow Jones increased 1.6%.

Both the S&P 500 and the Dow reached new all-time highs intra-day on Friday.

Not Left Out

The BDC sector was keen to join the party. BDCZ – the UBS-sponsored exchange traded note which holds most of the public BDC stocks – increased 0.3% in price.

The S&P BDC Index – on a “total return” basis – went up 0.2%.

BDCZ actually reached a new 52-week high on Friday of $20.24, slightly higher than the prior peak of $20.19.

That’s the good news.

Tougher

However, we can’t help feeling – based on the data – that the higher the sector climbs, the harder it’s getting.

This is especially the case as all this heady talk of lower rates will bring down BDC investment income once the cuts kick in.

27 BDCs were up in price this week, but 15 were down.

Ups And Down

Only two BDCs increased 3.0% or more in price – sometimes that metric can be in the mid-teens – and one BDC fell more than (3.0%).

For the record, the gainers were Saratoga Investment (SAR) and Horizon Technology Finance (HRZN) and the decliner was Great Elm Capital (GECC).

All the price moves seemed rational. As we reported on the BDC Publications News page, SAR reported its most recent quarterly results and – despite a lower Net Book Value Per Share (NAVPS) – convinced investors that its recent credit troubles with two portfolio companies – Zollege PBC and Pepper Palace – are behind them.

One Way To Do It

This turnaround has been achieved mostly by hugely writing down the value of both non-performing companies to the point that they represent only a tiny percentage of portfolio assets.

Also, SAR has taken control of both businesses which might – or might not – result in recoveries in the future.

As we all know, investors crave certainty and this quarter’s write-downs (which included a large realized loss on Zollege) clarified the credit picture.

Not Done

We won’t say, though, that SAR is fully out of the woods. As discussed at much greater length in the BDC Credit Reporter, significant valuation downside exists where SAR’s CLO and senior loan joint venture are concerned.

Investors, though, didn’t seem to mind and increased SAR’s stock price 3.4% this week.

Repaid

Up 3.2% was HRZN, probably due to the release of their regular quarterly portfolio update. Apparently in the IIQ 2024, the BDC received a large pre-payment from portfolio company Divergent Technologies.

We’re guessing that some investors are hoping for higher income as a result in the IIQ 2024 from outsized end-of-term payments and prepayment fees.

Otherwise, HRZN booked little in the way of new investments. We project its portfolio will shrink in the second quarter versus the first.

Unknown

What the press release did not address is HRZN’s credit quality.

Investors may believe – as is the case with SAR – that the worst is passed.

Going by HRZN’s IQ 2024 valuation there are only two troubled companies of any significance left on their books and one of them – Nexii Building Solutions – reached a “realization event” a few days ago.

Uncertain

However, we’re not certain that HRZN’s valuations can be counted on as a guide to companies true performance.

As a result, we’ll have to wait till the final IIQ 2024 results come out to see if the BDC’s long recent list of troubled investments has come to an end – at least for the moment.

As to GECC, the tiny BDC – which is tenaciously seeking to re-make itself into an owner of asset-based finance companies – is raising new equity capital.

Although the new shares are not dilutive, this may account for the drop in GECC’s stock price.

Where We Are

With 28 weeks gone in 2024, BDCZ stands at $20.16, just below the $20.24 newly-established YTD and 1 year high.

For the year, BDCZ is up 6.3%.

The equally important BDC S&P Index is up 12.7%.

That’s not quite in the same league as the red-hot S&P 500, which is up 18.6%, but not too shabby.

A Little Longer

After all, if we look back just 12 months the total return is 25% and since the very beginning of the rally – which we date back to October 2022 – the gain is 60%.

Unfortunately – and that’s always the problem when dealing with averages – “individual performance will vary” and one’s satisfaction as a BDC investor will vary depending on which stocks you’ve held.

Winners

In 2024, 27 BDCs have increased in price.

However, only 3 have increased in price more than the S&P 500: Hercules Capital (HTGC); Carlyle Secured Lending (CGBD) and Main Street Capital (MAIN) – up 28%,23% and 22% respectively.

We’re a little surprised by the presence of CGBD, which only shows that this is a humbling avocation.

HTGC and MAIN are long-time investor favorites you might have thought were “over-bought:” but nothing succeeds like success in BDC-land and investors continue to flock there.

HTGC trades at a 82% premium to book and MAIN 74%.

Think about that for a minute when remembering that only 20 BDCs out of 42 are trading at a premium to book and the sector average is – by our count – is at a 1% premium.

All Inclusive

If we take into account distributions received through June, the number of BDCs at or above the return of the S&P 500 climbs by 7 – according to our back-of-the-envelope calculations.

This means about a quarter of the BDC universe is out-performing the world’s most famous index at a time of maximum market hotness.

Of course, that also means three-quarters – or 32 BDCs – are behind that standard.

Still, we calculate that 22 BDCs – just over half – are delivering a double digit (10%+) return in 2024 to date.

Not So Great

The fact that 20 BDCs – the bottom half of the table – are generating single digit or even negative returns in the midst of this “everything rally” speaks volumes.

Presumably some BDCs that have been performing well shot up too much in price earlier in the rally and are now adjusting.

Bottom

Some others have not performed well where fundamentals are concerned and investors are not in a forgiving mood in 2024.

With all that said, there are only two BDCs that have been well and truly spanked this year: TriplePoint Venture Growth (TPVG) and OFS Capital (OFS).

TPVG – as this chart illustrates – is down (25%)

However, this is just the most recent stage of a vertiginous (57%) price descent that began in November 2021.

OFS is off (24%) in 2024.

The BDC’s price descent began in April 2022, and now amounts to a third of its market capitalization.

In neither case does the market – judging by the recent price action – seem to believe the worst is over.

We can no more predict this outcome than we can the result of the next election.

Looking Forward

We’d like to believe the markets are wise and far forward-looking and will recognize that even when BDC income begin to drops – brought down by lower interest rates, their stock prices will remain close to where they are, or even go higher.

After all, BDCs have many levers to pull to keep earnings and distributions up. BDC managers have been planning fior years how to respond when rates finally begin to deflate.

Some have kept their portfolios smaller than they might in order to boost earnings later by booking more investments.

Many BDCs are counting on increased M&A activity to generate a plethora of fees on new deals and pre-payment penalties on refinancings.

Then there are all those equity stakes BDCs hold – which have been quiet in recent years – that might get harvested if the PE groups get back into business big-time.

Virtually every BDC has a little treasure trove of undistributed income to support their future dividend payouts.

We Can Dream

In a few cases, we may see BDCs follow the lead of some of their peers (think Golub Capital most recently) and lower their compensation.

We won’t name names but the management and incentive fees some BDCs are charging are unconscionable.

Thank-You Very Much

It’s unlikely any BDC that has not implemented a shareholder-friendly “total return” feature in their incentive fee will do so, but we may get some temporary, noblesse oblige, fee waivers from managers who’ve been making money hand over fist in the last few years.

Our sister publication – BDC Best Ideas – projects overall BDC distributions will barely drop in 2024 versus the peak pay-out year of 2023.

More pertinently, Best Ideas expects the sector’s payout to shrink only (5%) in 2025 versus 2024.

That’s obviously an educated guess built on the back of many individual BDC projections, but subject to multiple assumptions.

Comparison Shopping

Even if BDC distributions do fall more than BDC Best Ideas anticipates, yields on other investments- from government bonds to REITS and high yield bonds – are likely to fall even more.

That SHOULD make BDC investing even more attractive in a relative world, and spur its stock prices.

However, we fear that the initial reaction to lower rates – a phenomenon that may begin even in advance of Chairman Powell lowering the Fed Funds rate – will be a rush to the exits by some investors.

Maybe the exodus will await the first rate-justified BDC dividend decrease.

“Gut Feeling”

In any case, while we believe there are solid arguments to be made for the BDC rally to continue – especially for the BDCs that are performing well – we can’t help feeling that a price drop is the more likely outcome.

As regular readers will know, though, we make no claim to prescience even after twenty years in this confounding market.

Like everyone else we shall have to wait and see how this plays out.