Runway Growth Finance’s (RWAY) credit performance as of the IIQ 2024 was NORMAL

INTRODUCTION

Now that the IIQ 2024 BDC earnings season is all but over, we’re reviewing the credit performance of each BDC – looking both at the most recent developments and long-term trends. This seems especially timely with all the loose talk about a recession round the corner – typically not good news from a credit standpoint. To be both systematic and even handed, we’re rating each BDC’s credit performance as ABOVE AVERAGE; NORMAL, BELOW AVERAGE or VERY POOR. We’re trying to incorporate a host of data points in these evaluations, but there’s always a degree of subjectivity involved. We began with Crescent Capital BDC (CCAP) and followed up with WhiteHorse Finance (WHF) – coming to very different conclusions. Now we turn to a BDC in the venture-debt field – a segment of the market that has been in considerable turmoil for two years now: RWAY.

“As Previously Discussed”

Not-so coincidentally, we discussed RWAY at length in the most recent BDC Common Stocks Market Recap for the week ended August 16, 2024. At that point, the BDC’s common stock was the third worst performer of 2024, going by Seeking Alpha data. We were wondering aloud if investor disenchantment was mostly related to the much weaker earnings the BDC posted in the most recent quarter – (20%) below the IQ 2024 and (24%) less than the IIQ 2023 – or the addition of a major non-accrual, which also resulted in an increase in unrealized losses and a continuing decrease to the BDC’s already slumping Net Asset Value Per Share (NAVPS)? This article gives us the opportunity to evaluate just how well RWAY is faring – or otherwise – where credit is concerned.

The Few

We reviewed the BDC’s portfolio in some detail – as we do with every BDC. That didn’t take very long because the number of borrowers comes to only 31. The BDC itself claims 55 portfolio companies but that includes many where exposure is in the form of only preferred/common stock/warrants. The $1.013bn in debt assets, though, represent the bulk of the portfolio at cost: 91%. The average size of the debt owed by RWAY’s portfolio companies is on the high side: $34mn. That’s an issue we’ll return to shortly. Overall, these loans are valued at a (2.2%) discount to cost, which is the equivalent of (3.7%) of the BDC’s equity at par. These metrics are not optimal, but are not unusual by BDC standards. Given that RWAY lends out monies at a “dollar-weighted annualized yield” of 15.1%, some loss of value is to be expected.

Self Reported

Not every BDC offers shareholders a quarterly rating of “investment quality” – an omission we occasionally rail about. Even amongst those who do, the valuations cannot always be counted on to properly reflect strains that may be occurring at some of the companies. None of this is a problem – as far as we can tell – at RWAY which does publish a quarterly 5 point investment rating system (just like the one employed by our sister publication – the BDC Credit Reporter) and appears to be attempting to capture what is happening from a credit standpoint to the companies involved. Here’s the latest data:

Here’s how RWAY’s ratings work:

Three To Five

For our purposes, we consider anything rated 3 or below to be underperforming. You can see that amounts to 11 companies – a troubling 35% of the total. In terms of FMV, underperforming assets come to $371.5mn – also high at 37%. Of course – like you – we can see that nine-tenths of the underperforming assets and and all but two of the companies are concentrated in Category 3 – the least dire of the underperforming categories, and where “full payment compliance” exists.

Trend Is Not Their Friend

That’s the glass half full. However, as a former historian we can’t help ourselves from looking backwards for clues that might illuminate the present. We can’t help noting that at the end of 2021 and even at the end of 2022, RWAY’s percentage of total underperforming assets amounted to less than 9%:

Since the first quarter of 2023, the credit ratings have been getting progressively gnarlier.

Notwithstanding

Those ratings are all the more worrisome because – in 2023 – RWAY booked ($18.4mn) in realized losses, principally related to a company called Pivot3, as well as Carecloud and Gynesonics. (We are not told the specific losses in each case). If those losses were not booked the value of assets 3-5 would likely be even higher.

Net Loss

To be fair to RWAY – and looking all the way back to the beginning of 2019 through mid-2024 – net realized losses have been what we’d consider normal for a BDC: ($19mn), which is equal to (7%) of all Net Investment Income achieved in this period. Essentially all these permanent losses occurred in 2023. None have been booked in 2024 but that does not mean much.

Independent Analysis

We turned to the BDC Credit Reporter to identify the companies in the portfolio to be most worried about. Top of the list is this quarter’s newest non-accrual – Snagajob.com. The BDC has invested $44mn ($43mn in debt) in this job seeking site aimed at hourly workers. The value of the investment has already been written down to $31mn for a ($13mn) unrealized write-down. In its 10-Q, RWAY even quantifies the loss of income from this setback – so far:

“From being placed on non-accrual status through June 30, 2024, cumulative interest of $1.8 million would be receivable from Snagajob, Inc. and $0.1 million OID would be accreted into the cost basis, for a total of $1.9 million not recorded in “Interest income” on the Consolidated Statements of Operations”.

Annualizing

We calculate that on annual basis ($6.7mn) of investment income in the form of interest and End Of Term Payments (ETP) could be forgone. To put that into context, in 2023 RWAY’s total investment income came to $164mn and its NII to $78mn. We would argue that as much as ($0.17) per share of Net Investment Income Per Share is involved until this situation is resolved. Moreover – and for what it’s worth – what the BDC Credit Reporter read in the public record does not give us comfort that this situation will be easily resolved and our sister publication projects another ($20mn) of losses might need to be booked.

Different

With that said, the rest of the portfolio does not seem to be in such distress. RWAY has only one other company on non-accrual – Mingle Healthcare Solutions. The investment at cost is much smaller: $5.4mn (value $3.1mn). This is what we consider non-material and the forgone annual interest is around ($0.650mn) – less than a tenth of Snagajob.com. Also on the BDC Credit Reporter’s radar is Circadence (half the size and still performing) and CareCloud (non-income producing preferred and with a non-material value). However, we must admit that we must be missing other trouble spots because RWAY itself admits to having 11 underperformers at various stages.

Portfolio Construction

As we’ve already discussed, RWAY’s portfolio is relatively highly concentrated in a higher risk, higher yield corner of the market. Given the concentration -as you’d expect – when something goes wrong at a borrower, the reverberations on the BDC’s asset value and income can be outsized – viz. Snagajob.com. Management seeks to tamp down the impact of these inevitable credit losses by holding a relatively large number of equity and warrant positions. The theory is that these positions will occasionally result in significant realized gains – offsetting credit losses. At the moment, though, the cost of all these preferred-common-warrants comes to $75mn and their FMV to $47mn. In a tough market environment, there do not seem to be any big gains – realized or unrealized – coming down the pike.We looked down the dozens of positions and struggled to find more than one or two companies where the equity position was worth more than its cost. This might change in a brighter future for latter-stage venture but at the moment RWAY’s equity may be more of a detriment than a benefit.

Impacted

Given the recent realized losses and the increase in underperforming assets, one should not be surprised that RWAY’s NAVPS has been in decline. This quarter the drop was only (1.6%) as those unrealized losses were partly offset by retaining a portion of earnings and the accretion that comes with buying back one’s shares at a discount. However, over the past 12 months, NAVPS is down (7%) and since the end of 2021 – when the venture market began to be shaken up – is down (10%). By the way, it’s long term data of that kind which informs the projection by our third publication – BDC Best Ideas – that RWAY’s NAVPS is likely to drop (10%) between its level at the end of 2023 and 2028. For the moment, that projection stands.

CONCLUSION

This is a difficult BDC to rate. Going by both short-term and long term losses – both realized and unrealized – RWAY’s credit performance is NORMAL. What the BDC earns from its richly priced loans more than adequately compensates for the occasional losses that occur. Even with the equity positions being “dead money” or worse, RWAY is still ahead. The number of non-accruals is on the low side – both in terms of companies and dollars – $33mn or 3.3% of the portfolio at FMV. Likewise – going by what the BDC Credit Reporter tells us – there is only 1 “Important Underperformer” and 3 other “Watch List” names.

Sweet Spot

Management makes the case at every opportunity that their focus on later-stage venture-backed companies is one of the best places to be in this segment of the market:

Further, we believe our focus on originating investments at the top of the capital stack and avoiding situations with significant downstream financing risk and junior capital at play reduces the risk of volatility often associated with investing in early-stage companies…Companies at the later stages of venture have been the most apt to lengthen runway and the most cautious to stay out of the market to stem further dilution.

On The Move

The BDC, though, seems to be re-positioning itself, either as a reaction to credit concerns or to take advantage of market opportunities. First, management is signaling its intention to “scale our strategy beyond late-stage companies in select industries. Second, RWAY plans to deliberately increase its investment diversification by size:

As larger deals refinance, we plan to replace them with smaller loans, thereby increasing the range of industries and verticals present in our portfolio. This is a trend we expect to continue. As you look at the larger deals we’ve done, many have started out as smaller loans and our balance has grown with the companies. In fact, over 1/3 of the portfolio companies have upsized their financing throughout our partnership. And of the loans that upsized, commitments increased 55% on average from the original commitment.By completing smaller deals, we now have a pipeline for more fundings and expanded fundings down the road, thereby allowing us to deploy more capital to performing companies.

Will these moves improve or worsen credit performance? We cannot say, but we’ll be watching.

Confusion

Our greatest concern is the large proportion of companies = according to the BDC’s own evaluation – that are not performing to expectations and the trend thereof. A similar situation exists at the grandaddy of venture BDCs – Hercules Capital (HTGC). 31% of its portfolio is underperforming according to its investment rating but the rest of its metrics – even more so than RWAY – are in very good shape. Is the credit future of both these venture sector BDCs hiding in plain sight or are these ratings causing us much ado about nothing? HTGC recently suffered a (15%) price drop after reporting middling IIQ 2024 results that included net losses and a (1.7%) drop in its NAVPS.

Deep Breath

At the end of the day, and everything considered , we’ve committed ourselves in this series to offering a rating for every BDC we get round to examining. For RWAY, credit performance remains NORMAL but the data does add a heightened level of concern that may not last. We can analyze till the cows come home but the future always remain unknown territory.