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Is My Business Development Company (BDC) Broken?

October 13, 2015

salesBDCs have had a rough 12 months with many investors wondering if the sector is broken. The 43 debt-focused BDCs ended October 7, 2015 at an average -13.9% discount, after healthy +7% average rebound from the -20%+ discount lows seen in recent weeks. This is still very far from their 10 year average discount of only -0.41%. Upon further review, over the last ten years BDCs ended each year at a premium five times with an average +12.4%; while they ended the year at discounts five times with an average of -11.8%. If you exclude the 2008 financial crisis (not a common event) the average discount is -6.6%. The debt BDC sector currently has an average yield of 11.2%, or almost 3% income a quarter.

When investors see BDC yields, many think the portfolio must just be “junk bond like” exposure. CEFA backs out discounts and accounts for leverage to get a sense of what the portfolio manager has to do to hit the board of director’s dividend policy. We call this Leverage Adjusted NAV Yield. For debt BDCs it is currently 6.8% and, for comparison, the average taxable bond CEF has a Lev Adj NAV yield of 5.8%; only 1% lower than BDCs. We think this shows BDC portfolios are not as risky as some fear.

BDCs are diversified public funds that primarily invest in US private or micro-cap companies. They raise equity capital and borrow to increase lending. They have current leverage of 40% with average leverage cost of 3.7%. It is comprised of both fixed and variable rate borrowing. For the past 2 years BDCs have yet to trade above their peak December 2013 levels. The concerns have been about dividend levels and risk to future net asset value pricing (NAV). However, we think investors have overreacted and miss some key information about the sector and the funds themselves.

BDCs are regulated by the 1940 Act and FINRA. They mark each investment’s fair market value (FMV) quarterly and offer more transparency than other investment vehicles that loan out money to private companies like banks or mortgage REITs. While they are leveraged, they also use far less leverage then mortgage REITs and banks.

The BDC sector has 3700 companies that have been invested in by the 43 BDCs. 75% of these loans are either 1st Lien Sr. Secured (54%) or 2nd Lien Sr. Secured (20%). They are generally safer than unsecured loans. 75% are variable rate in nature. When rates go up, the payments to the BDCs will typically go up as well. It needs to be noted that some loans have LIBOR floors and there will be a delay for when income increase to the BDC for these loans. However from 2004 to 2007 when LIBOR went up about 4%, and average BDC dividend level went up over 4% as well. In both third quarter 2015 and the previous year, there were more dividend increases vs. decreases for BDCs and the average BDC is currently showing 98% dividend coverage with only 88% debt/loan exposure and 12% equity for their portfolio.

BDC loans are also not long-term commitments, with an average maturity of 4.4 years; and it is not uncommon for a company to payback a loan early. Typically in order to get a second, often bigger, loan at better terms (lower cost). 76% of the loans outstanding are under $25MM in size. There is no other place for non-accredited investors to gain access to this part of the US economy, the middle market, which makes up 40% of the US GDP. As BDCs trade daily, you can buy or sell any day of the week with no lock-up periods or paperwork like other alternative investments.

10-13-2015 11-06-30 AMWhy are BDCs so cheap? In our opinion, current fears are caused by four factors:

Factor 1: Oil has had one if its worst declines in the past 12 months (though giving a decent rally the past week).

Energy exposure is only 6.4% of the BDC sectors investments; half the exposure of high yield bonds. Over the past three quarters many BDCs have written down the value of these investments when they deemed it appropriate. How can we track NAV write downs? Debt BDCs have a 1 year average NAV total return (TR) of +7.3% and a 3 year average NAV TR of 27.6%. 10% is generally normal (as experience in the previous 2 year history), so BDCs have “written down NAV” by -2.7% in the past year by our calculations. However, they have experience a 1 year price return (without dividends) of -17%. We think this is a clear market mismatch and provides a great opportunity to buy into the sector as BDCs can perform well with $30 oil or $130 oil.

One BDC we follow, MAIN, recently had two energy loans go into default, but they will recover more than the invested principal and all interest and payments owed as they were well structured Sr. Secured investments. I am not worried about energy exposure to a diversified portfolio of BDCs as one of the benefits of the BDC management is that many BDCs are smart investment bankers and work to know their investment companies well and help them succeed. We track that the average BDC has 63 employees and a company/employee ratio of 3.4 per BDC.

Factor 2: We are 6 years into the economic recovery, a recession must be on the near-term horizon?

While the economic data is not as robust as we would prefer for the US, housing, employment and items like auto sales are all very strong. Most of the economist we follow suggest a few more years of economic prosperity. There seem to be no significant bubbles or froth in the current economy. Are things as cheap and 2009 or 2010? … No, but they are generally not as “expensive” as 2000 or 2007 as well. Plus, with the ability to pick a focused but diversified portfolio of, gain exposure to about 500-1000+ underlying companies at $0.86 “cent” dollars (-14% discount referenced above) while getting paid almost 3% a quarter to wait? When you add in the 75% Sr. Secured Loans and 75% Variable Loans the risk/reward trade-off is very compelling to our firm.

Factor 3: Rates are going up? … Rates are not going up, sell everything yieldy!

The next time the FED gets together rates are either going up or staying the same. And I guarantee markets will react to the news. How will it react? I have no idea. If it were up to me, rates would start a slow, measured increase now by year-end 2015. I would like to see 2016 end with a target FED rate of 1.25% and 2017 with 2.75%. However, if this does not occur, we can wait out the FED and see what happens. Remember BDCs generally do well on a fundamental basis unless we see a significant recession causing small businesses to not be able to pay back their loans. But should this occur, losses are typically much lower than high yield bond defaults. This is a BDC benefit. Increasing rates, decreasing rates. They can handle both environments.

Factor 4: My BDC Pissed Me Off.

Some BDCs have treated themselves better than shareholders; secondary offerings bellow NAV, aggressive dividend policies leading to high profile 15%+ dividend cuts in the past year. The BDCs that cut dividends 15%+ are: ACSF, FSC, FSRF, FULL, KCAP, MCC, OHAI and PSEC. Now that there are over 40 options to choose from, you can pick which BDCs you want to own. You can also use a deep discounts to protect you from this risk or behavior. While we don’t like large dividend cuts, getting in after one can be a good entry into some funds. At current levels, we think BDCs will be forced to make better shareholder friendly decisions. We don’t expect to see any secondaries below NAV. We think there will be some BDCs that lower fees or give one-time concessions to help get stock prices back over NAV.

BDCs can (and should) buy-back shares which is positive in our experience whenever trading at a significant discount as it is accretive to NAV (like a secondary above NAV). For the BDCs that trade back over NAV, we expect them to gain back 2-3 times the revenue lost from a significant share-buy-back by being able to grow more equity later through future secondary offerings. BDCs benefit from the fixed capital nature of the closed-ended investment company structure. They get to choose when to increase or decrease share count vs. being at the whim of redemption pressures like the open-end fund and exchange-traded fund structure. Simply by putting shareholders first they can likely make more money down the road and investors can also experience positive performance.

BDC Selection: What is the starting point to selecting a BDC in our experience?

Based on our CEF Trifecta analysis, we look at NAV TR on a 1-year and 3-year basis in addition to the last 2 quarters of NAV changes. We review the net investment income (NII) for a fund the past 2-4 quarters and see is the fund is likely to meet its dividend obligation. We look at management track record and the underlying portfolio of investments in addition to how shareholder friendly the BDC has been over time. We access the risk of a BDC falling to a deeper discount (or lower premium) vs. floating up to a smaller discount or higher premium. Finally, we have access to many of the BDC analysts’ research and use that to help us with the final selection and weightings for a portfolio. Not recommendations, but some of our favorite BDCs are AINV, ARCC, BKCC, FSIC, MRCC, NMFC, and TCPC.

BDC Outlook: Fourth Quarter 2015 and Beyond:

We think BDCs will have a nice bounce in October, but should experience some tax-loss pressures again this year. However, once we get updates from the funds for 3Q NAV and income and enter 2016, we expect to see discount levels returning to an average of -3% to -6% during the first half of 2016 and ending the year between a -3% and +3% pricing level on average. This means we think investors in a diversified well selected BDC portfolio can experience total returns of +15% over the next 6 months and +25% in the next 15 months. While we cannot guarantee or predict markets, we noticed that after Lehman Brother failed in September 2008 starting the financial crisis, BDCs ended 2010 at +6% average premiums. In my opinion, the current environment and risks are far less scary than 2008-2009. BDCs are not broken, just unloved and based on experience, we prefer to buy before people agree with our investment thesis vs. chasing performance.

CEF Advisors is a 25 year-old Richmond, VA based Registered Investment Advisory firm that specializes in CEF/BDC Research, Trading and Investment Management Services. For more information on BDCs please visit www.BDCuniverse.net, a free BDC research site we created to help give investors transparency on the public BDC sector. We just completed our 3Q 2015 CEF/BDC Research Call and Outlook. The replay and slides are available one our website: www.CEFadvisors.com. For a downloadable 10-Year discount history and asset class performance table for BDCs and CEFs visit the investor resources page on our website:http://www.cefadvisors.com/investRes.html.

Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from the October 2, 2015 issue of our CEF Universe Data Project.

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