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“Best Entry Point into BDCs in over 5 Years? Discounts Can Be Expensive & Premiums Can Be Cheap” by John Cole Scott

February 12, 2018

Introduction:

Business Development Companies (BDCs) are a modification of the “1940 Act” created by Congress in 1980 to provide the opportunity for individual non-accredited investors to participate in private investments. BDCs are closed-end funds that provide small growing companies access to capital. They are domestically focused and are required to offer portfolio companies “managerial assistance”. On average, the portfolio company to BDC employee ratio is 2.4 which highlights the BDCs ability to be involved with their lendees in a direct and personalized way. As with mutual funds and ETFs, BDCs have tax-advantages and earnings are passed through to investors in the form of dividends. BDCs have gained interest since the Financial Crisis because traditional banks have generally reduced their focus on small business lending. There have been 14 BDC initial public offering (IPOs) in the past five years with a current market capitalization of $15.5B (47%) of the $32.8B total listed BDC universe. BDCs also provide much needed diversification in our opinion with a 10-year correlation to High Yield Bonds of 43.1% and to Senior Loan Funds of 37.9%. They also provide low correlation to MLP funds at: 44.9%, US Equity Funds at: 43.7% and REIT Funds at: 32.0% as of 12/31/17.

BDCs typically contain 25-150 different investments inside and are focused on loans vs. equity holdings. The loans are typically secured loans and pegged to Libor at a variable interest rate. There are 51 traded or listed BDCs. We benchmark the sector with CEF Advisors’ Debt-Focused BDC Index (http://cefdata.com/index/details/407/). As of February 5, 2018, the index is at a -11.5% discount to NAV and 10.47% indicated market yield, vs. a normal 8%-9% historical level. Leverage is 39.3%, bond exposure is 87.3%, BDC Article Table 175.1% of the loans are variable rate loans. Loans in non-payment or “non-accrual” status are 1.65% vs. a long-term average of 2%. You can see the recent price movements of market prices vs. net asset values in the charts below.

BDC Article Table 2

On February 5, 2018 the BDC sector saw a -3.4% pull-back, making the 1-month total returns -5.7% and the 1-year total returns -7.6%. This is a -17.18% difference than the 1-year NAV total returns of +9.60%. Usually we find that market prices trend back to the long-term NAV performance, and this gives us good reason to expect positive price performance for the BDC sector in the next 6-18 months.

BDC Article Table 3

While past performance cannot predict future results, and returns cannot be guaranteed. If you look at the 2015 BDC index returns below, you can see that market prices lagged NAV total returns by -6.8%, while rallying ahead of the 2016 NAV performance of +9.8% by an additional +11.7% for a +21.4% market price total return. In 2017 market prices also lagged NAVs by about -7% and we may be positioned for a solid BDC rally in 2018.

BDC Article Table 4

Will all BDCs do well?

Looking at our BDC index and reviewing BDCs that are known to be good at underwriting loans and also fair with shareholders, we see two very different types of BDCs available to investors today. As investors can trade BDCs freely on a daily basis, we believe that BDC pricing can be a telling relationship about the market confidence in NAV and the dividend policy being maintained.

Based on market conditions, press releases and earnings season, BDCs NAVs and market prices can move up plus or minus 5% to 20% without much warning. By segregating the universe into the highest and lowest discounts/premiums we wanted to see what attributes seem to make investors pay-up for a BDCs in the market. This is often an actual premium to NAV or ‘book value’ which can allow the BDC to raise capital above NAV and grow over time.

After dividing the index, we looked at the average fund in each group using our CEFData.com research and data system. In this manner we wouldn’t cherry pick “good” or “bad” BDCs based on management, credit underwriting, fee schedules or personal preference. We summarize the data below, with the red column accounting for the deepest discounts and the yellow column accounting for the narrowest discounts or highest premiums. Then we netted out the difference for better comparison in green.

This article is important for us to share as when we started covering BDCs in 2014 we BDC Article Table 5initially focused on blending our usual, discount, manager, and dividend analysis, our “trifecta” or “three-legged stool” blending our data and due manager diligence.

We tried to identify BDCs whose discounts were below the sector average, attempting to capture the extra returns of a narrowing discount. We found this could often lead to underperformance, and that unlike most traditional closed-end funds, it is not uncommon for a well-run BDCs to trade at premiums over NAV of 5% to 20%+. We disclose the two groupings below so you can research the funds on your own. We offer free limited BDC data on www.BDCuniverse.net as well as free public profile on BDCs powered by our internal data team. BDC Fund profile example: www.cefdata.com/funds/main.

 

What attributes were the same in both groups of BDCs?

Of the 20 data points we analyzed, only 4 were statistically similar in our opinion. 1. Expense Ratio, 2. Gross Non-Leverage Expense Ratio, 3. % Portfolio Debt and 4. 1-Month BDC Article Table 6Market Price Total Returns. Sixteen data points were materially different which we will discuss later.

Expense Ratio and Gross Non-Leveraged Expense Ratio: These are related data points but have a few key differences. Expense ratio is all cost divided into net portfolio assets while Gross ratio excludes leverage cost and divides non-leverage cost into total portfolio assets. The 0.32% increase for premium BDCs could be attributed to larger incentive fees for BDCs that provide better investment results on NAV and for net investment income (NII). Portfolio Debt, being 0.02% different suggests that BDC loan exposure doesn’t change how investors price the fund in the market. 1-Month Market Price Total Returns being only -0.11% difference suggest that recently BDC investors have been selling BDCs regardless of quality.

What attributes were different in both groups of BDCs?

BDC investors are typically income focused and want stability of NAV, dividend coverage and successful investment results after cost. They also generally favor secured loans that are set to variable interest rates. As we selected funds based on discount levels, it is not surprising the discount difference is over 32%. However, it should be noted that the spread on 1-year average discounts is similar at 28%. Even 5-year average levels are at 12%. The percentage of the time in the past year that each group traded above NAV was 78% for premium BDCs and only 16% for discount BDCs. Funds that trade well, tend to trade well in benign and volatile conditions.

Premium BDCs

Adjusted Core Net Investment Income: This looks at the reoccurring NII for a BDC and we find it is usually a better determinant of dividend coverage vs. traditional NII coverage which can be impacted in positive and negative one-time events. Premium funds have about 103% coverage, vs. Discount BDCs at 98.9%.

Loan Composition: We find BDCs that focus on variable first lien secured loans tend to trade better. While they might yield a little less, they can potentially be more protective if the economy gets softer. Premium funds have 88% variable vs. 61% for discount BDCs and 60% of the loans are first lien vs. 43% for Discount BDCs.

Last Quarter Net Asset Value Growth: This looks at whether the NAV was stable or growing as of last earnings release. If a BDC writes a bad loan they will often have to reduce NAV over time and this typically hurts investor performance. Premium BDCs average +0.24% NAV TR last quarter vs. -3.3% NAV TR for Discount BDCs. We find that high yields and deep discounts often may not be enough to insulate investors from poor NAV performance.

3-Year NAV Total Return: We realized that BDCs can have bad quarters and that long-term at how the manager works though performing and non-performing loans. While investors cannot invest directly in a BDCs’ NAV TR, we find that it is the anchor point for BDC market pricing over time. Premium BDCs are showing a current +30.5% 3-Year NAV TR vs. Discount BDCs at only +12.8% 3-Year return. At the end of the day, dividends come out of NAV and we believe NAV has to grow on pace with yield to be maintained. We think Discount BDCs averaging +4.27% a year in NAV performance makes it hard to yield a sustainable 8% to 9% typical for the sector and dividend cuts are very likely.

Beta to the S&P 500: Beta is a measure of how volatile an investment is to a benchmark. We look at BDC volatility to the S&P 500. While most funds are less volatile, we see a clear improvement in trading for higher quality funds. Premium funds show a current 2-year weekly Beta of 0.59 vs the discount funds at 0.82, a reduction of volatility of almost -30%.

Discounted BDCs

Market Price Indicated Yield: First it is important to note that a BDC’s yield is not a promise or guaranteed by the fund to investors. It can be increased or decreased by a simple press release. Investors currently require a 11.9% yield from Discounted BDCs, or 2.7% more than from premium BDCs generally based on the perceived risks on NAV or yield for the fund.

3 Year Discount Range: We find that investors over the past year have traded weaker BDCs lower to their own 3-year trading range in addition to general widening in the sector. Discount BDCs currently trade at the 19.6% peak to valley levels and Premium BDCs at the 50.1% level.

Leverage Levels: We believe in order to try and fuel higher yields, discount BDCs tend to employ higher amounts of leverage at 40.5% vs. Premium BDCs at 38.1%. If the BDCs portfolio holdings’ fair market values fall too far, then the leverage levels could prove troublesome and in rare cases could lead to delaying dividend payments until the leverage levels are reduced. The ability to use leverage is crucial to a BDCs success to investors, but it means they still have use leverage prudently. The BDC Modernization Act when passed by Congress is likely to increase the amount of leverage allowed by BDCs. The intent is to allow a little higher leverage on better quality loans. Some BDCs may try to overleverage lower quality loans, potentially leading to more risk, however we feel that both investors and lenders of the leverage will generally keep that in check and not lead to a material risk increase for most BDCs.

Non-Accrual Levels: One good reason for a BDC to trade below its NAV is if you are concerned about the potential reduction in NAV over time. BDCs place loans that are not paying income on non-accrual status. It is not surprising that Discount BDCs show 2.26% vs. 1.05% non-accrual levels. Currently BDCs average 1.6% levels and the 10-year average is close to 2%.

Energy Exposure: Even though oil prices have rebounded rather well, investors seem to prefer BDCs that avoid this sector as the Discount BDCs have an average 5.9% oil exposure vs. 2.5% for Premium BDCs.

Conclusion: The 10-year is up to about 2.80% and the Federal Reserve is on track to increase interest rates 3-4 times in 2018. BDCs historically have done well in rising rates and many would benefit from the gradual increase. Our models indicate that 6%-8% NII growth is likely for many of the BDCs with 70%+ variable loan exposure and reasonably low variable leverage costs.

We are not suggesting to buy any BDC in the top half of pricing nor are we suggesting that you can’t find a diamond in the rough in second half of Discounted BDCs. We wanted to identify the two groups of BDCs in the market: #1 Those generally writing good loans, covering their dividend and being good to shareholders and #2 those the generally do not behave in that manor. Being selective can prove prudent. Even as Premium and Discount BDCs have similar poor -6% recent market price returns in the increased market volatility of early February, over the past year, Premium BDCs have outpaced Discount BDCs by almost +19%. We would not be surprised to see a similar spread on pricing in the next 1-2 years.

Is It the Best Time in 5 Years to Buy BDCs? Yes, we think now is one of the best times we have seen in the past 5 years because of the combination of: 1. Solid economic growth, 2. Rising interest rates. 3. Recent significant discount widening and 4. We are at the beginning of year-end 2017 earnings season. We think the better BDCs will have small increases in NAV, a few dividend increases and an opportunity to close the significant disparity in market princes vs NAV. We may see lower prices before the up-tick, and as mentioned earlier believe that 2018 will have more volatility than 2017. But we also have found small premiums can lead to better returns than  deep discounts.

Example of “Broken BDC”: Medley Capital (MCC) announced their quarterly results February 6. Going into today’s announcement MCC traded at a -42.5% discount. NAV was written down as of the release by -8.8% and NII was down -18%. MCC closed down -6.6% to a -41% discount. Technically the discount narrowed. We also believe a -20%-30% dividend cut would not be surprising in next few quarters. I doubt any previous shareholders were happy with the results. We plan to avoid BDCs like Medley regardless of pricing at essentially any discount to NAV.

John Cole Scott, CFS, Chief Investment Officer John Cole Scott Headshot
Closed-End Fund Advisors, Inc.
(800) 356-3508 / (804) 288-2482
www.CEFadvisors.com / www.CEFData.com

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 CEFData.com as of February 5, 2018.

 

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