Market Mayhem: As we discussed at length already in our premium BDC Common Stocks Market Recap, last week was surprising as the BDC sector – and many individual BDCs – fared much better than the main indices and all the main categories from investment grade to “junk”. However, we’d be very surprised if the BDC sector can continue to remain uncorrelated with the broader markets for very much longer. As this chart below shows – comparing the price progress of the Exchange Traded Fund SPY, which is based on the S&P 500, and the exchange traded note with the ticker BDCS,which reflect the BDC sector – the two have moved pretty much in tandem since the decline began in the markets on September 20.
We don’t know with any certainty where the broader markets are headed or we’d own that Caribbean island we’ve had our eye on. However, we’re pretty sure that where the S&P 500, the Dow Jones and the NASDAQ go this coming week, and in the weeks ahead, the BDC sector will follow. Maybe it’s algorithms or maybe it’s the groupthink involved in stock market investing when investor anxiety rises or some other explanation.
Annus Pretty Horribilis ?: With 5 weeks to go – and sentiment leading to the downside – the chances of the BDC sector – as represented by the BDCS stock price – matching the year end 2017 of $20.76 seems highly unlikely. BDCS closed on Friday at $19.29, or (7.1%) down. Notwithstanding that BDCS was up on Friday November 23 and only marginally down in price last week, we’re more worried that if the current downswing in the markets continue BDCS might drop below it’s 2018 lowest level of $18.72. That’s just 3.0% down from Friday’s close, a distance that the BDC sector at times of stress has sometimes covered in a day. Still, if the BDC sector can hold its own for the next few weeks from a price standpoint, the total return for the year will remain in the green. That would make the BDC sector one of the few market segments not in the red on a year that began with much unfounded optimism. As they say in sports, this could go either way, but we can say with some confidence that 2018 will not be a year to remember whether the BDC sector ekes out a small positive total return result or joins most other markets in the red.
Last Minute Earnings: If you thought BDC earnings season was over because there were no releases last week, we regret to inform you that there are still three laggards with scheduled results coming up this week. We start with Golub Capital (GBDC) that has already offered shareholders some advance information about third quarter 2018 investment activity in a press release on October 10, 2018. In that release GBDC did not provide an early estimate of earnings or book value or credit losses or what might happen to the dividend – unchanged since March 2011. However, we and most everyone else doubt if the BDC had anything very surprising to report. GBDC trades at nearly 15x current earnings and a 15% premium to par, and all has been well where fundamentals are concerned. We are most interested in two items: i) what the BDC has to say about its joint venture, which has been shrinking for several quarters. Will that venture continue or will GBDC bring those off balance sheet assets back onto the balance sheet ? Which leads us to question number two: will anything change about GBDC’s attitude towards adopting the lower asset coverage rules allowed by the Small Business Credit Availability Act (SBCAA) ? To date, GBDC has firmly said: no thank-you. Should that change, so might the risk-return at this well run BDC and its stock price as well.
Then there are the Oaktree Capital twins coming to the plate: Oaktree Strategic Income (OCSI) and Oaktree Specialty Lending(OCSL). The earnings release by the latter will be the most important. OCSL is the Fifth Street Finance (formerly FSC) that was before the change of Investment Advisor and has been in turnaround mode even before Oaktree took the helm. Last quarter the external manager claimed – supported by plenty of data – that the transition from troubled BDC to a more “normal” status was largely completed. NAV Per Share had stabilized as had the dividend. On the other hand – and as a reminder that credit never takes a holiday – OCSL ruefully conceded another portfolio loan was added to non-accruals in the period. That was Garretson Firm Resolution Group, which went straight from our internal Corporate Credit Rating (CCR) of 3 to a CCR of 5 in one quarter. This quarter we’re less focused on what more may have happened to Garretson – we already know from Sierra Income’s filings – also a lender to the company – that the valuation has likely dropped sharply. However the Garretson exposure is modest: just $1.2mn at cost. We’ll be curious to see if any other shoes have dropped. On the loan side we’ve got our eye on the $16.7mn second lien loan to Onvoy, LLC, which is rated CCR 4. Thanks to the database of Advantage Data, we know three other BDCs hold investments in the telecom company and have already reported third quarter marks, which are slightly down from the second quarter. We’ll also be curious to see if any new names transition from performing to under-performing and whether OCSL will begin systematically taking realized losses on the many non-performing and largely written down loans and investments on the books left over from the Bad Old Days. By our count there are 7 companies in this category with a cost basis of a quarter of a billion dollars. Probably such write-offs will not affect book value as unrealized losses have already been booked, but $100mn of fair market value remains in 4 of the 7.
Time To Vote: This week will be the last full week before the shareholders of FS Investment (FSIC) and Corporate Capital Trust (CCT) get to vote on their merger. We don’t expect shareholders to say no, but it’s been a tough time to own the stock of either BDC – now both co-managed by FS Investments and KKR. Here’s a chart of the two BDCs stock price since August of this year, which shows the latter down (19%) and the latter down (26%). Not to rub things in – but only to illustrate how much the mighty have fallen (and in a benign credit environment no less) – FSIC is down (44%) in price from its February 2017 highest point.
To their credit, the new co-Investment Advisors have taken “full responsibility” for the credit troubles at FSIC, and are – like Oaktree Capital – seeking to repair and restore their portfolios. Some observers may believe the stock price drop at FSIC and CCT is a temporary feature brought on by the uncertainty surrounding the merger and the hangover effect from the managers former intention – now put on hold – to fold in the non-traded BDCs which they own into FSIC. The BDC Reporter had an in-depth look at the credit position at FSIC and came away more worried about fundamentals than any passing change of sentiment that might change with the merger vote and the recent decision to leave the non-traded BDCs out of the equation. We’ll be interested to see if the markets continue to punish FSIC’s stock price this week and after the merger. We expect to see a major stock buyback program announced if and when the merger goes through, but will that be enough to help ?
The Never Ending Story: All the above are just a small selection of interesting items that will be popping up in the week ahead. Here at the BDC Reporter – with earnings season finally coming to a close and with investors worrying more about what the future will bring – we’re going to circle back and start systematically reviewing the credit portfolio performance and outlook of most every BDC we track and bringing the summary results to our premium subscribers. (Frankly, we’ve been spending a great deal of time already digging into the 3,000+ portfolio of private and public companies to which public BDCs have investment exposure) We find that looking beneath the hood at BDCs is the best early warning signal of trouble ahead. Much of what we identify today is likely to show up in next quarter’s results and into 2019. Unfortunately, only a fraction of the time do under-performing companies identified by the BDC Reporter’s eagle eye, make a quick round trip back to performing to plan. Today’s question marks usually end up tomorrow’s exclamation marks. If we get the recession that so many seem to expect in the midst of this booming economy both the number of Watch List companies and the speed with which they go from hero to zero will accelerate. The good news: most BDCs portfolios are in very good shape. The bad news: this can change very quickly so eternal vigilance is necessary. Which is why we’re committed to tracking virtually every BDC credit portfolio out there on a daily basis, with special focus on the still modest number of under-performing companies. For what it’s worth – and we’re scrubbing the data constantly – we estimate 1 in every 12 BDC portfolio companies overall is under-performing or non-performing.