BDC COMMON STOCKS

On A Run

For the fifth week in a row, the BDC sector ended up in price on the week. The upward push appeared to have taken on a life of its own.

In prior weeks, the hike in BDC prices seemed to be tied to the upward direction of the broader markets. This week, however, BDCS – the UBS Exchange Traded Note which includes most BDC stocks and which we use as our gauge of price change – was up 0.9% while the S&P 500 was down (o.5%).

Since Friday August 16, the last time the BDC sector was down for the week till this last Friday, BDCS is up 2.6% and the S&P 500 2.3%. We don’t know what’s more intriguing: that the two indices are so close or that BDCS is (slightly) ahead of the S&P. (That’s not traditionally the case: YTD the gap is 5% in favor of the latter and over 5 years 69%! Of course, distributions are much higher for BDCs than the S&P 500).

Thumbs Up

All our regular metrics confirm a BDC sector in a buoyant mood. BDCS at $20.25 is now at the highest level we’ve seen all year, beating the $20.23 prior record set on February 22 at $20.23.

The sector is only a little bit away from the $20.91 twelve month high of $20.91 set September 21, 2018 and (3.7%) off the highest level of all last year, which occurred in August.

Et Tu

Likewise, the Wells Fargo BDC Index, which we look to for a “total return” perspective reached a new high of 2823.46. This index was up 1.1% and now sits at the highest point of the year. The YTD increase – and a hard number for most investors to beat – is 21.6%, boosted by those heady few weeks of 2019 when prices were shooting up after sliding down in the last few months of 2018.

Different This Time

We’re not quite in that excitable environment – the BDCS and Wells Fargo Index numbers notwithstanding. This week 27 individual BDC stocks were up or flat and 19 were down. That’s a positive net number, but hardly outrageous.

Last week, there were 36 in the black. Back in the December 2018 – early February 2019 rally days as many 43 (out of 45 BDCs at the time) were up in price. There were 5 weeks in which there were at least 40 BDCs headed northwards.

Since the latest surge began – from low to high – BDCS is up 3.2% over 5 weeks. In a similar number of weeks from the December 2018 low, BDCS moved up 11.7% at the beginning of the year.

This week three BDCS were up by 3.0% or more – our arbitrary threshold. Last week, there were seven. Admittedly, there are more BDCs trading above than below their 50 and 200 day moving averages ( 31 vs 15 and 28 vs 18 respectively).

Furthermore, there are now 18 BDCs , versus 16 last week, trading above book value, but that still leaves 28 at a discount. Or, in so many words, the current price enthusiasm in the BDC sector is some way from fully taking fire.

Counter Intuitive

Interestingly, BDC prices moved up in a week where the Fed Funds rate was dropped by another 0.25%. According to the WSJ – and a thousand other news sources – “Fed Chairman Jerome Powell left the door open to additional cuts”.

Trouble

From an earnings standpoint, lower short term rates are indubitably bad for every BDC we cover. Let’s put some numbers to the issue: 1 month LIBOR has dropped from 2.51% at January 2 2019 to 2.06% as of Friday, a nearly half percent drop.

Investors are taking comfort from the fact that many BDCs have interest rate “floors” in their loan agreements with borrowers, but those are often at 1.0%.Base LIBOR rates could drop by half before the parachute opens.

Lower LIBOR rates, judging by comments made by BDC managers on Conference Calls, were already affecting Net Investment Per Share levels in the first and second quarter results. That erosion due to lower yields will only show up more sharply in the third quarter and periods to come.

A further 1.0% drop from here in LIBOR – should that occur – will cut BDC investment income by over 10%, and that will only be partly offset by lower borrowing costs. Everything else being equal, and given that management fees, operating expenses and most incentive fees will not be dropping commensurately, Net Investment Income across the BDC sector is going to take a hit.

At a time when most BDCs are talking the talk about growing their proportion of “safer” first lien loans with single digit yields, compensating for this loss of income by taking on more risk is difficult.

Not In The News

Otherwise, there was – for another week – very little in the way of BDC developments to discuss – a difficulty for a publication that prides itself on bringing you hot-off-the presses “News, Views & Analysis”. What there was of interest we covered in our Twitter feed, beginning with the merger of Golub Capital’s public and non listed BDCs into one another with

GBDC as the survivor. However, there was nothing very controversial or unexpected relating to the move – with continues to grow the FMV of the public BDC segment.

Coming Soon

We hear on the grapevine that FS-KKR Capital are working feverishly on the merger of FSIC II, FSIC III and FSIC IV and a public offering of the combined entity of FSIC II. Even more than the Golub Capital transaction, this will increase public BDC assets to a new record level.

Our data shows there were $73bn in 46 BDC portfolio assets at June 30,2019. After you add in the Golub deal; the coming FSIC II public offering and the projected growth in debt-funded assets thanks to the Small Business Credit Availability Act (SBCAA) we could get to $100.0bn.

Concentrated

For what it’s worth, we expect that nearly 90% of those BDC investment assets will be held by the Big Boys: BDCs with portfolios valued over $1.0bn and concentrated in 19 names out of 47. Even the BDC Reporter – always free with an opinion – is not quite sure what to make of that.

A Different Time

We’re a long way from 1980 and the days when BDC legislation was first introduced to provide capital for America’s hard pressed smaller private companies (at the time public entities were explicitly excluded).

Supposedly smaller private companies were having a hard time getting financing and the BDC legislation was a proposed solution. Now – thanks to Wall Street getting involved – most of the 3,000 plus portfolio companies served by the BDC sector are borrowing very large amounts and receive a plethora of offers from a variety of sources.

Where there used to be investment “teams”, there are now “platforms”. As the asset managers come to dominate the BDC sector, expect loans to get ever bigger and for the BDC sector; the leveraged loan market and the high yield sector to increasingly overlap.

We don’t know if bigger is better for BDC investors, but we can say that today’s landscape is very different from when we were first getting familiar with BDCs in the years before the Great Recession.

Testing Times

The biggest unknown is how all the new players and debt market segments will fare in the next financial crisis. That’s more than our crystal ball can handle right now, but there’s no doubt the result will define the BDC sector’s long term future.

Busy as we are, the BDC Reporter is planning to undertake for select BDCs what the Federal Reserve does for the big banks: “stress tests”. We’ll be making some tough – but not unrealistic – assumptions about credit defaults and losses; changes in liquidity etc in a hypothetical future recession. These are the sorts of calculations that typically satisfy nobody given the range of possible assumptions, but if it’s good enough to apply to JP Morgan & co, why not the BDCs?

Existential Question

More so than the major banks, with their different lines of business and the Fed standing in the background to provide support in extreme conditions, what happens in terms of credit will determine the ultimate performance of BDCs. As Medley Capital (MCC); MCG Capital, Patriot Capital and several other BDCs have proven: get credit wrong and the value of the firm can be almost completely gutted.

Those examples are from the days of 1:1 debt to equity. How will BDCs fare in the Brave New World of debt to equity of 2:1?