A dissection of the latest quarter’s BDC portfolios by LevFin Insights and Advantage Data shows that non-accruals dropped significantly over the past year. For the 24 public and nonpublic BDCs with at least $1 billion in assets under management, the non-accrual rate has retreated to an average of 1.77% for the three-month period ending June 30, down from 3.31% in the same period last year.
(LFI and ADI calculated the rate by the cost amount of non-accrual debt against all debt investments.)
The drop is due mainly to a decline in oil & gas non-accruals, which have been largely worked out since they spiked in late 2015 and early 2016 in the aftermath of falling oil prices.
At 1.77%, today’s average is well inside historical norms of 3-5% and supports the view by many that there are several innings left to this credit cycle, now in its eighth year or so.
Of the 24 BDCs, 15 showed declines in non-accruals, with energy-heavy portfolios recovering the most dramatically. Apollo Investment Corp.’s (NASDAQ: AINV) non-accruals fell to 2.22% for the period ending June 30, from 12.11% in the same period last year, while FS Energy & Power’s (nonpublic) non-accruals dropped to 1.24% from 8.47%.
Four BDCs in the sample had zero non-accruals: PennantPark Investment (NASDAQ: PNNT), down from 3.55% in the second quarter last year; TCW Direct Lending (nonpublic), from zero a year ago; TPG Specialty Lending (NYSE: TSLX), down from 0.95%; and Owl Rock Capital Corp. (nonpublic), from zero.
On the flip side, nine showed increases year over year. Triangle Capital Corp. (NYSE: TCAP) reported the largest increase in non-accruals within the group, jumping to an 8.40% rate at June 30, from 4.58% in the same quarter last year.
Triangle Capital added to non-accrual status Community Intervention Services, an H.I.G. Capital company that operates a national network of specialized mental health and substance abuse facilities. PIK investments for Cafe Enterprises andEckler Holdings also went on non-accrual. Cafe Enterprises does business as Fatz Cafe and has been backed by Milestone Partners since 2008, while Eckler Holdings, is a retail auto parts company that’s been backed by Baird Capital since 2012.
The next largest increase came from Business Development Corp. of America (nonpublic), where non-accruals rose to 6.14%, from 3.74% a year earlier. Second quarter additions to non-accruals included Tax Defense Network (sponsor unknown), a company that provides tax collection resolution services and which hired a new CEO last month, and NexSteppe (venture capital backed), a producer of biofuels, biopower, and other biobased products.
Triangle Capital and Business Development Corp. of America took first and second place, respectively, for the highest non-accrual rates of the group.
Triangle Capital is still in a state of transition. In the first quarter of 2016, a new CEO came on board to turn the ship around. Keefe, Bruyette & Woods notes the new investment strategy of more senior secured investments in larger portfolio companies has resulted in lower yields and operating income, but should improve credit quality. However, a complete shift in the portfolio will take several years to implement. TCAP “2.0” investments current account for about 43% of the portfolio, according to Wells Fargo.
Benefit Street Partners took over as advisor to BDCA in October last year as NAV declined and is “positioning BDCA for a liquidity event.”
Smaller names, more potholes
Drilling down into the portfolios of a few BDCs that strictly target lower middle market companies, the picture for non-accruals is not as pretty. There are more bad apples, some of which reside outside troubled sectors such as retail and energy.
Capitala Finance Corp. (NASDAQ: CPTA), a BDC that targets companies with $4.5 million to $30 million of EBITDA, had a tough quarter. Non-accruals rose to 20.26% of all debt investments for the three months ended June 30, up from 7.37% in the same period last year. Capitala added three new names: Kelle’s Transport, a provider of semi-wheeler tractors and trailers backed by sister company Capitala Group; Cedar Electronics, a Monomoy Capital Partners company that makes consumer radar detectors, radios and cameras for drivers and boaters; and Print Direction, a Capitala Group-backed mobile technology and print marketing supplier that rebranded in June as “NIMBLE[is]”.
The non-accrual rate for Alcentra Capital Corp.(NASDAQ: ABDC), a BDC that targets companies generating $5 million to $25 million of EBITDA, jumped to 6.62% from zero in the same periods. My Alarm Center joined Show Media on non-accrual. On July 26, Oaktree Capital said it would buy the home security company. As part of the deal, Alcentra is taking equity.
Garrison Capital (NASDAQ: GARS), which casts a wider net of $5 million to $50 million of EBITDA, saw non-accruals rise to 9.51% for the period ending June 30, from 5.24% in the same period last year. Rooster Energy, which filed for Chapter 11 last quarter, joined the non-accrual list, which includes another energy name - Badlands Production.
Harvest Capital (NASDAQ: HCAP)’s non-accrual rate dropped in the second quarter, but still sits at a relative high of 7.04%, down from 12.86% in the same period last year. Harvest Capital targets companies with less than $15 million of EBITDA. While non-accruals have improved, analysts were disappointed to see how quickly the BDC wrote down to zero its CRS Reprocessing investment, which went on non-accrual in the first quarter this year.
Do the higher non-accrual rates in these lower middle market portfolios portend that winter is coming, or do they illustrate isolated flare ups at individual businesses?
Most market participants today believe it’s the latter.
“BDCs have been chasing marginal credits in order to get yields, and this is the result,” says one portfolio manager at a multi-platform lender. “I think it’s more a function of bad credits going bad than widespread early cracks in middle market,” he said.
Of course, that view may change a year from now, when 2017's aggressive underwritings have been tested by annual performance and/or potential market upsets.
Also keep in mind, that while BDCs offer the most transparent view into middle market lending, they are not always crystal clear.
“BDCs only mark these puppies down when they really, really have to,” says Nicholas Marshi, publisher of The BDC Reporter and an investor in several BDCs. He cautions that, “BDCs have become like Houdini in restructuring problem credits without having to fully recognize a loss, if at all, and to spare themselves non-accruals.”
For the lower middle market BDCs, about 11.8% of their debt investments was marked below 75, compared to 4.7% last year, according to Advantage Data.
Among the 24 public and nonpublic BDCs, 4.37% of debt investments was marked below 75 in the second quarter, down from 7.64% in the same quarter last year, according to AD. As noted earlier, the reduction coincides with oil & gas workouts.
“Once a portfolio company slips into under-performing status, very few come off with their boots on, but the process takes ages,” Marshi said. “So if a BDC is rife with early stage credit problems expect more misery ahead.”
Strong outlook ahead
On the whole, the non-accrual outlook among BDCs for the rest of the year remains positive, with little to no increases expected. Today’s non-accrual rates match up with default rates for large cap loans and high yield.
For all U.S. leveraged loans, the trailing 12-month default rate was 1.9% in July, according to Fitch Ratings. For high yield, the rate also stood at 1.9%, according to Fitch. - Kelly Thompson
Kelly Thompson, LevFin Insights