GSBD Q1 2019 Update

The following is a quick GSBD Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • GSBD beat best-case projections (again) mostly due to lower incentive fees paid during the quarter covering its dividend by 123% (average coverage of 117% over the last 8 quarters).
  • NAV/share declined by 2.3% due to the restructuring of ASC Acquisition Holdings, discussed in the previous report and Country Fresh Holdings which was placed on non-accrual status.
  • Country Fresh is also an investment held by PFLT that contributed to its recent NAV decline.
  • Effective May 8, 2019, GSBD commenced the dissolution of its SCF and will receive around $216 million of assets financed directly on its balance sheet. This will instantly increase leverage and returns to shareholders as well as increase the amount of first-lien and overall diversification of the portfolio.
  • NTS Communications remains on non-accrual representing 3.5% of the total investments and is expected to be repaid in Q2 2019. Excluding NTS, non-accruals represented less than 0.1% of the portfolio.

 

Goldman Sachs BDC (GSBD) beat best-case projections (again) covering its dividend by 123% mostly due to lower incentive fees paid during the quarter. The company has covered its dividend by an average of 117% over the last 8 quarters. The company is in the process of dissolving its Senior Credit Fund(“SCF”) and will receive around half of the assets financed directly on its balance sheet. Effective May 8, 2019, GSBD commenced the dissolution of the joint venture partnership and GSBD received its pro rata portion of the SCF investments on balance sheet. This will instantly increase leverage and returns to shareholders as well as increase the amount of first-lien and overall diversification of the portfolio.

Net asset value (“NAV”) per share declined by $0.40 per share or 2.3% (from $17.65 to $17.25) due to the restructuring of ASC Acquisition Holdings, LLC(“ASC”) discussed in the previous report and Country Fresh Holdings which was placed on non-accrual status due to financial underperformance. Country Fresh is also an investment held by PennantPark Floating Rate Capital (PFLT) that contributed to its recent NAV decline.

In June 2018, shareholders approved the reduced asset coverage ratio of at least 150% (potentially allowing a debt-to-equity of 2.00) and management reduced the base management fee from 1.50% to 1.00%, lowering expenses and improving dividend coverage as shown below. GSBD is now well above its previous targeted leverage of 0.75 and has obtained all of the necessary approvals and is positioned to benefit from the reduced asset coverage requirement.

 

ASC Acquisition Holdings, LLC (“ASC”) was discussed on the previous call with management:

“Animal Supply is a more fluid situation but there are recent developments that we would like to share. Animal Supply is a nationwide distributor of pet food and supplies. Our investment thesis centered on the Company’s leading industry position and positive industry tailwinds driven by long-term trends driving demand for pet food supplies. During 2018 the Company’s performance and profitability declined. We determined that the best course of action was to deleverage the capital structure to better position the company to perform. As of last Friday, we successfully closed restructuring by swapping our debt for equity and providing additional working capital to enable the company to increase fill rates, revenue and EBITDA. We believe that with a clean balance sheet and a more focused management the Company is well positioned to benefit from stable industry trends and consolidation opportunities.”

During the previous quarter,  Its first lien, last-out unitranche debt investment in NTS Communications, Inc. (“NTS”) was added to non-accrual status and represents 3.5% and 3.8% of the total investment portfolio at fair value and amortized cost, respectively. This investment is expected to be repaid in Q2 2019 in connection with the sale of NTS.

“However, the exact timing is dependent on the satisfaction of certain closing conditions to the sale transaction, including receipt of Federal Communications Commission approval.”

Excluding its investment in NTS, non-accruals represented less than 0.1% and 0.7% of the total investment portfolio at fair value and amortized cost, respectively.

 

 

New investments during Q1 2019 were mostly first-lien and the portfolio remains heavily invested in first-lien debt including its SCF as shown below. Over the past four quarters, GSBD’s proportion of its first lien debt investments within its investment portfolio increased by 74% and second lien debt investments decreased by 44%.

 

 

Senior Credit Fund (“SCF”) Portfolio

The SCF was GSBD’s largest investment and is a joint venture with the Regents of the University of California (“Cal Regents”) that invests primarily in senior secured loans to middle-market companies. GSBD and Cal Regents have both subscribed/invested $100 million and using off-balance sheet leverage have invested in 32 companies with a total fair value of almost $452 million. GSBD will directly invest in around 50% of the portfolio using its own leverage and likely selected the higher-yielding assets. The SCF portfolio is 95% first lien and 100% floating rate diversified by sector:

 

 

“On May 8, 2019, the Company and Cal Regents each contributed $125,555 to the Senior Credit Fund, which was used by the Senior Credit Fund to repay in full all outstanding indebtedness, including all accrued and unpaid interest and fees, under the Asset Based Facility and to fund certain other related expenses that the Senior Credit Fund expects to incur in connection with its dissolution. The Asset Based Facility was then terminated and all liens securing the collateral under the Asset Based Facility were released. The Company funded its portion of the contributed amount through additional borrowings under its Revolving Credit Facility.”

“Following the repayment and termination, the Senior Credit Fund distributed each member’s pro rata share of all of its assets (other than cash and cash equivalents), primarily consisting of senior secured loans, to the members. The Company also assumed the obligation to fund outstanding unfunded commitments of the Senior Credit Fund that totaled $7,795 as of March 31, 2019, representing 50% of the Senior Credit Fund’s aggregate unfunded commitments. The pro rata portion of the assets received by the Company will become the Company’s assets and will be directly included in the Company’s consolidated financial statements and notes thereto, and will also be included for purposes of determining the Company’s asset coverage ratio. Based on March 31, 2019 balances, the assets to be received by the Company are approximately $221,769 and $215,728 at amortized cost and at fair value, respectively. In connection with the repayment of the Asset Based Facility and the distribution of all of its loan assets, the Senior Credit Fund declared a $2,000 cash distribution to its members, representing estimated quarter-to-date net investment income, 50% of which will be paid to the Company.”

 

 

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated GSBD target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

SUNS Q1 2019 Update

The following is a quick SUNS Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • SUNS hit its base case projections covering its dividend only due to continued fee waivers with realized gains of $0.1 million mostly due to the exit from Genmark Diagnostics.
  • NAV/share increased by 0.6% primarily due to appreciation on its investments in North Mill Capital, Gemino Healthcare and TwentyEighty Investors, partially offset by depreciation in Trident USA Health Services.
  • Trident was added to non-accrual status and accounts for 0.2% of the portfolio and is the only portfolio company with an “Internal Investment Rating 4”.
  • SUNS remain underleveraged with plenty of growth capital and debt-to-equity of 0.80 compared to its target a range of 1.25 to 1.50.
  • North Mill Capital remains around 15% of the total portfolio and the weighted average yield decreased from 17.4% to 13.1% (closer to previous levels).

 

Solar Senior Capital (SUNS) hit its base case projections covering its dividend only due to continued fee waivers. As predicted, its total portfolio declined closer to previous levels and there was a meaningful increase in leverage with a debt-to-equity ratio of 0.80 (previously 0.65). North Mill Capital (“NMC”) remains around 15% of the total portfolio and the weighted average yield from NMC decreased from 17.4% to 13.1%. Net asset value (“NAV”) increased by $0.10 to $16.40 per share and the Board declared a monthly distribution for May of $0.1175 per share payable on June 4, 2019, to stockholders of record on May 23, 2019.

Michael Gross, SUNS Chairman/CEO: “We are pleased with Solar Senior Capital’s first quarter operating performance. Overall, the financial health of our portfolio companies remains sound and over 98% of our portfolio is invested in first lien senior secured loans. With our continued focus on asset-based specialty lending and cash flow investments in defensive, non-cyclical industries, we believe SUNS is positioned to perform well through economic cycles. The Company has ample capital to expand our specialty finance platform while continuing to be highly selective in cash flow lending.”

 

Risk Profile Update

SUNS continues to have mostly “true first-lien” positions, historically stable NAV and low non-accruals. Management has a history of doing the right thing including waiving fees to cover the dividend without the need to “reach for yield” and deploying capital in a prudent manner.

NAV per share increased by 0.6% from $16.30 to $16.40 primarily due to appreciation on its investments in North Mill Capital LLC, Gemino Healthcare Finance LLC and TwentyEighty Investors, LLC, partially offset by depreciation in Trident USA Health Services (cost of $7.0 million, fair value of $0.9 million) that was added to non-accrual status. Trident accounts for 0.2% of portfolio fair value and is the only portfolio company with an “Internal Investment Rating 4” implying that the investment is “performing well below expectations and is no anticipated to be repaid in full.” During Q1 2019, SUNS had net realized gains of $0.1 million primarily related to the exit from its investment in Genmark Diagnostics, Inc.

Liquidity and Capital Resources

As mentioned in previous reports, shareholders approved the reduced asset coverage ratio allowing for higher leverage and the immediate integration of its First Lien Loan Program (“FLLP”). SUNS will target a range of 1.25 to 1.50 debt-to-equity and took on additional debt associated with the FLLP but its debt-to-equity is still only 0.80.

Previously, SUNS announced that it had amended its credit facilities’ leverage covenants to allow for the asset coverage ratio minimum of 150%. At March 31, 2019, SUNS had $88 million of unused borrowing capacity under its revolving credit facilities. However, including NMC and Gemino non-recourse credit facilities, the company had approximately $225 million of unused borrowing capacity under its revolving credit facilities as of March 31, 2019.

 

 

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated SUNS target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

 

Quick BDC Market Update: April 2019

Previous Quick Market Update:

The following is a quick update that was previously provided to subscribers of Premium Reports along with target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

Quick BDC Market Update:

  • BDCs will begin reporting Q1 2019 results later this month. Please see reporting schedule below.
  • As predicted in previous updates, BDC prices rebounded strongly in Q1 2019.
  • I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B). I consider BDCs oversold when the yield spread is 4.0% higher and overbought when it is 3.0% lower.
  • The average BDC dividend yield is now over 10.2% and 3.7% higher than Corp B implying that the BDC sector is heading into oversold territory.
  • BDC fundamentals remain strong including a healthy U.S. economy, low market defaults and most BDCs focused on protecting shareholder capital with first-lien assets with protective covenants as discussed in many Deep Dive reports.

Estimated BDC Reporting Schedule

 

Are BDCs Overbought or Oversold?

Business Development Company (“BDC”) pricing is closely correlated to yield spreads including other non-investment grade debt and ‘BofA Merrill Lynch US Corporate B Index’ (Corp B). As shown in the chart below, I typically make multiple purchases when Corp B effective yields rise including January/February 2016, when the markets experienced similar concerns of slowing Chinese growth and increased energy sector defaults driving higher yield expectations, especially for non-investment grade debt (Junk bonds suffer a rare negative return in January).

Also shown in the chart below, is the recent pullback in Corp B yields which is/was driving higher BDC pricing this year.

 

 

Yield spreads are important to monitor as they can indicate when a basket of investments is overbought or oversold compared to other yield-related investments. However, general market yields can change at any time. Also, spreads change depending on the perception of risk and these are only averages that then need to be assigned a range for assessing individual investments/BDCs. BDCs can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher quality portfolio that will deliver consistent returns over the long-term.

I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B) that recently increased from 6.36% on October 1, 2018, to 8.45% on December 26, 2018. However, as discussed earlier, these yields have been declining in 2019 and are currently around 6.53% (compared to the historical average of 6.50%). This is meaningful for many reasons but mostly due to indicating higher (or lower) yields expected by investors for non-investment grade debt.

The following chart uses the information from the previous chart showing the average yield spread between BDCs and Corp B. I consider BDCs oversold when the yield spread is 4.0% higher and overbought when it is 3.0% lower.

As shown in the chart below, the BDC sector is heading into oversold territory as the current yield spread is slightly over 3.7% (the difference between 10.2% for BDCs and 6.5% for Corp B). Please see the table at the end of this update for a list of current BDC yields.

Establishing a Range of Yields for BDCs:

Initially, I start with a baseline average yield that is driven by various comparable investment spreads. As shown in the first chart, the average historical yield of the ‘BofA Merrill Lynch US Corporate B’ index is around 6.5% with an average BDC yield spread of 3.5% implying an expected average BDC yield of 10.0%. I use the “standard deviation” or [σ] of the current BDC yields to develop an appropriate range. The following diagram shows a typical “bell curve” or normal distribution of results, with 95% represented within 2 standard deviations of the mean. The current standard deviation [σ] is around 1.4%. I use 2.0 σ to come up with a range that should accommodate around 95% of all BDCs which calculates to yields between 7.2% and 12.8% as shown in the diagram below.

 

 

Once I have established an appropriate yield range for BDCs, I assign a corresponding yield to each BDC using rankings of risk and dividend coverage. It is important for subscribers to understand that much more analysis goes into the pricing for each company.

For BDC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

Analyzing BDCs: 

 

Hercules Capital (HTGC): CEO Steps Down, What Comes Next?

 

The following is a quick HTGC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • On March 12, 2019, federal authorities arrested dozens of people involved in the largest college admissions fraud scam in U.S. history. Prosecutors have named 33 parents including Manuel Henriquez, Chairman/CEO of HTGC.
  • Mr. Henriquez has voluntarily stepped aside but will continue as a member of the Company’s Board and an adviser to the Company.
  • I sold shares in May 2017 due to Mr. Henriquez seeking externalization which was bad for the company/shareholders but excellent for Mr. Henriquez and fully supported by the Board.

As mentioned at the bottom of each of my articles, to be a successful BDC investor:

  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

This is a good example of why you need to diversify your BDC holdings.

On March 12, 2019, federal authorities arrested dozens of people involved in the largest college admissions fraud scam in U.S. history. Prosecutors have named 33 parents (including Manuel Henriquez, Chairman and CEO of HTGC) and 13 coaches but said the investigation continues and more parents and coaches could be charged.

Federal prosecutors allege that Mr. Henriquez, along with his wife, participated in the cheating scheme on four occasions for their two daughters and were charged with conspiracy to commit mail and wire fraud. Mr. Henriquez surrendered to the FBI on Tuesday and was released on a $500,000 bond following a court appearance.

On March 13, 2019, HTGC announced that effective immediately, Manuel Henriquez has voluntarily stepped aside as Chairman and Chief Executive Officer. The Board has elected Robert P. Badavas, currently Lead Independent Director to be Interim Chairman of the Board and elected Scott Bluestein, the Company’s Chief Investment Officer as Interim Chief Executive Officer.

Mr. Henriquez will continue as a member of the Company’s Board and an adviser to the Company.

Mr. Bluestein has nearly 20 years of financial services, direct investment and credit experience. He joined the Company in 2010 as Chief Credit Officer and was appointed Chief Investment Officer in 2014. Before joining Hercules, Mr. Bluestein served as Founder and Partner of Century Tree Capital Management, a fund established to make senior secured debt investments with warrants and equity co-investments in small and micro-cap public and private companies.

Mr. Badavas stated, “The Company has a strong and deep management and investment team and a preeminent position as a provider of financing for innovative, venture backed companies. We are fortunate that Hercules has Scott, who leads our investment and origination team and was previously our Chief Credit Officer, to assume the role of Interim Chief Executive Officer. Scott has deep knowledge of our investments and has played a key role in defining our underwriting strategies. We are confident that our market leading role in providing financial solutions to innovators and their venture capital partners will continue uninterrupted.”

As mentioned in previous articles and the BDC Risk Profiles, the ‘Quality of Management’ is likely the most important part of BDC analysis as management is responsible for building a portfolio to deliver returns to shareholders while protecting the capital invested. BDC management controls all the levers including the quality of the origination/credit platform, managing the capital structure with appropriate leverage, meaningful share repurchases, accretive equity offerings and dividend policy, creating an efficient operating cost structure and willingness to “do the right thing” by waiving management fees or having a best in class fee structure that protects returns to shareholders.

Also mentioned in previous public HTGC articles, including “Hercules Capital: External Management Analysis”, in May 2017 Mr. Henriquez attempted “externalization” which would have increased the overall cost structure as well as making it less scalable for future dividend increases. This likely has weighed on the stock (for fear of another attempt to externalize) and shareholder’s trust in management.

The recent events did not appear to have any relation to activities at the company but will be a distraction for HTGC management and will likely impact the near term stock price. I have taken into account lower expected portfolio growth starting in Q2 2019 as well as lower core portfolio yields. However, HTGC had a $1.5 billion pipeline of potential opportunities and had been actively hiring additional personnel driving higher operating expenses in 2018. Please see the discussions below.

From recent earnings call: Now, let me take a brief opportunity to discuss our views of the marketplace and activities as we enter the first quarter 2019. We remain very optimistic about what we’re seeing so far in Q1 of 2019. As we continue to be hyperly selective in evaluating and reviewing the potential pipeline that now stands at over $1.5 billion of new investment opportunities that we’re evaluating. This is above and beyond the already $345 billion of close or pending to close commitments that we already have in-house today as outlined in our earnings release this afternoon.

From a previous call: In an effort to address the increasing loan demand, we’re actively expanding our offices in Boston and Palo Alto. We’re adding additional new headcounts across all levels of the company, which we expect to continue throughout the remainder 2018 and early part of 2019. We see tremendous opportunities continue to grow our loan portfolio rolling into 2019 and we want to make sure that we’re properly capitalized as well as staffed to continue to address the strong demand that we are seeing for our capital.

What Comes Next?

As many readers know, I am typically a ‘Buy and Hold’ investor making additional purchases during general market/sector pullbacks and only selling if there are serious issues. I have been investing (on and off) in HTGC over the last 10 years and writing public articles on Seeking Alpha discussing the stock for over 6 years.

Previously, I sold my shares of HTGC at an average price of $15.17 on May 4, 2017, due to the company seeking “externalization”. However, I have been slowly repurchasing shares including most recently on December 26, 2018, at $10.95. As shown below, HTGC’s stock price never recovered from its pre-externalization highs likely for the reasons discussed earlier.

I also own shares in another internally managed BDCs, Main Street Capital (MAIN), which is one of the best-managed companies in the sector as discussed last month in “Dividend Increases For The High-Yield BDC Sector Part 4“. Shortly after the HTGC externalization announcement, MAIN’s management was asked if they would ever seek to be externally managed and Vince Foster (the CEO at the time) responded with:

Yeah. If I went to the Board and expressed an intent to externalize, I would — I think I would become externalized, I expect to be terminated. And if the Board let me, I would hope that the shareholders would terminate them.

Source: Main Street Capital’ (MAIN) CEO Vince Foster on Q1 2017 Results – Earnings Call Transcript

I sold my shares in May 2017 because the externalization was a bad deal for the company and shareholders but excellent for Mr. Henriquez and fully supported by the Board. My previous articles discussed why I thought it was a ‘bad deal’ including:

  • Optics for investors and changes in trust of management.
  • Increased conflicts of interest.
  • Reaching for yield due to a higher cost structure.
  • 2% base management fee – the highest in the sector and much more important than the incentive fee structure.
  • 7% hurdle rate for incentive fees – too low and not shareholder-friendly.
  • Lack of total return hurdle to protect shareholders from capital losses – as most BDCs are headed toward shareholder-friendly fee structures, HTGC has decided to take the opposite approach.
  • Changes to stock valuation based on lower expected dividend coverage/growth and likely higher risk profile (from increased conflicts of interest and potentially reaching for yield).

It should be noted that Mr. Henriquez has around 2 million shares currently valued at almost $25 million which is much more than the interim CEO and Board of Directors as shown below.

 

Source: GuruFocus

What Can The Board Do From Here?

The following is from the Retention Agreement, dated as of October 26, 2017, between Hercules Capital, Inc. and Manuel A. Henriquez:

The Executive’s employment may be terminated by the Company prior to the occurrence of a Change in Control at any time and the Executive will be entitled to the benefits provided by Section 4, provided the Executive has incurred a “separation from service” as defined in Section 409A, unless such termination is the result of the occurrence of one or more of the following events: “Cause” shall mean, with respect to the Executive: (II) the Executive’s conviction (or entry of a plea bargain admitting criminal guilt) of any felony or a misdemeanor involving moral turpitude.

If anyone has any doubt of whether Mr. Henriquez will be found guilty “of any felony or a misdemeanor involving moral turpitude”, please read the charging documents including pages 44 through 57:

The following is from “How Silicon Valley became epicenter of college-entry cheating scandal“:

The Henriquezes of Atherton, however, seemed to have few qualms of drawing in their daughters’ participation. In 2015, after paying upward of $25,000 to arrange for a proctor to sit next to one of their daughters during her SAT exam at a private Belmont high school and feed her the answers, the young man “gloated with” Elizabeth Henriquez and her daughter “about the fact that they had cheated and gotten away with it,” according to the indictment.

Clearly, Manny (Mr. Henriquez) is still important to the company and needed for the transition as he is very influential in the VC community. But it would be nice if the Board would do the right thing this time for shareholders including adjusting/canceling current and future stock option awards or even a potential clawback of shares and restricted stock units.

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated HTGC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

BDC Market Update: March 2019

Previous Quick Market Update:

The following is a quick update that was previously provided to subscribers of Premium Reports along with target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

Quick BDC Market Update:

  • As predicted in previous updates, BDC prices have rebounded strongly in 2019 with the average BDC up 15% as compared to the S&P 500 up 11%.
  • I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B) that recently increased from 6.36% on October 1, 2018, to 8.45% on December 26, 2018.
  • However, these yields have been declining in 2019 and are currently around 6.82%.
  • The average BDC dividend yield is almost 10.4% and 3.6% higher than Corp B implying neither oversold or overbought conditions.
  • There is a chance for lower BDC prices potentially due to another ‘flight to safety’ and retail investor fear-related selling when they should be holding or buying.
  • I’m closely watching various economic and BDC fundamentals as well as ‘Corp B’ effective yield spreads looking for oversold conditions. This update outlines the two most likely general market scenarios and my potential purchase plans over the coming weeks.
  • BDC fundamentals remain strong including a healthy U.S. economy, low market defaults and most BDCs focused on protecting shareholder capital with first-lien assets with protective covenants as discussed in many Deep Dive

Business Development Companies (“BDCs”) were down sharply through December 31, 2018, likely due to final tax-loss harvesting and/or year-end position changes in various investment funds. As predicted and shown in the chart below, “BDCS” has rebounded from the recent lows. During previous years, the average BDC stock price typically declined from December through January/February and then rallied through May/September.

As predicted in the previous updates, most BDCs have been outperforming the S&P 500 so far in 2019, but still, have an average dividend yield of around 10%. The average BDC continually outperforms high-yield corporate bond ETFs such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), and UBS ETRACS Wells Fargo Business Development Company ETN (BDCS). It should also be noted that the following table does not take into account returns from dividends paid.

BDC pricing is closely correlated to yield spreads including other non-investment grade debt and ‘BofA Merrill Lynch US Corporate B Index’ (Corp B). As shown in the chart below, I typically make multiple purchases when Corp B effective yields rise including January/February 2016, when the markets experienced concerns of slowing Chinese growth and increased energy sector defaults driving higher yield expectations, especially for non-investment grade debt. Also shown in the chart below, is the recent pullback in Corp B yields which is/was driving higher BDC pricing this year.

2019 BDC Buzz Plan:

The S&P 500 is still around 5% below its previous highs for various reasons, some of which are related to BDCs (including a potential economic slowdown), but the underlying fundamentals of the U.S. economy and BDCs remain strong.

There is a chance for lower BDC prices potentially due to returned flight to safety and fear-related selling when investors should be holding or buying. I believe that the following are the two most likely general market scenarios and what I will be doing in each case:

  • Continued/additional positive news regarding interest rate policy, U.S. and world economy driving a full rebound beyond previous levels where I will be making meaningful purchases on the way back up.
  • BDC prices continue to rebound or at least remain higher through May or even as late as September and then back down through December/January. In this scenario, I will be making select purchases of underpriced BDCs and then waiting to make meaningful purchases.

As discussed in the BDC Risk Profiles Rankings report, most BDCs have built their portfolios and balance sheets in anticipation of a recession with investments supported by high cash flow multiples and protected by protective covenants and first-lien on assets for worst case scenarios.

The following comment is from the recent ARCC call: “As we look at the portfolio and evaluate the economy, we continue to approach the market with the belief that we are late in a credit cycle, and that economic growth is slowing. As a lender, these are perfectly healthy conditions for underwriting and strong portfolio performance. However, we do believe that slowing economic growth can challenge weaker companies. And if this thesis proves itself out it should benefit Ares Capital as more differentiation among credit managers is a good thing for established companies like ours which has resources and access to capital that surpasses our peers. A more fundamental credit downturn can be a significant market opportunity for us. We have been able to consolidate market share during times of distress, and outperform other credit managers. And we’re positioning ourselves to take advantage of this if an opportunity arises.”

Are BDCs Overbought or Oversold?

Yield spreads are important to monitor as they can indicate when a basket of investments is overbought or oversold compared to other yield-related investments. However, general market yields can change at any time. Also, spreads change depending on the perception of risk and these are only averages that then need to be assigned a range for assessing individual investments/BDCs. BDCs can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher quality portfolio that will deliver consistent returns over the long-term.

I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B) that recently increased from 6.36% on October 1, 2018, to 8.45% on December 26, 2018. However, as discussed earlier, these yields have been declining in 2019 and are currently around 6.82%. This is meaningful for many reasons but mostly due to indicating higher (or lower) yields expected by investors for non-investment grade debt that will likely result in higher portfolio yields over the coming quarters.

The following chart uses the information from the previous chart showing the average yield spread between BDCs and Corp B. I consider BDCs oversold when the yield spread is 4.0% higher and overbought when it is 3.0% lower. As shown in the chart below, BDCs are appropriately priced which is confirmed by the average RSI discussed earlier. The average BDC is currently yielding around 10.4% compared to Corp B at 6.8% for a current yield spread of 3.6%.

 

Analyzing BDCs: 

 

For BDC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

BDC Total Returns For 2019

Previous BDC Market Updates:

The following is a quick update that was previously provided to subscribers of Premium Reports along with target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

BDCs will begin reporting results next week:

BDC Total Returns For 2019

It is important for investors to understand that BDC pricing can be volatile which is a good thing for investors that watch closely and take advantage of ‘oversold’ conditions measured using various methods including RSI as shown in the BDC Google Sheets.

This volatility drives very different returns depending on the time period used for measuring rather than using actual purchase prices.

I mostly cover stable predictable BDCs that hopefully require minimal trading for investors with the exception of buying more on the dips as I have done with my personal portfolio and discussed in the BDC Buzz Positions report. I will expand on this report to include my actual purchases as well as Suggested Portfolios with commentary.

FS KKR Capital (FSK) has been outperforming so far in 2019 due to being heavily discounted for the reasons discussed in the following article including an estimated decline in book value of 9.3% in Q4 2018:

Explanation of total returns: The Change in Price assumes you purchased the stock at the end of 2018. Dividends do not assume reinvestment and are calculated using the amounts paid (or accrued) divided by the purchase price.

 

For BDC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

GAIN & Overall BDC Market Update: January 23, 2019

Previous Quick Market Updates:

Relative Strength Index or RSI is an indicator that I use after I already know which BDCs I would like to purchase, but waiting for a good entry point. Please see the definition from Investopedia as well as the discussion of net interest rate spreads

The following is a quick update that was previously provided to subscribers of Premium Reports along with target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

Quick BDC Market Update:

Business Development Companies (“BDCs”) will begin reporting results in less than two weeks, starting with Gladstone Investment (GAIN), and the following article from earlier today discusses some of the items that investors should be watching:

As mentioned in previous updates, in December 2018, I purchased additional shares of multiple higher-quality Business Development Companies (“BDCs”) with risk-averse balance sheets prepared for a potential economic slowdown, including TCG BDC Inc. (CGBD) for the reasons discussed in “I Just Bought More TCG BDC, Which Is About To Rally With A Safe 13% Yield.” As investors jump back into financial stocks, the average BDC has easily outperformed the S&P 500 so far in 2019 but still have an average dividend yield of almost 11%:

 

Most BDCs were down sharply on December 31, 2018, likely due to final tax-loss harvesting and/or year-end position changes in various investment funds. As shown in the chart below, “BDCS” has rebounded from the recent lows. During previous years, the average BDC stock price typically declined from December through January/February and then rallied through May/September.

 

 

However, it should be pointed out that BDC pricing is closely correlated to yields spreads including other non-investment grade debt and the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B). As shown in the chart below, I typically make multiple purchases when Corp B effective yields rise including January/February 2016, when the markets experienced similar concerns of slowing Chinese growth and increased energy sector defaults driving higher yield expectations, especially for non-investment grade debt (Junk bonds suffer a rare negative return in January). This also resulted in wider interest rate spreads and favorable lending conditions. Higher quality BDCs typically have much higher portfolio growth during these periods as they take advantage of higher market yields. Also shown in the chart below, is the recent pullback in Corp B yields which was driving higher BDC pricing this month.

 

 

Higher effective yields result in counter-intuitive pricing and usually the time when investors are discounting pricing for BDC stocks, expecting higher yields due to “a flight to safety mode”. The average BDC yield is around 11% which is higher-than-average over the last seven years:

 

 

The S&P 500 is still around 9% below its previous highs for various reasons, some of which are related to BDCs (including a potential economic slowdown), but the underlying fundamentals of the U.S. economy and BDCs remain strong. There is a chance for lower BDC prices potentially due to returned flight to safety and retail investor fear-related selling when they should be holding or buying. I now believe that the following are the two most likely general market scenarios and what I will be doing in each case:

  • ‘Dead cat bounce’ where stock prices continue to rebound but then continue back down to previous lows. In this scenario, I will be making select purchases and then waiting to make meaningful purchases of many BDCs likely in late February 2019.
  • A solid round of good news regarding interest rate policy, world economy and the end of the government shutdown driving a full rebound toward previous levels where I will be making meaningful purchases on the way back up.

Also, over the coming weeks, I will continue to monitor economic and BDC fundamentals as well as ‘Corp B’ effective yield spreads looking for oversold conditions and:

  • Actively purchase additional shares if economic and BDC fundamentals improve driving lower ‘Corp B’ effective yield.
  • Hold current positions and wait if economic and BDC fundamentals decline driving higher ‘Corp B’ effective yield.

As discussed in the BDC Risk Profiles Rankings report, most BDCs have built their portfolios and balance sheets in anticipation of a recession with investments supported by high cash flow multiples and protected by covenants and first-lien on assets for worst case scenarios.

For BDC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

Main Street (MAIN) Preliminary Estimates of Fourth Quarter 2018 Results

Main Street (MAIN) Preliminary Estimates of Fourth Quarter 2018 Results

Main Street’s preliminary estimate of fourth quarter 2018 net investment income (“NII”) is $0.68 to $0.69 per share. Main Street’s preliminary estimate of fourth quarter 2018 distributable net investment income (“DNII”), which is NII before non-cash, share-based compensation expense, is $0.71 to $0.72 per share.(1) The preliminary estimates of NII per share and DNII per share each include a non-recurring benefit of approximately $0.03 per share related to lower operating expenses. The preliminary estimate of DNII of $0.71 to $0.72 per share, or $0.68 to $0.69 per share as adjusted for the non-recurring benefit of $0.03 per share, significantly exceeds both the regular monthly dividends paid for the fourth quarter of 2018 of $0.585 per share and the previously provided DNII guidance range for the fourth quarter of 2018 of between $0.63 and $0.65 per share.

Main Street’s preliminary estimate of net asset value (“NAV”) per share as of December 31, 2018 is $24.04 to $24.14. After adjustment for the semi-annual supplemental dividend paid in December 2018

of $0.275 per share, this represents a decrease of approximately $0.28 to $0.38 per share, or 1.1% to 1.5%, from the reported NAV per share of $24.69 as of September 30, 2018. Main Street estimates that the decrease in NAV per share is primarily due to net unrealized depreciation relating to its Middle Market and Private Loan portfolio investments, which Main Street believes is in large part due to the widening of middle market credit spreads during the fourth quarter. This net unrealized depreciation is partially offset by net unrealized appreciation relating to its Lower Middle Market portfolio investments.

For target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs  (including this one) please see Premium Reports.

SEC Proposes Changes to Regulatory Framework of Fund of Funds Arrangements

Many BDC industry participants have recommended that the SEC’s Division of Investment Management remove or alter the line item titled “Acquired Fund Fees and Expenses” (“AFFE”) that is currently required to be included in a BDC’s prospectus fee table. AFFE disclosure requires acquiring funds to aggregate and disclose in their prospectuses the amount of total annual acquired fund operating expenses and express the total amount as a percentage of an acquiring fund’s net assets. The calculation of AFFE typically results in an overstated expense ratio because an acquiring fund’s indirect expenses are often significantly greater than the expense ratio of the BDC. As a consequence, some index providers removed BDCs from their indices, causing a significant reduction in institutional ownership of BDCs. On September 4, 2018, The Coalition for Business Development, Apollo Investment Management, L.P., and Ares Capital Management LLC submitted an application requesting that the SEC issue an exemptive order exempting BDCs from the AFFE disclosure. On December 19, 2018, as part of the release for Rule 12d1-4 described below, the SEC formally requested industry suggestions to improve AFFE disclosure. The BDC market would likely be receptive if the SEC takes action with respect to AFFE disclosure in 2019.

The Securities and Exchange Commission voted on December 19, 2018, to propose Rule 12d1-4 (proposed rule) and related amendments to the regulatory framework governing funds that invest in other funds (“fund of funds” arrangements). The proposed rule would allow a registered investment company or a business development company (acquiring fund) to acquire shares of any other registered investment company or business development company (acquired fund) in excess of the limitations currently imposed by the Investment Company Act of 1940 without obtaining individual exemptive relief from the SEC.

The SEC is also proposing to rescind Rule 12d1-2 under the 1940 Act as well as most exemptive orders granting relief from sections 12(d)(1)(A), (B), (C) and (G) of the 1940 Act. Further, the SEC is proposing to make related amendments to Rule 12d1-1 and Form N-CEN.

Although the proposed rule would allow fund groups to establish fund of funds arrangements without undergoing the costly and time-consuming process of obtaining individual exemptive relief from the SEC, the proposed rule and related amendments would, if adopted as proposed, limit a number of the fund of funds arrangements currently in place (namely, certain three-tiered fund of funds arrangements). However, the proposed rule would also permit new types of fund of funds arrangements, including fund of funds arrangements involving listed and unlisted business development companies (BDCs) and closed-end funds.

Further, in potential foreshadowing of the adoption of changes to the “Acquired Fund Fees and Expenses” (AFFE) disclosure requirements for which the BDC industry has been advocating since 2014, the Proposing Release solicits comments on potential revisions to these requirements, including whether the SEC should “exempt certain types of acquired funds from the definition of acquired funds for the purposes of AFFE disclosure” and “[i]f so, which types of acquired funds should be exempted and why[.]”

The comment period for the proposed rule is 90 days following its publication in the Federal Register. As of the date of this OnPoint, the proposed rule has not yet been published in the Federal Register.

BDC Market Update: January 3, 2019

Previous Quick Market Updates:

Relative Strength Index or RSI is an indicator that I use after I already know which BDCs I would like to purchase, but waiting for a good entry point. Please see the definition from Investopedia as well as the discussion of net interest rate spreads

The following is a quick update that was previously provided to subscribers of Premium Reports along with target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

Quick BDC Market Update:

On Wednesday, a series of purchasing managers’ indexes for December mostly showed declines or slowdowns in manufacturing activity, including much of Europe and Asia as the U.S.-led trade war and a slowdown in demand hit production. U.S. activity was a bit slower, but still expanding, in a sign that China has suffered more from trade issues than the U.S.

It is important to note that BDCs mostly invest U.S. companies as they were created by Congress in 1980 “to fuel job growth and assist emerging U.S. businesses in raising funds“. The following chart shows the recent performance for U.S. Financial Select Sector SPDR ETF (XLF) and UBS ETRACS Wells Fargo Business Development Company ETN (BDCS) that have declined around 13% to 14% over the last three months. However, both have started to rebound:

 

The S&P 500 has declined by over 15% over the last three months for various reasons, some of which are related to BDCs (including a potential economic slowdown), but the underlying fundamentals of the U.S. economy and BDCs remain strong. In January/February 2016, the markets experienced similar concerns including slowing Chinese growth and increased energy sector defaults driving higher yield expectations, especially for non-investment grade debt as shown in the chart below (see Junk bonds suffer a rare negative return in January). This also resulted in wider interest rate spreads and favorable lending conditions. Higher quality BDCs typically have much higher portfolio growth during these periods as they take advantage of higher market yields.

 

 

However, this drives counter-intuitive pricing and is usually the time when investors are discounting pricing for BDC stocks, expecting higher yields due to “a flight to safety mode”. The average BDC yield is around 12% which is much higher-than-average over the last seven years:

 

 

 

There is a chance for continued lower BDC prices potentially due to continued flight to safety and retail investor fear-related selling when they should be holding or buying. The following are the three most likely general market scenarios and what I will be doing in each case:

  • ‘Dead cat bounce’ where stock prices start to rebound but then continue down. In this scenario, I will be making select purchases and then waiting to make meaningful purchases of many BDCs likely in late January or February.
  • Continued market declines through January/February 2019 where I will be waiting for the selling pressures to abate before making multiple purchases.
  • A solid round of good news regarding interest rate policy and the economy driving a full rebound toward previous levels where I will be making meaningful purchases on the way back up.

Also, over the coming weeks, I will continue to monitor economic and BDC fundamentals as well as ‘Corp B’ effective yield spreads looking for extreme oversold conditions and:

  • Actively purchase additional shares if economic and BDC fundamentals improve driving lower ‘Corp B’ effective yield.
  • Hold current positions and wait if economic and BDC fundamentals decline driving higher ‘Corp B’ effective yield.

As predicted in previous updates, BDC prices continued lower and as shown in the chart below, “BDCS” is now near the previous lows from January/February 2016. Also shown in the chart, the average BDC stock price typically declines from December through January/February and then rallies through May or September. Clearly, this could be coincidence but BDCs are largely retailed-owned and pricing often does not follow the fundamentals which are strong as most companies are beating expectations, with higher NII/NAV and special dividends. There have been a handful of BDCs reporting new credit issues including MRCC, FSIC, TCRD but I view these idiosyncratic. There is a good chance that I will be holding off on making significant purchases until February 2019 but could make smaller individual purchases over the coming weeks.

Are BDCs Overbought or Oversold?

I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B) that has increased from 6.36% to 8.40% since October 1, 2018. This is meaningful for many reasons but mostly due to indicating higher yields expected by investors for non-investment grade debt that will likely result in higher portfolio yields over the coming quarters as discussed earlier.

Yield spreads are important to monitor as they can indicate when a basket of investments is overbought or oversold compared to other yield-related investments. However, general market yields can change at any time. Also, spreads change depending on the perception of risk and these are only averages that then need to be assigned a range for assessing individual investments/BDCs. BDCs can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher quality portfolio that will deliver consistent returns over the long-term. As you can see, the average BDC yield is still trending higher:

 

I consider BDCs oversold when the yield spread is 4.0% higher and overbought when it is 3.0% lower.

For BDC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.