Assessing Risk For BDCs
Assessing risk is critical when setting the target prices for each BDC focused on capital preservation, including NAV per share stability and portfolio strength, to sustain dividend coverage. This includes the ability of the portfolio to retain value during an economic downturn.
One of the best approaches to assessing risk in a BDC portfolio is using a “vintage analysis” that takes into account many aspects including the time frame that each loan was originated as well as asset class, maturity, directly originated vs. syndicated, industry sector, PIK vs. cash yields. BDCs that were lending during times of less protective covenants and higher leverage multiples while maintaining higher-than-average yields will likely have upcoming credit issues regardless of the overall economy
Assessing which vintages are potentially riskier than others is an evolving art and there are a few key indicators that we use, including historical market liquidity levels, default rates, leverage multiples, and covenant light trends. More importantly, we compare the cash/PIK yields of each loan by the time frame that they were originated, but also taking into account the asset class and company sector. Specifically, we are looking for “above market” yields that could imply higher risk. Another important indicator is loans that should have been refinanced at lower rates and are past their “prepayment penalty” windows. This would include loans with much higher than current market yields and could easily be refinanced unless the portfolio company has potential credit issues.
BDC ‘Watch Lists’
The Deep Dive Projection reports for each BDC are increasingly focused on portfolio investments that may have upcoming credit issues and comparing the amount of ‘watch list’ investments and the potential impact on net asset value (“NAV”) per share using various default and recovery rates.
What Are Watch List Investments?
We are continuously monitoring BDC portfolios to identify potential defaults, including loan performance, rating downgrades, specific company/sector news and events, etc. Watchlist investments are portfolio investments that may have upcoming credit issues.
What Is the Default Rate?
The default rate measures the number of loans that have gone into default, usually expressed as a percentage of the total number of loans in a portfolio. A default occurs when a borrower fails to make the required payments on a loan. The default rate is an indicator of the credit quality of a loan portfolio and can be used to assess the risk of a lender’s portfolio. Default rates can be affected by various factors, including the quality of the loan portfolio, the state of the economy, and the effectiveness of the lender’s loan underwriting and risk management practices.
What Is the Recovery Rate?
The recovery rate is a measure of the amount of capital that a lender can recover from a loan that has gone into default, typically expressed as a percentage of the original loan amount. The recovery rate reflects the ability of the lender to collect on a defaulted loan and can be used to assess the risk of a lender’s portfolio. A higher recovery rate generally indicates that the lender has taken steps to minimize its losses from defaulted loans, such as securing collateral, using loan guarantees, or taking legal action against the borrower. A lower recovery rate may indicate that the lender has not taken adequate steps to protect its interests and may result in higher losses from defaulted loans. The recovery rates on first-lien secured debt positions with appropriate covenants/protections/collateral will be much higher than junior/subordinated positions.
Comparing BDC Watch Lists
The following chart shows the potential impact on NAV per share for each BDC, assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery. This is the worst-case scenario for this group of investments. It is important to note that the chart only takes into account watch list investments and any changes to other positions will also have an impact (positive or negative). BDCs with larger amounts of equity positions, most of which are not included in the watch lists, will likely have more NAV volatility (higher or lower).
The largest NAV declines over the last 4 quarters were mostly BDCs with larger amounts of watch list investments. Subscribers who believe the economy is headed for a ‘hard landing’ with a deep, broad, and/or extended recession should focus on the BDCs closer to the top left corner.
Last week, we updated the watch list for Trinity Capital (TRIN) which remains higher than average and includes companies with crypto, FinTech, and real estate exposure discussed in the updated TRIN Deep Dive report.
During Q3 2023, TRINs non-accruals increased from 2.0% to 2.5% of the portfolio fair value (2.6% of debt portfolio) due to adding its investments in Bowery Farming and Molekule partially offset by exiting Fernished, Inc.
Bowery Farming is a vertical farming company also held by FSK which has its first-lien position marked at 22% of cost but with an earlier maturity date and a PIK component (likely higher risk).
Molekule is an air purifier company that filed for bankruptcy in October 2023 and could be marked lower in Q4 2023.
GoFor Industries is a delivery company that was seeking capital through a SPAC merger that fell through and was previously added to non-accrual.
As mentioned earlier, TRIN’s stock price had recently declined likely for a few reasons including the drop in the price of bitcoin which has declined by over 15% since January 8, 2024. TRIN has equipment finance facilities with three companies (Core Scientific, Hut 8 Mining, and Cleanspark) in the crypto space representing around $49 million or 4.3% of the portfolio on a cost basis and $42 million or 3.8% on a fair value basis. These investments accounted for around $0.97 or 7.4% of its NAV per share and are included in its watch list.
Core Scientific is a Bitcoin company that suspended its equipment and other financing payments in October 2022 due to “a liquidity crunch and overextension of debt” and was placed on non-accrual “pending the outcome of future developments at the company”. In December 2022, the company filed for Chapter 11 but was marked higher in Q3 2023 as management was expecting the bankruptcy to be finalized in Q4 2023:
Q. “Can you provide an update on where the situation with Core Scientific stands? Obviously, we know what’s going on there with that investment at least from the backdrop. It looks like it was maybe written up slightly in the quarter but still remains at a heavy discount. There’s been a big move in Bitcoin prices. I’m not sure what the equipment has done. But just can you give an update on that investment? And — have you seen any changes in the underlying market recently given the big move higher in Bitcoin over the last several months?”
A. “There’s been a couple of significant updates within the quarter. The claim amount and our collateral amount, has been finalized with the company, which is obviously a positive thing. And the company has also come to agreement with the equipment lenders under three different restructuring options. So continues to move forward through the process. The collateral amount and the claim amount were finalized with the company. That’s what they’re bringing into court. We understand the company is very close to reaching agreement with convertible note holders, but as of right now, we haven’t heard that that’s finalized. The judge in the case needed to recuse themselves, there’s a new judge. We think the judgment date is at or around the end of the year. And so, we can’t really say what will happen, what the court judgment will make. But as Ron alluded to the agreement, the Trinity and the company have reached as well as all the other equipment lenders. The company has three debt repayment options, A, B, C, they can choose which suits them best. So we consider those three options do discounted cash flow analysis to value our holdings and still maintained relatively high discount rate just to account for the overall risk. We will have an equitization option as well to consider moving forward. The valuation and the exact terms of that are not completely clear at this time. So it’s impossible for us to say what we might pick. We expect to make that election within Q4. And we’re going to do what, we believe is in the best interest of our shareholders when we make that decision.”
Hut 8 Mining (HUT) is a publicly traded company that mines bitcoin and is constantly in the news including a recent short-sell paper last week from JCapital Research:
On January 24, 2024, HUT countered the activist short-selling report, asserting the allegations as misleading and affirming its financial stability and operational integrity:
“Hut 8 has assessed the claims set forth by the authors of the report and believes that the report is filled with inaccuracies, misrepresented data, speculative claims, and unfounded character attacks. The report appears to represent a deliberate attempt to spread misinformation about Hut 8, its operations, finances, management practices, and key executives. The statements made by the short seller expose an inadequate, distorted understanding of the Company, its operations, and its key executives. The report appears to have been made to distract from the Company’s achievements and progress since closing its merger of equals. The Company believes that the report was designed for the sole purpose of negatively impacting Hut 8’s share price for the short seller’s own benefit, at the expense of Hut 8’s shareholders, partners, and employees. The Company continues to focus on driving strong operating and financial results. On December 31, 2023, Hut 8 held 9,195 Bitcoin in reserve, with an approximate value of $390 million, and had North American-wide operations spanning 205,759 miners under management. In addition to its strong balance sheet, Hut 8 is distinguished from its peers by its diversified business, as approximately 30% of its revenue was generated from fiat revenue streams as of September 30, 2023.
Knockaway (Knock.com) remains on the watch list partially due to significant exposure to home sales which were previously declining was recently marked higher but its equity positions remain valued at zero.
Nexii Building Solutions designs and manufactures low-carbon buildings which also held by HRZN and continues to be marked lower likely related to liquidity issues. During Q3 2023, TRIN provided a small short-term loan through December 31, 2023, likely for working capital, and could indicate upcoming credit issues. As mentioned in other reports, many BDCs with healthcare-related exposure have experienced credit issues mostly related to staffing shortages.
Nomad Health is a platform for travel nurses that reduced its staff by 25% in October 2023 following a previous reduction of 17% earlier that year and could be added to non-accrual.
One of my primary concerns for TRIN is Petal Card which provides cards for consumers who are new to credit and is reportedly exploring “a number of options following several months of struggle”. Some of these reports say Petal is expected to “go out of business” if it does not find a buyer, while others say that outcome is unlikely. As mentioned earlier, the loans to Petal have been extended and partially converted to PIK including its largest loan during Q3 2023. Please note that its loans to Petal remain fully valued accounting for around 3% of the portfolio and over 5% of NAV per share.
As shown below, we have added Petal Card to TRIN’s watch list investments that increased from 13.5% to 16.8% of the portfolio at fair value (18.5% of the portfolio at cost), which is higher than the average BDC, as shown in the previous comparison chart.
Some of my primary concerns for FS KKR Capital (FSK) include many of its health care (similar to other BDCs), asset based finance (“ABF”), capital goods, and software investments as well as real estate and aircraft leasing exposure (similar to previous declines from Global Jet). It is important to note that FSK management could restructure or sell watch list loans resulting in realized losses rather than placing it non-accrual. This has the optics of lower non-accruals but results in realized losses similar to Pure Fishing during Q3 2023 and is a potential sign of lower quality management (if it is a common occurrence).
Even after taking into account the recent and previous exits/repayments/restructuring of Pure Fishing, Angelica, Gracent, Hilding Anders, Arrotex Australia, Misys (Finastra), Monitronics International, NBG Home, One Call Care Management, and ThermaSys, the amount of watch list investments remains 15.5% of the portfolio fair value (19.8% at cost) and around 33% of NAV per share, which is more than most BDCs. This is one of the reasons that FSK typically trades at a 20% to 30% discount to NAV.
There is a good chance for additional credit issues potentially related to Advania, Avida, Constellis, Industria Chimica, JW Aluminum, Miami Beach Medical, Prime ST, and Reliant Rehab Hospital. These 8 investments account for around $775 million of the portfolio at cost or around $576 million at fair value which is around $2.06 per share or 8.6% of NAV per share.
As mentioned earlier, FSK has experienced net realized losses of $990 million or $3.53 per share over the last 9 years after including the most recent $66 million in Q3 2023. Also, its NAV per share has declined by 34% over the last 6 years:
The following table shows the potential impact on FSK’s NAV per share using a range of default rates only for its watch list and non-accrual investments, but also considering a range of potential recovery rates.
For example:
- If 100% of these investments defaulted with 0% recovery, the negative impact on NAV per share would be around $8.13 or 32.7%. This is the worst-case scenario for this group of investments.
- If 50% of these investments defaulted with a 50% recovery, the negative impact on NAV per share would be around $1.35 or 5.4%.
- If 20% of these investments defaulted with an 80% recovery, the positive impact on NAV per share would be around $0.11 or 0.5%.
It is important to understand that FSK’s watch list is currently marked at a weighted average of 75% of cost and any changes to other investments (especially equity positions) will also have an impact (positive or negative).
The table below uses what I consider to be conservative estimates for annual total returns (dividends plus capital gains) and takes into account current price levels. As shown later, the average BDC has provided annualized returns of 58% for investors who purchased shares near the lows in March 2023.
