BDC Common Stocks Market Recap: Week Ended April 30, 2020Posted on May 4, 2020
BDC COMMON STOCKS
For a third week in a row, the BDC sector as a whole went pretty much nowhere, up just 0.8%.
That’s in such contrast to the weeks ended March 14 through April 9 when weekly moves up and down went from a low of 14% to a high of 29%.
For the moment – the evidence seems to suggest – the markets appear comfortable with where valuations are.
Where We Are Now
As of Friday, the indicator we most frequently used – BDCS – is down (41%) since February 20, 2020 when the crisis began.
By comparison with the S&P 500 up over this same period – down just (16%) – investors have taken this downturn to heart.
Still, at the very bottom BDC prices were down (59%), so there’s definitely been a dose of optimism injected from the darkest days, which culminated on March 23.
Since March 26 when BDCS closed at $12.19, we can see that the market has not gone anywhere in price terms.
Lots Of Drama
As we’ve noted in prior Market Recaps, there’s still plenty of “price discovery” going on in individual stocks.
This week – like last week – an almost equal split occurred with 28 BDC prices up and 27 down.
Furthermore, the extent of the moves was still impressive with 17 up 3.0% or more and 10% down (3%) or more.
Getting specific, the Biggest Winner was Saratoga Investment (SAR), up 14.7%.
No, there was no material news to justify the sudden surge.
On the flip side, the Biggest Loser was Oxford Square Capital (OXSQ), off (20.25%).
In this case, there was plenty of news as the BDC was first out of the gates reporting IQ 2020 results.
Most notably, the BDC warned shareholders that third quarter 2020 distributions might be “reduced or suspended“.
That was a signal for many investors to exit, along with the (35%) drop in book value.
We wrote about the BDC before the 10-Q was published.
Since then, we’ve had an opportunity to review the non-CLO investment portfolio in detail.
We were struck at the completion of our review by the fact that EVERY SINGLE PORTFOLIO COMPANY was underperforming at the end of March 2020.
Worst Of Times.
That’s – partly – because debt investors – like all investors – run first and ask questions later.
At the end of the quarter values for leveraged debt investments were as low as they’d been in eleven years and only slightly above the March 24 lowest point, according to industry data.
Most every loan OXSQ holds is nominally traded so we expect the valuation staff at OXSQ had little choice but to use those – useless – numbers.
We say useless because as far as we’ve heard no actual transactions occurred at those levels on that particular day and every credit moved down indiscriminately.
One month later and those same loans are trading 4% higher.
That’s an average, but data from S&P Global Ratings shows that most names move up in price but a significant minority remain in the basement, with many headed lower.
As fact follows rumor, prices of loans begin to firm up but we’re at a very early stage in the process.
Two-thirds of OXSQ’s portfolio companies were transferred from performing to underperforming this quarter, but only to a Credit Corporate Rating (CCR) of 3 on our 5 point scale.
If the economy recovers – and even if not – most of those companies will muddle through and return to performing status in the near-term.
That will then boost the BDC’s NAV but nothing will really have happened except extreme changes in sentiment.
We’ve looked at the business in which each OXSQ portfolio company operates and we’ve noticed that virtually all are in sectors that should perform relatively well going forward.
These are technology; software; communications, business services and insurance.
Thankfully, the underwriters at OXSQ managed to mostly stay away from energy; restaurants; transportation; retail and all the other obvious sore spots of the moment.
Still, we don’t know how broad and all-encompassing the recession will be and could yet drag down many of these CCR 3 credits.
To boost its portfolio yield OXSQ did take a large number of second lien positions and those have a bullmark on their back if the underlying company falters.
For OXSQ – and every other BDC – credit could still go either way.
Nothing Happening Here
With 4 BDCs having released IQ 2020 results, not one yet has reported a payment default from a previously performing portfolio company through March 31.
Even Fidus Investment (FDUS), which added three companies to its non-accrual list (which only had one denizen at 12/31/2019) did so pro-actively and was actually paid its debt service due in the period.
As we reported about Barings BDC (BBDC), half the companies in what is – relatively speaking – a “lower risk” portfolio are now in the underperforming category, yet none is on non accrual.
The moral: it’s just too early to tell where the chips are going to fall in terms of credit losses as a result of the current crisis.
In some ways Horizon Technology (HRZN) has its right by only marking down portfolio companies that have discernable difficulties, whether operational or in terms of liquidity.
The rest of the portfolio is marked at cost as before.
That valuation technique helped the BDC to an NAV write-down of only (3%) in the IQ 2020 over year-end 2019.
By contrast, FDUS saw its NAV Per Share fall (8.8%) and BBDC (20.8%).
Unfair Or Just Different?
Both off the record and on conference calls we’ve heard BDC managers speak ruefully about the valuation methodologies of their peers or defending their own approaches with reference to outside firms validation and the depth of their analysis.
For our part – given the unusual economic conditions and the myriad uncertainties that line the block – we don’t give much credence to any of the book value numbers at this stage.
We also continue to question whether fair market value accounting – which as we can see can result in a wide range of valuation outcomes – is the best methodology for investors and for the BDCs themselves.
In any case, the markets just look through the numbers as given and make their own assessment of book value and likely future earnings.
As we see from the continuously changing individual BDC prices in recent weeks that remains an ongoing process.
If the first week of BDC earnings season is any guide the “price discovery” process for BDCs will continue for some time.
As we’ve said before – and echoed on BDC conference calls this week – much more reflective of where BDCs will eventually end up will be IIQ 2020 results – coming out in July.
Much can happen and not happen in the intervening time.
Anecdotally this week – and speaking in general terms – we got the impression that BDC portfolio companies are not getting much in way of previously uncontracted support from either sponsors or lenders.
Both sources of rescue capital appear to be spooked by the difficulty of assessing the end-game and whether it’s a “good money after bad” or simply a short term bridge situation.
Furthermore, we get the impression both groups are having a hard time scraping up additional funds beyond those necessary to operate to offer to cash-strapped borrowers.
Unfortunately, that presages that a flood of bankruptcies are coming this way, and sooner rather than later, given the almost complete cut-off of income in many situations.
For many companies, the last few weeks and the months ahead involve much sharper downturn in business than even in a recession and at a time of maximum leverage.
With that said, we were surprised by version 2 of the Main Street Lending Program rolled out this week.
After taking 2,000 comments (does anyone really read them ?) the Fed expanded the number of financing programs from 2 to 3 and made most every company in America eligible.
If you had an “adjusted EBITDA” of only a few hundred thousand dollars last year you could – theoretically – borrow as little as $500,000.
Yet, if you have up to $5bn in revenues or 15,000 employees you’re also eligible suggesting that the Fed’s idea of Main Street is a broad-minded one.
Come One. Come All. Except You.
Most every kind of non-financial American business is allowed to participate.
We’ve read the exclusions – and even those may be negotiable.
Apparently the Fed wants nothing to do with strip clubs (“live performances of a prurient sexual nature”) ; “oil wildcatters” and the Mafia (“Businesses engaged in any illegal activity”) and non-profits.
That last group might get a program of their own down the road.
From a BDC perspective the most important exclusions are for casinos; life insurance companies; companies that bundle SBA loans and most importantly – lenders (except some pawn shops !).
Leverage? No Problem.
Furthermore – and clearly guided by the BDC Reporter’s input – the Fed has increased the debt to EBITDA multiple allowed in one of the programs to 6x.
The Fed has made clear that the amounts available to fund the programs are essentially unlimited, unlike what’s been the case at the Payroll Protection Program (PPP).
Overall – and we’ve been a critic in the past but are more positive now – this dangles out the stick of untold billions of capital being made available to help most every business in America, excepting the very smallest and the very largest.
The financial terms are generous, with loan yields of 4.0% and principal and interest not due for a while and the entire length of the advances going 4 years but repayable at any time.
So what’s the problem?
You’ll notice the credit markets or the stock markets generally did not jump up on the news of the revised Main Street Lending programs.
The central weakness was, and remains, that the Fed is relying on the banks to implement this complex rescue program (companies have to choose one – and one only – of the three different facilities).
As we’ve said before, the banks are not the primary lenders to the companies most in need of rescuing.
Moreover – and the PPP has been a sad, but telling recent example – the banks take a PR beating every time they get involved in supporting a financial rescue campaign.
Journalists who don’t really understand how finance work; politicians with an axe to grind and various other constituencies pile in and create a “no good deed goes unpunished” situation.
Also, a problem is how the new programs are constructed which involves the Fed financed loans sitting pari passu with the existing bank debt and often maturing before the incumbent loans.
The Fed does allow the existing lenders to be paid interest and mandatory principal repayments and even to use proceeds to pay off other lenders.
At the end of the day, though, the Fed wants its new financings to sit at the top of the capital structure of borrowers who were already fully leveraged before the Covid-19 recession.
You can just see bank lenders scratching their heads in their conference rooms and asking themselves if they want to partner up with the U.S. Government to rescue their borrowers.
We expect the response from Wall Street will be a Bronx cheer.
There may be s0me take-up but the amounts and borrowers involved are those that would likely have sourced monies through the regular channels.
The flaw in all this is that since the Fed started to consider how to help American business the crisis has shape shifted from a short term shock, which required bridge financing, to a long drawn out recession, which requires long term capital.
This is not a matter anymore of offering enough cash to tide over a couple of bad months but of contending with a likely global drop in demand; production and employment.
Offering up more debt to companies whose EBITDA has sharply dropped and which – even when we’re all back at work again – will be much lower than before going forward – serves no one.
The borrowers worry that they’ll be almost immediately unable to service the new debt; the banks will take losses both on their existing outstandings and (to a lesser degree) on the new monies and the Fed will have credit losses too.
In any case, the Middle Market Loan Programs have come along too late.
Covid-19 was damaging global supply chains in the beginning of the year. By February the markets had cottoned on to the risks.
In March and April we saw huge drops in business activity; payroll numbers and cash flows.
We’re now in May and many businesses have been essentially out of business for two months.
The so-called opening of the economy – even should the moves not be reversed – will continue through the summer and leave huge swathes of American business out in the cold.
Like at the Alamo, help – such as it is – has come too late.
Even with the best will in the world, the first round of material disbursements under the three programs – all of which await further elaboration – will not land till June.
For some businesses that will be as many as 6 months after the impact of the worsening conditions was felt.
Tried And True
We expect that – for better or worse- most troubled American companies will fall back on the traditional methods for contending with drastic business decline.
That’s a mix of cost cutting; lay-offs; debt restructuring; equity capital injections; asset sales and the like.
In many cases that will require a trip to bankruptcy court and a formal reassignation of corporate rights and responsibilities.
Unfortunately, we expect that there will a great deal more liquidations than we’ve seen in the past as many sectors and business models prove to be unviable at any price.
Could this have been done differently and with greater success?
We think so, but the cure we propose would have been politically untenable.
Instead of a Fed lending program the U.S. government – like it is doing with the airlines (and only the airlines)- should have created a pool of capital to invest in the equity of troubled companies.
Rather than dealing with intractable banks, the government should be working with the much-hated private equity sector to inject new junior capital into companies that require the help.
It is the private equity community, and company owners, generally who have most to lose if enterprises fail and who would be open to accepting new funds at almost any price.
We would have suggested -if asked – that the government be offered a special LP status above the current owners and below the debt.
The capital invested would allow companies to weather the storm in whatever way necessary.
The government – and American taxpayers – would benefit by sharing in the eventual increase in value that would ensue in years ahead.
Of course, not every rescue would be successful but those that did occur should more than offset the failures.
Unfortunately, both the bulk of the American public and politicians would rather cut off off their nose to spite their face rather than “bail out” private-equity owned companies.
We would think of such a program more as “distressed investing” and that the gains – both in financial returns and in terms of the general good – well worth the effort.
(Instead – and it’s deliciously ironic – those very same “fat cat” asset managers that own the private equity groups also run “distressed” investing and will be those who will benefit.
“Tails or heads, we win either way”).
Our notion of a government “turnaround fund” is obviously a non-starter but does underscore that the patchwork of ideas put forward by the Fed and the Treasury so far have relied too much of what has worked in the past.
As you’ve heard ten billion times, this crisis is different than those that came before and requires an “outside the box” response.
We’ll be getting no “New Deal” breakthroughs in a country so bitterly divided and so reliant on the policies and tools of 2008-2009.
Back To Our Sector
As a result, BDC investors will have to prepare themselves – as they’ve been doing – for the most damaging economic downturn in either twelve years or 91 years.
We still hope that SOMETHING will happen to divert us from the credit losses ahead.
However, should a wave of bankruptcies be inevitable, we remain confident in the longer term resilience of the U.S, financial system and the built-in mechanisms to handle such a situation.
There will be great losses but the bulk will be absorbed by the equity providers; the unsecured creditors; the employees and managers of the companies and the government in the form of lower tax revenues and higher social costs.
BDC investors will also be impacted – and possibly on an unprecedented scale.
However – as investors seem to have already worked out judging by the stabilization of prices in the last few weeks – the sector has the ability to weather these conditions.
Counting The Ways
BDC leverage is still low compared to other financial institutions (and what it might have been if all the players had had the time to “leverage up” as allowed under the SBCAA).
Moreover, more BDC managers than not shifted higher up the balance sheet in recent years as the economic expansion grew longer in the tooth.
Most BDCs – thanks to the BDC regulations but also common sense – are well diversified by sector and by company.
All the managers are experienced, and all but a few have the support of larger organizations for both operations and capital.
Less understood – but soon to be appreciated – the BDC model itself is very flexible and allows for all sorts of ways to handle financial adversities.
That includes diverting income from shareholders to creditors; below par stock offerings both shareholder approved and not and the ability to raise unsecured debt or preferred.
We’d be remiss if we didn’t mention the BDC managers themselves most of whom are experienced, thoughtful and creative lending practitioners and will rise to the occasion.
The BDC Reporter spends a great deal of time pointing out what is not working out in BDC performance; highlighting conflicts of interest and perceived mistakes in judgement (any energy loan for example !).
Nonetheless, after twenty years in the trenches, we remain impressed with the dedication; financial acumen and innovation coming out of the BDC sector.
This Is How It’s Done
Thanks to developments like holding a high proportion of unsecured long term debt capital; increasing control over loan arrangement and documentation; deliberate lower exposure to some of the most beaten-down sectors; the ability to advance more capital when needed to portfolio companies and/or exchange debt for equity where sensible, most BDCs will be able to dig themselves out of any pending credit troubles.
For investors in the sector this will be the ultimate test in the history of the BDC sector – around since 1980 – of it’s viability and importance in the broader financial services industry.
We expect to learn a great deal about who has being swimming naked and who is reasonably transparent with its shareholders and who not.
We expect to witness the implosion of several players whose business models were questionable even in a favorable environment.
We won’t be surprised if a few well-respected names with billions of dollars outstanding trip up along the way.
Yet, we still expect the BDC sector to weather this storm that has just begun to take shape and which no governmental program appears able to mitigate.
We’ve never had a BDC file for bankruptcy or recorded any secured or unsecured lender to the sector lose any money advanced.
We expect that record to continue.
What we can’t say, at this stage, is whether a (41%) drop in BDC equity value is warranted, or is low or high compared to the eventual outcome.
Only a considerable amount of time will tell and even a rough idea of what the final impact of this crisis will look like remains out of our ken.
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