BDC Common Stocks Market Recap: Week Ended August 28, 2020

BDC COMMON STOCKS

The initial reaction was for almost every BDC common stock to drop in price.

The BDC Reporter – not an inveterate Fed watcher – was surprised at first as we wrote on the Twitter Feed:

For reasons unclear to us, most every BDC common stock has taken a price tumble intra-day. The sector ETF $BIZD was as down as much as -1.4% even as major indices all in the green. Ours is not to reason but to wonder why ?

A reader pointed to the Fed announcement and all made sense.

However, within hours, the market had decided that low rates as far as the eye can see was not so bad after all and prices moved up.

For the week, BDCS was up to $14.13, or +0.78%.

34 of the 46 individual BDCs we track increased in price or stayed static and only 12 went down, a 75/25 split.

Everything Considered

For our part, we’ve given the matter some thought and come to the same conclusion as the market: a long period of low short term rates – if Fed Funds and LIBOR remain in sync – may not be so bad.

Obviously, portfolio yields and gross investment income will be negatively impacted, but most of that damage has already occurred.

In fact, most of the impact of the pandemic on the BDC sector has been occasioned by the drop in LIBOR.

Between February 20 – a date we use as the beginning of the pandemic and early May, one month LIBOR dropped from 1.63% to 0.18%, or a (1.45%) interest rate drop.

Most of those BDCs that we’ve seen cutting their distributions (25 at that last count) did so because of the sudden drop in their investment yields –  not because of credit losses.

Partial Offset

Thankfully, though, most every BDC with floating rate-linked assets also has “floors” in place.

These range from 0.8%-2.0% but tend to average between 1.0%-1.2%.

Furthermore, you can be sure that lenders will be demanding floors of every borrower not already bound by such an arrangement whenever possible.

Those “floors” were reached at different points by the loans in BDC portfolios, but should all be kicking in from the IIIQ 2020 going forward and for the years to come.

That will partly offset the huge drop in absolute income levels from the (89%) drop in the reference rate.

Borrowing Costs

Benefits coming down the pike from the Fed’s approach will be lower cost of borrowing on LIBOR-linked secured facilities, most of which do not have “floors” of their own.

Some of those benefits came through in the second quarter but will max out in this coming quarter and in the future as some BDCs will be paying as little as 2.00% all-in to their secured lenders.

Moreover, as the unsecured debt market – already healing at a rapid rate as the readers of the BDC Fixed Income Market Recap know only too well – improves, the cost of medium and long term debt capital will go lower.

That’s the context in which Capital Southwest (CSWC) decided to redeem some of its “expensive” Baby Bonds with a 5.95% coupon this week by drawing on cash and it’s Revolver.

We should also see the cost of SBIC debentures – already low by historical standards – drop  ever lower with every new price fixing for the BDCs with access to that form of debt capital.

More

There are other positives that might follow but will vary by BDC.

One of them is lower compensation rates charged by BDC managers.

We’re not talking about temporary waivers instituted to “defend” a dividend in the short term, but permanent changes in how much BDC shareholders are charged by the asset manager granted the stewardship of their portfolios.

Barings BDC (BBDC) – which prides itself as a leader  in this area – led the way with the recent drop in its management fee (announced at the time of the MVC acquisition).

First Eagle (FCRD) has also been generous to shareholders in how much or little is being charged in terms of management and incentive fees. The former has been reduced to 1.0%.

Hopefully – speaking from the shareholders standpoint – we’ll see other BDCs follow suit in an attempt in this low yield environment to ensure a decent ROE by cutting compensation costs.

Only Fair ?

Given that most every BDC manager has benefited extensively where compensation is concerned because of the ballooning of BDC balance sheets brought on by the Small Business Credit Availability Act (SBCAA), a little quid pro quo seems appropriate.

Let’s put that point into some quantifiable context because we’ve been tracking BDC portfolio values (on which management fees are typically based) versus their level on March 31, 2018, just before the SBCAA was enacted.

As of the IIQ 2020 – and despite the substantial drop in asset values in the first quarter of this year – BDC portfolio AUM is 32% higher than in the IQ 2018.

Case By Case

Some will hear the call for lower compensation costs and some will not.

We could not help noticing this week when Prospect Capital (PSEC) reported its fiscal 2020 and IVQ results that the BDC continues to charge the full 2/20 fee structure.

PSEC is one of 33 of the 42 externally managed BDCs charging 1.50% or greater in management fees.

However, only PSEC and Harvest Capital (HCAP) – a very different BDC in size – are charging 2.00%.

Perhaps PSEC – with its strong insider ownership and seeming absence of Board oversight – may be able to continue to charge these very high fees, but elsewhere the pressure is for lower comp costs.

The BDC Reporter will call out any changes in compensation structures on these pages when we hear of any.

Finally – in the short run and till the market returns to “normal (i.e. hyper-competitive as opposed to just competitive) – many BDCs will be able to add new loans at higher spreads than in the recent past, and with better protections.

So – all in all – the BDC sector should adapt pretty well to the new deliberately low rate world which – by the way –  bears a strong resemblance to the 2009 to 2015 period.

An Important Maybe

Another unexpected benefit that might be headed our way is a smaller credit tsunami from the Covid-19 dislocations than we’d been expecting.

With August almost over, the number of BDC-financed company bankruptcies appears to have slowed down when we would have expected the opposite to happen.

By the BDC Credit Reporter’s count there were 12 filings in June, 10 in July and just 6 in August.

Furthermore – in some cases – even the outlook for bankrupt companies is not as dire as seemed to be the case a few months ago.

Take for example AG Kings which filed for bankruptcy protection this week but already as a buyer in place and favorable market conditions.

Or Mood Media, which was in and out of bankruptcy in 48 hours.

Interesting Question

Could all that support the Fed is throwing at the markets result in a lower level of credit catastrophe than the markets – and the BDC Reporter – expected in the spring ?

We’ve been diligently reviewing the credit standing of every BDC after the IIQ 2020 results and updating the BDC Data Table accordingly.

Speaking in general terms we’re finding the number of companies in the two lowest rungs of the BDC Credit Reporter’s credit rating system to be more modest than we’d anticipated.

Sure, the usual suspects are still there who were already clearly underperforming before Covid and some who were in sectors directly in the pandemic line of fire.

Energy, retail and restaurant investments are all taking it on the chin, and the occasional healthcare business.

Overall, though, the credit trends appear to be improving, helped by PPP; PE sponsor support; obliging lenders and all that cheap money out there.

We could be wrong and this could be the quiet before the resumption of the storm but that’s the impression we’re getting as we make our way through portfolio after portfolio.

If the glass is half full, that augurs well for the BDC sector’s prospects for the rest of the year.

In fact, BDCS has been on an upward trend since July 9, as this chart shows:

There was a drop back after the bulk of BDC results came out on August 10, but now we’re headed upward again: 11.9%+ since that July starting date, but still below the post-Cvid-19 high of June 8.

As we’ve said before, if BDCS breaks through that June level we’ll have tangible proof investors are beginning to believe the worst is behind us.

We’ll also be looking at how many BDCs are trading above net book value.

That’s always a useful way to take the BDC sector’s temperature.

Back in February before the storm broke there were 20 BDCs in this category, 0 for several weeks in March and April and 9 this week.

We wonder – when we look back at year end whether this week will have been a turning point of some sort, or just another data point along the way…

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