BDC Common Stocks Market Recap: Week Ended May 15, 2020Posted on May 18, 2020
BDC COMMON STOCKS
Coming Into Focus
BDC earnings season is almost at an end as of Friday May 15, 2020.
We’re just waiting for the annual results from Apollo Investment (AINV) and Capital Southwest (CSWC).
Both of whose results will be interesting but are unlikely to change any minds about the direction of the industry.
Market participants – with most all the IQ 2020 results in hand – are getting a pretty good idea of what the first phase of the Covid-19 crisis has wrought.
Interestingly, if we track the price of BDCS – the ETN that owns most of the BDC common stocks – from the beginning of earnings season till last Friday we find its price has moved from $12.51 to $12.50.
Or, in other words, gone nowhere.
All the revelations that came out during earnings season – and there were many – have not managed to move the overall sector price arrow.
Plenty Of Drama
Which is not to say that we have not had wild swings upwards and downwards amongst individual BDCs.
This week was no exception in that regard.
7 BDCs moved up 3.0% or more in price and 20 moved down by (3.0%) or more.
Those numbers are less drastic than in recent weeks when at one point all 45 individual BDCs moved 3.0% or more in price, and all down.
However, in case you’ve forgotten, back in February and just before everything change, we had 1 individual BDC moving to the upside and 3 to the downside by that 3% threshold.
How our world has changed…
Ups & Downs
This week, Garrison Capital (GARS) jumped up an impressive 45% and bottom of the barrel Medley Capital (MCC) increased 16%.
Probably more telling, though, is that 5 BDCs dropped (10%) or more in price during the week.
In fact, the top 6 price percentage losers were BDCs that reported results this week.
Taking a slightly wider perspective and looking back at price movements over the last month, there have been roughly as many individual BDCs going up as going down in price.
This suggests to the BDC Reporter that there’s still a great deal of “price discovery” going on as investors and analysts keep updating their models and re-thinking their outlooks.
X Marks The Spot
At this stage – and with much a better picture than we had in March when markets were panicking – the BDC sector is down (37%) since the crisis began, after adjusting BDCS for the dividend paid along the way.
That’s much worse than the S&P 500, which is down only (15%) in the same period, much to the annoyance of many pundits who consider those component stocks over-valued.
BDC investors, having lost more than a third of market value – which is equal to nearly 4 years of historical income – will feel that their sector has gone in the other direction and is oversold.
Now that we’re in possession of the book value per share numbers for almost every BDC for the IQ 2020 compared to IVQ 2020 we estimate the actual AVERAGE loss of net assets is (15%).
That’s lower than many anticipated (including the BDC Reporter) and certainly less than if BDCs had closed their books at the nadir of the price implosion on March 23.
Furthermore, dividend announcements have been made by 43 BDCs and 26 have maintained or increased their prior regular distribution level.
Only 3 BDCs are not paying any dividend at all, and one of those is MCC which has been a zero distributor for some time.
(The other two are Saratoga Investment and Capitala Finance).
Numerous BDCs on their conference calls have sought to reassure their shareholders by talking boldly – although in very general terms – about going “on the offensive” in the weeks ahead.
That would entail making new investments – as separate from aiding existing borrowers with emergency advances – and on much better terms and pricing than before.
Not So Bad
Even the non accrual data we’ve gathered does not seem so bad.
We count “only” 181 companies on non accrual (from the 42 BDCs surveyed) at the end of the IQ out of 3,777 companies on BDC books.
That’s just under 5% of the total.
In fact, half the BDCs we counted had only 0-3 non performing companies each to contend with.
Very few new names were added in the first quarter and a few BDCs even managed to reduce the number of non performing companies in the period.
You Might Think…
Maybe – an observer might say on reviewing that data – the BDC sector has a good deal of price runway ahead.
Perhaps the markets over-reacted to the changing economic conditions and we’ll see a climb back in prices closer to those beaten down book value levels.
After all, as many BDCs are eager to note on their conference calls, in some segments of the leveraged finance market since IQ 2020’s end average loans have regained one-third of their fair market value lost.
Heck, there are even 4 individual BDCs trading over book value versus none just a few weeks ago.
Unfortunately – and after reviewing every BDC’s latest results and reading their conference call transcripts – we are not optimistic that the worst is passed.
Let’s start with those book value changes.
As of March 31, there was only one month of the downturn baked into those valuations.
As a result, a quarter of BDCs were able to book net asset losses in the single digits percentage-wise, starting as low as just (3.2%).
(Two BDCs (SAR and MVC) reported results before the coronavirus struck and actually saw NAV Per Share increase).
Yet, when we look through most BDC portfolios where management undertakes internal quarterly portfolio risk ratings we’re struck by what a large proportion are in what we term the “underperforming” category.
There’s a whole range there from single digits to over 60% !
(Some of that may be down to different standards of expectations for portfolio company performance).
More jarring, though, is how great (in most cases) the percentage increase is of underperformers since IVQ 2019.
One example amongst many will do to illustrate: the percentage of underperforming assets at Goldman Sachs BDC (GSBD) jumped more than four fold in those 3 months.
Like Counting Grains Of Sand
Furthermore, our sister publication -the BDC Credit Reporter – has begun the arduous task of cataloging each underperforming company at every BDC.
We’ve been struck in several instances, as we begin with the smaller BDCs, how many of their companies have slipped into the ranks of the underperformers.
For example, we’ve just completed a first pass of Investcorp Credit Management’s (ICMB) 38 company portfolio and found 37% to be credit questionable.
One portfolio company has since the quarter end filed Chapter 11 and another – almost fully valued – has run out of all cash or borrowing capability, except the proceeds from the PPP…
Four others are in the energy field. And so on.
Nor is ICMB unique.
We’ve had the same sort of experience at OFS Capital (OFS); Oxford Square (OXSQ); Great Elm Capital (GECC) and several other BDCs.
It’s no secret to anyone reading this that IIQ 2020 economic fundamentals were the worst in modern history so there’s no reason to expect much solace when the quarter closes. .
Nor will that be the worst of it from a BDC lender’s perspective.
In this quarter and the next, the bulk of losses will be of the unrealized kind, pesky on paper but with no immediate impact on the P&L.
BDC after BDC has indicated that virtually every borrower not previously in default has made their first quarter interest payments.
A slightly larger number of companies have, both before the quarter end and after, sought waivers or amendments and a number have drawn the funds available under their revolvers.
That relatively small impact through the end of earnings season should not give BDC investors false confidence.
At the moment many BDC borrowers are working down their excess liquidity and drawing up their needed rescue plans.
Given how this process works, most of those requests – as well as the first wave of defaults of those who can’t pay/won’t pay – will not occur till late this quarter and into the next.
Effectively, BDC investors won’t be getting a full sense of the credit impact on investment income till October 2020 when the IIIQ 2020 results get published.
Winners & Losers
Between now and then we expect some BDC investments that have managed to dodge the Covid-19 bullet to be written back up, which will boost NAV.
However, a large number of companies will continue to get written down as their financial condition worsens and BDC valuation methods play catch up.
Overall, we may even see some BDC book values consolidate in the IIQ but drop again in the IIIQ.
Most of the impact on BDC P&L performance will begin in that third quarter.
With earnings dropping from those credit losses; still low LIBOR; shrinking portfolios etc, distribution cuts or suspensions are likely to follow.
Based on what we know today, we’ve reviewed our expectations for each BDC’s dividend in turn for the end of 2020 compared with its status at the beginning of the year.
At the moment, we expect only 13 (versus 26 in the IQ) will be in a position to maintain an unchanged regular distribution.
The rest (32 names) will be on a spectrum between full suspension of their dividend to a reduced amount and in a mixture of cash and stock.
Unfortunately, we also expect the BDC sector to sharply divide between those BDCs that are weathering the economic storm and those that will be clinging on for dear life.
If the stock price of BDCs is anything to go by, that’s already occurring.
As of Friday’s close, exactly one-third of BDCs had a stock price below $5.00, and of those 9 were below $3.00 a share.
The market appears to be questioning whether these BDCs have a long term future.
Compounding the situation is that even three months after the beginning of the crisis there are still several players with liquidity problems.
These vary from being cut off from or having fully drawn their Revolvers; having cash resources for only a few quarters or at risk of having their secured debt availability reduced.
Reasonably enough shareholders tend to pull back when they discern liquidity constraints.
Generally in those situations – and we have the examples of MCC; OHA Capital, MCG Capital and Full Circle Capital to remind us – the preferred solution is to shrink the portfolio.
That allows debt to be repaid and/or serviced; bills to be paid if cash income is insufficient and covenant and regulatory limits to be met.
The ability of a BDC to sell its assets – typically the best, most liquid ones for obvious reasons – is one of the reasons we don’t see BDC bankruptcies.
However, the result over time is ever lower quality of earnings; ever lower ROE and distributions and an unattractive remaining portfolio both to prospective lenders and would-be buyers.
We worry that we’ll shortly have – if it hasn’t happened already – a score of “zombie” BDCs, unable or unwilling to liquidate and of no interest to a third party as an acquisition candidate.
Before the current recession almost any troubled BDC could find a home when capital was flowing around freely.
Now everyone is being more circumspect about what they will or won’t buy and that includes both individual assets and entire portfolios.
No Sudden Movement
At the moment – based on what we know about each BDC’s liquidity – we don’t expect to wake up to any sudden fails.
More likely are that several players will gradually shrink in terms of portfolio size and become less and less relevant in the market.
We won’t name names as yet until more conclusive information comes out, probably in the IIQ 2020 results – now just 10 weeks away.
(However, we do point readers to the BDC Reporter’s NAV Change Table which seeks to summarize where each BDC stands on such items as liquidity, and which we update in real-time.
For example, this week we upgraded Golub Capital’s (GBDC) Liquidity Outlook from POOR to FAIR following the raising of $300mn through its Rights Offering).
At the same time, even amongst the BDCs able to navigate through this crisis there will be those who will just survive and those who will thrive.
The latter will have the liquidity; balance sheet and earnings to maintain and eventually increase their profits and distributions.
Many BDCs for years have been telling us that’ they’ve been preparing for a market opportunity like this, after years of overheated and overcrowded conditions.
As they say in boxing, “everyone has a plan till they get hit”.
Not In The Script
Some BDCs that seemed candidates to dominate the leveraged lending space in the event of a downturn have fallen back at the first hurdles.
Whether well regarded BDCs like Bain Capital Specialty Finance (BCSF) and GBDC who’ve had to raise capital at the worst possible time will be able to regain their footing remains unknown.
The proof of the pudding will be in what BDC earnings and dividend look like in 2021 or even 2022.
We’re keeping a list for ourselves of who we expect will Thrive, Survive or Struggle.
At the moment – and it’s very early days and subject to change at any time – there are 11, 22 and 10 in those respective categories.
Our principal conclusion at this stage is that the financial performance – and the resulting stock price – of the 45 public BDCs we track is going to differ very, very widely.
That process is already underway with the top priced BDC priced at $28.71 and the lowest at $0.57.
Which individual BDCs an investor owns – or avoids – will be more important than at any other time we can remember.
That’s especially the case given that as much as a fourth of the BDC universe may not be with us in their current form a year or two from now.
Old fashioned in-depth fundamental analysis is going to be essential for BDC investors.
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