BDCs – beware of mediocrity

 

 

Business development companies (BDCs) are, by nature, a strange beast. The equity trades like any other listed corporate but the underlying portfolio is made up of debt. They are structured and regulated like mutual funds, but they charge fees like private equity funds. They are public vehicles that invest in private companies.

Inherent contradictions aside, BDCs offer benefits to both investors and private debt providers. Managers get access to permanent capital and the retail market. In turn, those retail investors gain exposure to the private loan market without the high minimum investments set for closed-ended funds as well as handsome dividends and stock market liquidity.

But even with all these obvious draws, the sector hasn’t performed well in trading for over a year now. According to research by Keefe, Bruyette & Woods (KBW), there are currently 51 publicly traded BDCs totalling $35 billion in market capitalisation, of which just $6 billion was trading above book value in mid-May.

There are two theories as to why. The first focuses on the withdrawal of BDCs from indices by both Russell and Standard & Poor’s due to issues with fee accounting. The impact was that BDCs lost a lot of their institutional shareholder base – an estimated 20 percent on average.

But this happened more than 12 months ago and many industry experts say that explanation is outdated.

“I would refer to that as an easy excuse,” says Jonathan Bock, a senior analyst at Wells Fargo Securities.

Bock and many other industry experts argue that poor performance by some BDCs is down to increasingly discerning investors. “Educated investors are becoming much more selective on factors that are important to them, such as ROE, safety and security of their assets, including underlying collateral, an all-out conservative and prudent approach to equity issuance,” explains Bock.

Several large BDCs have raised equity despite trading below net asset value (NAV), a practice frowned upon because it dilutes existing shareholders. Others have cut dividends and reported poor performance on their underlying portfolio holdings.

Despite these problems, there are still many new BDCs in the pipeline. Managers raising large direct lending funds often, if not inevitably, follow it with a BDC. Between non-public entities and firms with vehicle registration in the works, there are at least ten new BDC hopefuls in the wings.

 It takes brand and scale for a strong BDC launch as well as alignment with shareholder interests, say analysts, and only a handful do all of this well. Of the vehicles listed in recent years, only TPG, Goldman Sachs and FS Investment Corp. stood out. The other eight vehicles that started trading in the same period failed to develop scale and have been trading below NAV.

 

SUCCESS STORIES

Private debt is a gossipy sector so gaining the respect of peers is a hallmark of success. BDCs unequivocally well-regarded by lenders and analysts include Ares Capital Corporation (ARCC), FS Investment Corp.(FSIC), Golub Capital BDC (GBDC), TPG Specialty Lending (TSLX) and Goldman Sachs BDC (GSBD).

Ares controls one of the longest running BDCs and gets high marks for consistent performance, low default rates and managing well through the financial crisis. “They have a great management team and one of the best track records of credit performance through the downturn. We think very highly of them,” says Greg Mason, managing director at KBW, who covers BDC stocks. With $9 billion in capital, ARCC is the largest publicly-traded BDC.

FSIC is advised by Franklin Square Capital Management, which has strength in raising capital from financial advisor platforms. The sub-advisor, GSO Capital Partners, has the largest private debt business in the world and good performance across strategies. The publicly-listed FSIC I handles about $5 billion, while FS Investment Corp has about $14 billion across other non-traded vehicles which it plans to eventually roll into the public entity.

Golub has also enjoyed good performance since its launch in 2010 and offers investor friendly fees and terms. Golub was the first BDC to change its fee structure to better align with investors and the rest of industry is starting to follow suit, according to a Wells Fargo research report on GBDC. Though Bock noted that fees are still a nuanced argument. “To be fair, just because you have better fee alignment, it doesn’t necessarily make you a good credit manager. If you’re generating return on equity and doing well, investors tend not to care. And when you’re not, they care a lot,” says Bock. “There are several BDCs out there that have lost so much institutional credibility that alignment is a pre-requisite to get back to book value.”

TPG Specialty Lending (TSLX), which went public in 2014, and the Goldman Sachs BDC (GSBD), which listed this March, get high marks for successful starts. TPG launched with over a billion in assets and reported strong earnings in its first public report. The Goldman Sachs vehicle also launched with a sizeable portfolio ($687.6 million), declared decent earnings and a good dividend and also charges investor-friendly fees. The firm has also instituted a share buyback programme which kicks in if the stock falls below book.

 

BAD SEEDS

At the other end of the spectrum are the managers that have drawn heat from analysts, shareholders and the press. Misdemeanors include raising equity below NAV, taking management companies public to shore up new capital while BDCs were underperforming, charging excessive fees, cutting dividends or some combination of the above.

Under a lot of scrutiny lately are Prospect Capital Corporation (PSEC), Fifth Street Finance Corp. (FSC) and Medley Capital Corporation (MCC). All three have been trading at some of the biggest discounts to NAV. All three grew rapidly post-credit crisis, when good credit opportunities were easy to source but they have since had trouble sustaining their dividends, explains KBW’s Mason.

Medley and Fifth Street also took their management companies public last year, harping on the growth and success of their BDCs, which are their largest vehicles and main source of revenue. But those listings were immediately followed by weaker earnings.

“When they were going public there was some idea that they could continue growing and their BDCs have since moved below book which makes it more difficult to raise capital,” says KBW’s Mason. Unsurprisingly, equity prices for the management companies have declined. Medley Management opened at about $17 in September last year and has since dropped to about $11 per share this May. Fifth Street Asset Management priced at $16 per share in October and declined to $8.75 as of 18 May.

Fifth Street is working on several initiatives within the BDC and outside of it, to shore up new capital and management has recently offered to cut fees on future capital raises, though analysts on a recent earnings call pointed out that the impact of these moves are more for the benefit Fifth Street’s management rather than existing shareholders who have already been diluted by capital raising. “We are undergoing a strategic review of FSC's business, with the goal of implementing changes that we believe are in the best long-term interest of our shareholders,” Todd Owens, chief executive at FSC, said in the firm’s fourth quarter 2014 earnings report.

Wells Fargo research on Medley concluded: “MCC results were ‘less than stellar’ as credit losses emerged and less stable fee income driven by portfolio growth filled the earnings gap to cover the dividend. With the stock trading well below NAV today, portfolio growth and associated fee income will be below the levels needed to cover the dividend, in our view. Thus, we expect MCC will reduce the dividend in early 2015 and expect the stock to trade weak until that reduction occurs.”

MCC management announced during its first quarter earnings call that it would engage in share buybacks. Well Fargo’s Bock said in an updated report on Medley that this could put the vehicle back on the right track. The stock price has recovered somewhat since but is still well short of NAV.

Prospect has repeatedly issued shares below NAV and cut its dividends. Its most recent plan to recover investor confidence was to move existing and new shareholders into a higher-yielding CLO vehicle called Prospect Yield Corporation.

The firm is terming it a spin-off though analysts have more accurately characterized it as a dilutive rights offering. Wells Fargo noted the potential for fiduciary duty / valuation concern centered around Prospect’s planned transferrable rights offering of a portion of the CLO book.

 

HARD TO KILL

While these and other BDC managers are trading below book, managers note that it only precludes them from raising new equity. They can still churn existing capital into new deals as they exit maturing facilities. “How the BDCs trade doesn’t really matter, there is no real impact on their ability to pay dividends. If they’re not always raising equity, they could actually spend time optimizing their portfolio rather than chasing their tail,” Brad Marshall, senior portfolio manager on the FSIC BDCs, tells PDI.

All told, there are far more new entrants in the space than there are blowups or exits.  Ares bought the fledgling portfolio of Allied Capital in 2010 and PennantPark has made a bid for MCG Capital’s portfolio. The NGP Capital Resources BDC portfolio manager, which had underperformed for a while and is majority-exposed to energy, was absorbed by Oak Hill Advisors and re-named OHA Investment Corporation last year while Patriot Capital was bought out by Prospect in 2009. But these four are a drop in the bucket of the some 50 to 60 BDCs.

“BDCs are hard to kill. You’d have to get credit very wrong” to go out of business, says one credit manager. Because they are permanent capital vehicles, even if many shareholders redeem, the stock remains to find a new home.

KBW’s Mason also points out that folding if you’re trading below NAV isn’t inevitable. “They didn’t have to quit, they could have survived if they wanted to. With MCGC, they were not forced to liquidate by a lender, they were just tired of the company trading at a perpetual discount to book value. Same thing with Allied, the board had just become fatigued with a seven-year battle with David Einhorn and bad publicity along with a discounted stock valuation and they gave up and said ‘we’re tired and we’re done’, and sold the business to Ares,” explains Mason.

 

STILL ATTRACTIVE, NOT WITHOUT CHALLENGES

With access to permanent capital, no requirement for growth even while trading below book value, the draws of BDCs are obvious. But a successful public launch is a lot harder than it used to be, BDC experts point out.

BDCs rarely go straight to the public market any longer, and need to have a team, a track record, size (at least a few hundred million) and a recognizable brand in order to launch well. “For the past several years Investors are insisting that BDCs have proven investment processes, best-in-class back office function and operations, and, most importantly, a broad originations pipeline,” says ARCC’s chief executive Kipp deVeer.

Getting up to scale is also not that simple. Many of the large successful BDCs have a strong institutional shareholder base, such as the big mutual fund shops, traditional investment managers and hedge funds. A retail base alone isn’t a good strategy, says Bock. He estimates that for successful BDCs, institutional capital makes up 50-70 percent of the base, while for others, it’s around 10-20 percent.

Registering with and selling through financial advisor and broker-dealer platforms, of which there are thousands, is time consuming. Some brokers take commission-based fees and get higher fees for selling expensive products to retail clients. Several sources told PDI this could emerge as an issue for private BDCs, especially since the SEC identified financial advisory fees as its number one priority this year.

It’s no secret that BDCs involve a significant number of headaches, including a plethora of regulatory filings, raising money from retail investors, and quarterly reports to name just a few. “You have to air out your dirty laundry every quarter,” a BDC manager says. If performance is poor or stock falls, there is nowhere to hide.

Is access to permanent capital worth all the headaches? For now the resounding answer seems to be yes.

“The bottom line is: differentiation is taking hold. It’s a big theme we outlined early in the year. This came on the heels of the BDCs being excluded from the indices and you’ll notice that several folks are able to differentiate themselves by operating at a lower cost structure, high senior security on loans, strong risk-adjusted returns and having a perceived view of treating shareholders fairly,” says Wells Fargo’s Bock.

BDCs will keep launching, but only the lucky few will really stand out or achieve scale. The poorest will join the growing list of the mediocre.