The third quarter came to an end, and we all know what that means: earnings season is upon us, the time of the year when analysts and journalists don’t sleep.
As the results roll in investors will be watching out for dividends, a subject Private Debt Investor has been discussing with sources in the BDC world.
Dividend policies should be flexible and based on the earnings power a BDC’s strategy implies, one expert told us. This person pointed to the current low-interest rate environment, which has troubled many BDCs, as an example of when managers might feel under pressure to change strategy to meet expected dividends.
If a BDC is not making its target, it can choose to take on more risk to meet a dividend that was set under different economic circumstances or it can simply cut the payment – the approach this source favours.
“I am of the view that dividend policy should be a function of strategy, and I think one of the mistakes we’ve seen in the sector is the reverse of that,” the source said.
The idea of paying a dividend based on an investment strategy, rather than shaping an investment strategy based on a dividend is sound, and Apollo Investment Corporation, for one, buys into it.
In its second-quarter earnings call, chief executive Jim Zelter highlighted the company’s focus on maintaining a quality portfolio. Apollo had reduced its dividend from 20 cents per share to 15 cents after posting a 5.2 percent drop in net asset value.
“We believe our target dividend payout ratio should be a function of our desired portfolio construction,” Zelter said on the call.
TCP Capital Corporation also backs such a philosophy, as it noted on its second-quarter conference call.
“Our focus on senior secured loans, most of which are floating rate, has resulted in a lower overall risk profile and strong portfolio performance,” the company said. “This has enabled us to consistently out-earn our dividend.”
Another source suggested taking into account the expected return on equity over the course of the business cycle when setting dividends.
This person advocated finding the right balance between weighing risk and yield versus current market conditions, cautioning against a BDC “chasing yield without a view of where we are in the economic cycle to meet a dividend that could have been artificially set too high”.
The conventional wisdom, to use a baseball analogy, has the credit cycle in the seventh or eighth inning, and the idea of weighing risk and yield against the economic environment could arguably become all the more important as the game heads towards the final inning.