Debunking Business Development Companies Misconceptions: Part II

Man examines the blocks with word facts with a magnifying glass. Checking facts and data for plausibility. Debunking fakes and counter propaganda. Conspiracy, mistrust of official information sources

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This article is coproduced with Williams Equity Research (‘WER’).

Many retirees look to the BDC sector as complementary to their REIT and MLP exposure, and we consider all three high-income alternatives to be terrific for income as well as for diversification.

BDC sector stocks

iREIT on Alpha

As part of our continued effort to expand our income-oriented coverage spectrum, we have incorporated BDC coverage as means to provide enhanced value.

Of course, just as we found in the REIT and MLP sectors, there are nuances that require education, and thus we have decided that one way that we can provide “alpha” on Seeking Alpha is to debunk the myths as a means to educate readers.

Time For Round 2

As mentioned in Part I, Business Development Companies (“BDCs”), like Real Estate Investment Trusts (“REITs”) and Master Limited Partnerships (“MLPs”) are special company structures created by legislation to solve certain problems. Revisit Part I for a quick overview of why REITs and MLPs were created by Congress.

BDCs, unlike REITs and MLPs, are not focused on the ownership of hard assets. Instead, BDCs are required to invest at least 70% of assets in the debt and or equity of U.S. businesses. These are almost always private companies that don’t have many options outside of the BDC lending system for external financing. In addition to the constraint on the types of investments they can make, there are limits BDC leverage.

As noted in Part I, the positive attributes of (most) BDCs include floating rate investments less sensitive to changes in interest rates, average yields above 7%, highly diversified loan pools, and a proven business model that precedes the Great Recession.

Some BDCs maintain significant (25% of the portfolio by gross assets) equity holdings, such as Main Street Capital (MAIN) and Ares Capital Corp (ARCC), while others shy away from equity exposure and invest almost exclusively in senior secured loans, such as Owl Rock Capital Corp (ORCC) and Golub Capital BDC (GBDC).

This is a good time to make a few points. This is not a BDC popularity contest. There’s no need to become emotional if your favorite BDC isn’t mentioned. If curious if your favorite BDC meets certain qualifications, you’re welcome to shoot me a note.

BDCs tend to illicit one of two responses: marked enthusiasm or “I’ll never invest in BDCs.” The reason is usually one of these four perceptions/situations:

  • Poor performance and corporate governance concerns of certain non-traded BDCs;
  • Poor performance and corporate governance concerns of certain publicly traded BDCs and their external managers;
  • Confusion around the return profile of BDCs in general; and/or
  • Confusion around what BDCs do and own in their portfolios.

This article is designed to do what the title says: Articulate several common BDC misconceptions and provide a brief but useful explanation of what is right and wrong about each. It is not, however, intended to comment on every BDC or touch on topics reserved for Part I and potentially Part III.

As a reminder, these are the first set we tackled in Part I:

  1. BDCs Are Too Risky
  2. Those Must Be Sucker Yields
  3. High Loan Default Rates

There are reasonable justifications as to why these assumptions are held by many. Believing one or more are true before or after reading this article is not cause for alarm or a reflection of your investing acumen. This series designed to test assumptions by telling the whole story.

I know you’ve all been waiting anxiously, so let’s get started with the first BDC misconception we are tackling today.

4. Supplemental Dividends Are Everything

This opinion seems to have grown in popularity in recent months to the point that every BDC article I author receives multiple comments along this line. The reasoning goes something along:

BDC XYZ doesn’t pay special/supplemental distributions. The best performing BDCs pay them regularly. If it isn’t generating special distributions, something is clearly wrong and I’m out.

The other is:

BDC XYZ generated special/supplemental distributions in the past but hasn’t lately. For that sole reason, I’m dumping the stock and will criticize it every opportunity I get.

A few of my more experienced readers might be thinking “wait a second, hasn’t WER stated that the top performing BDCs have paid significant supplemental dividends over time?”

They are right, but there’s more to the story.

Investing 101 includes the adage if you want more return, you’ll have to accept greater risk. If we take a diversified group of companies with low, medium, and high-risk strategies, it’s reasonable to assume zero of the lowest risk companies will be top performers, a couple medium risk could be near the top, and most spots will be held by those that targeted the highest potential economic return.

Simultaneously, the lowest risk companies are proportionally absent from the lowest performing subgroup and that’s the tradeoff. In BDC terms, those with significant (25%) equity holdings are, by definition, taking greater risk than if holding first lien senior secured loans tied to the same portfolio companies.

Two of the top performing BDCs, MAIN and ARCC, both consistently hold double-digit percentage of equity and have fantastic track records of transforming that part of the portfolio into capital gains over time. Both firms have met or exceeded the total return of the S&P 500 over multiple economic cycles.

In effect, they’re a hybrid of private equity and private debt. This strategy entails paying a comparatively lower base dividend derived from the stable loan portfolio coupled with supplemental (i.e., irregular) dividends as other forms of income are harvested over time.

As a BDC’s strategy matures of many years, it’s possible to generate more consistent capital gains annually. BDCs are effectively forced to pay out all gains as income because of BDC tax rules. Too much undistributed income causes excess and avoidable taxes to be paid by the BDC, and that doesn’t tend to please shareholders.

Now we transition back to the traditional BDC’s portfolio with 95%-100% senior secured loans. These portfolios generate more predictable income, and it makes sense for the Board of Directors to set the dividend policy just under the anticipated distributable income.

Depending on many factors, such as the credit worthiness of the borrowers and terms applied by the lender (granting more control to the BDC may allow the borrower to negotiate lower interest rates, for example), any given BDC portfolio could yield less than another. Leverage is also a major factor since there is a massive 500-900 yield spread between most BDCs’ borrowing costs and the income they receive on their investments.

What’s the right way to think about supplemental dividends?

When comparing two BDCs, the total amount of cash flow generated over time adjusted for the risk involved is the key. Risk means different things to different people, but a good starting point is looking at leverage, the weighted average yield on investments, track record of non-accruals/realized losses, the portfolio’s position in the capital stack of borrowers, and the BDC’s credit rating. We measure and consider all these variables and more every time we underwrite a BDC.

We want to avoid misleading ourselves because a BDC pays or doesn’t pay supplemental distributions. The exact same BDC but with different directors is likely to result in different base and supplemental distribution policies and payments.

The goal is to own BDCs that generate the most favorable total return (Net Asset Value (“NAV”) appreciation/depreciation + dividends) for the risk taken. Personally, I like to own a diversified group of BDCs that focus almost entirely on current income (e.g. ORCC and GBDC) as well as those with a meaningful allocation to equity (e.g. MAIN and ARCC).

These same concepts apply to companies that change their dividend policy over time. MAIN, for example, is believed to be transitioning away from high supplemental dividends and incorporating more of that income in the base dividend.

Once again, I suggest forgetting what a dividend is classified as and focus on:

1) the total income generated by the portfolio against

2) the risk taken by the BDC to achieve that level of income.

Time for our next topic.

5. BDC Distributions Are Unreliable

Just like all our previous items, they aren’t entirely misconceptions. Depending on one’s macro perspective, timeframe, and definition of “reliable,” any sector’s distributions could be perceived as unreliable. Even the Dividend Aristocrats aren’t perfectly reliable as the group does lose members during crises. That’s why we must evaluate track records with our eyes wide open.

Let’s start with a few facts from both sides of the coin. On the plus side, MAIN has never lowered its base dividend since its inception years before the Great Recession. One of the few other mainstream BDCs that were around prior to the Great Recession was ARCC.

That company IPOd in 2004 and paid a $0.30 quarterly distribution that quickly climbed to $0.38 (25% increase) by mid 2006. It quickly reached $0.42 shortly thereafter and held until mid 2009. Ares cut the dividend by approximately 17% to $0.35, which is where it stayed until it increased again in Q4 of 2011 to $0.36.

As someone who was employed as a portfolio manager/trader at a hedge fund throughout the Great Recession, I remember how difficult that period was and particularly for leveraged financial services companies. Ares’ dividend performance during that period exceeds my expectations.

It was reduced, but not by much, and it was still higher than the payout of just a year prior. Looking through a different lens, if ARCC simply maintained their IPO dividend instead of implementing those large and rapid increases, the stock would have never lowered its base dividend and could make the same impressive attestation as MAIN. Investors often get caught up in the details and lose sight of what matters.

Not every BDC that was around before the Great Recession has done as MAIN and ARCC, however. Prospect Capital Corp (PSEC) IPOd in 2004, and like ARCC, the dividend increased rapidly from $0.10 in Q4 of 2004 to $0.15 by June of 2005 – that’s a 50% increase in one year. By Q4 of 2005, the dividend was at $0.28 and nearly triple the IPO’s. Q4 of 2006? $0.39 quarterly. The dividend of the pre-Great Recession era peaked at $0.40 at the end of 2008. Prospect then increased the dividend to $0.41 in March of 2009. Not long after, Prospect switched to a $0.10 monthly dividend that eventually increased to $0.11.

This begs two immediate questions: Given this excellent performance during the last true financial crisis, why is PSEC used as a problem child? Second, why don’t I cover it today?

Here’s a clue: PSEC would yield 16.1% on today’s share price of $8.50 if that old $0.11 monthly dividend was still in place. Instead, the base yield is closer to 8.5% and that’s despite the…

Read More: Debunking Business Development Companies Misconceptions: Part II

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