High Yield: Owning BDCs During The Crisis

Co-produced with PendragonY

Given recent market action and the on-going issues with the coronavirus and its spread, many are concerned about how BDCs will perform during today’s extraordinary times. BDCs invest in middle-market companies, not the tiniest but far from the largest. Many of these can be very vulnerable to economic disruptions and a slowing economy.

In the near term, BDCs will see some decline in their NAV as assets will have to be written down to reflect current risks. We also should assume there will be some disruption to their cash flow. The keys to a BDC and its investments doing well, beyond just good management at the BDC level, is to have three things:

  1. Low exposure to the most vulnerable sectors, a diverse portfolio of companies with solid debt metrics.
  2. Having access to cash to both keep paying the dividend and to help portfolio companies over short-term cash flow difficulties. Likely, many companies, especially the smaller companies that make up BDC portfolios, will seek some relief from rent and or loan payments. Those BDCs that have enough cash to bridge that payment shortfall will do best over the next few quarters. Therefore having good liquidity is key.
  3. Much of the costs for BDC is driven by LIBOR rates. So the drop in LIBOR should over the short term reduce their costs. While it also impacts the payments they receive, the reset period is longer, so the spread will increase for a while.
Data by YCharts

We will analyze in this report five BDC companies that we recently covered here on Seeking Alpha.

1- Ares Capital Corp

Ares Caiptal Corp (ARCC) is by far the strongest BDC in our model portfolio. During the last recession, while it did have to cut its dividend 20%, that cut did not last long and we now have a larger dividend. In the near term, we are likely to see a big decrease in NAV and share price, but unless they have to waive payments for more than 90 days (or fear they might have to), the company will likely not have to cut the dividend. Let’s look at some financial data from the latest report.

Source: March 5 Investors Presentation

The green arrows point to how much exposure ARCC has to multiple vulnerable sectors. They have less than a 1% exposure to the hotel and gaming sector, about 3% to oil and gas, and just 2% to retailing. Food and beverage adds another 2% (we will include it all just in case this is all restaurants). That makes for an 8% exposure to the most vulnerable sectors. That should be manageable.

Source March 5 Investor Presentation

In the slide above are details on ARCC’s access to the debt markets. They have plenty of room on their revolver. More importantly, as a BDC, ARCC has a limit in how much leverage they can use. As of March 5, they had less than half the leverage they could use. That means they will be able to borrow more money if they need it, and won’t be squeezed on borrowing by declines in the value of their portfolio companies.

Source March 5 Investor Presentation

ARCC has plenty of liquidity. In January they added $750 million from selling some unsecured notes and expanded various funding facilities by more than $300 million. This should provide them with the funds needed to cover any help they provide to their portfolio companies as well as any payment relief they extend to them. So ARCC is in a position where it can extend some relief to its portfolio companies, likely a delay in payments with a higher rate when payments resume.

At this point, a quarter or two of relief and cash flow issues should not result in a dividend cut. Likely there will be some hit to both NAV and share prices over this period. Holding should be fine at this time, but one should be cautious in adding shares.

Investors here should keep in mind that this is not the first recession that ARCC management has gone through. ARCC has paid a dividend for the last 15 years. During the last recession, when many companies were eliminating their dividend, ARCC continued to pay a dividend. That dividend, while lower than the prior years, but it was still $1.40/year vs. $1.65/year prior to the recession. ARCC was able to significantly increase the dividends following the recession back to $1.60 (not including special dividends). Since its inception as a public company in 2004 until the end of 2019, ARCC has outperformed SPY by a large margin.

2- Newtek Business Services Corp

Newtek (NEWT) is a slightly odd BDC in that it doesn’t only offer loans and equity to small and medium-sized businesses. NEWT also has a network of portfolio companies that offer business services as well. And a lot of its income and the income of its portfolio companies come from referrals by other companies in this network. None of its largest portfolio companies are in any of the most vulnerable sectors, although they do provide business services to those sectors to some extent.

Newtek and its portfolio companies make a lot of SBA 7(A) loans. The guaranteed portion of these loans is then quickly sold for a very hefty profit (typically the loans are sold in a few weeks). NEWT sells the guaranteed portion of the SBA loans at a premium between 106% and 120%. The un-guaranteed portions of these loans are then bundled and eventually securitized. Since NEWT and the SBA split the profits and losses from the sale of the un-guaranteed portions of these loans, this helps mitigate the risk to NEWT from losses. From the last 10-K, NEWT had around $63 million in outstanding unsold loans to businesses in either food service, hospitality, or gaming. That’s out of a total of $430 million of outstanding SBA 7 ((NYSE:A)) loans and $659 million of total assets. That works out to be less than 15% of SBA loans and less than 10% of total assets. With the federal government taking steps to both increase the amount of funds loaned through the SBA and increase the percentage they will guarantee, the additional opportunities for NEWT should largely offset this risk.

For NEWT, as a BDC, the asset coverage ratio is important as well. As the value of their assets drops, likely at this time as they will have to take some write-downs due to current conditions, that will lower the amount of outstanding debt that they can have. If they exceed the debt limit they will have to sell assets (likely at a loss), and also will likely have to reduce if not eliminate the dividend. At the end of 2019, NEWT’s asset coverage ratio was about one-third of where it was two years ago. Coupled with SBA loans having a larger portion guaranteed by the government, NEWT should have enough cushion to not exceed its debt limit.

As part of the response in the U.S. to the COVID-17 crisis, NEWT CEO Barry Sloane announced that the SBA is making available some $350 million in new money for loans. NEWTs referral volume also has seen a very large increase. NEWT is a great place to be. Alternatively, the baby bonds NEWTL (NEWTL) and NEWTI (NEWTI) are bonds with a high degree of safely and carry a yield of 6.5%.

3 – Saratoga Investment Corp

Saratoga Investment (SAR) is a small REIT, but a rapidly-growing one. Fortuitously as it turned out, the company had just sold off one of its bigger investments and so had quite a bit of ready cash that it has yet to redeploy.

Source: Q3 2020 Report

Only a very small amount of SAR’s investments is in vulnerable sectors like food and beverage. Also geographically, since a large portion of its investments is located in the U.S. southern states, the higher temperatures there could limit the impact of coronavirus as well.

Source: Q3 2020 Report

Having a total of $301 million of liquidity also will come in handy if SAR needs to help its portfolio companies out, or weather some disruption in payments from them. Also, with so much debt paid down due to exiting a large investment, SAR has less to worry about exceeding its maximum leverage as well. Between cash on hand and other sources of cash, the more than $300 million in liquidity should also allow SAR to take advantage of other BDCs needing to liquidate assets.

And as of the end of Q3 in SAR’s 2020 fiscal year, 99% of its loan investments carry its highest credit rating.

4 – Pennant Park Investment

Source: Q1 2020 Report

Pennant Park Investment (PNNT) has only a small amount of its portfolio in such at-risk sectors as oil and gas (1%) and hospitality (3%). Unfortunately, lumping healthcare, education, and childcare into one category combines areas that should do well with areas that might have significant issues. That’s somewhat mitigated by 77% of the total being secured debt.

Source: Q1 2020 Report

While PNNT has more exposure to vulnerable sectors than we might like, it has plenty of liquidity to handle any issues. It has more than $180 million of room left on its various credit facilities, plenty of cash to handle any shortfalls over the next six months or so. More importantly, its regulatory leverage of only 1.06x is well below the legal limits. Having three or more years before any debt maturities relieves any pressure to refinance.

5- Monroe Capital Corp

Source: Q3 2019 Report

Monroe Capital ‘s(MRCC) portfolio includes exposure to investment funds (6.5%) and retail (4.4%) and to some extent construction (5.4%) are likely the most vulnerable. The fairly heavy concentration in secured loans (over 80%) mitigates that risk to a large degree.

One area of concern was the amount of leverage and liquidity MRCC had. During the fourth quarter conference call when Aaron Peck addressed the issue with the following statement:

Regarding liquidity, as of December 31, we had approximately $75 million of capacity under our revolving credit facility. At the end of the quarter, our regulatory leverage was approximately 1.16 debt-to-equity, a decrease from the regulatory leverage of nearly 1.3 at the end of the prior quarter. The current level of regulatory leverage is within the targeted leverage range we have guided you to on prior calls.”

Having $75 million or so of capacity available and reducing regulatory leverage should leave them in a reasonable position going forward.

Insider Purchases

Don’t just take our word for it that these BDCs are at good values and in good financial shape. Look at what their management is buying.

Source: ARRC OpenInsider Report

Source: NEWT OpenInsider Report

Source: PNNT OpenInsider Report

Source: MRCC OpenInsider Report

Each of the BDCs, except for the small SAR, had insiders making purchases in March. Barry Sloane, CEO of NEWT bought over 12,000 shares of NEWT so far this month. Arthur Penn, CEO of PNNT, bought 115,000 shares of PNNT. Theodore Koenig, CEO of MRCC, bought over 60,000 shares of MRCC. This level of confidence by those who know the company’s operations best is a good sign. These insider buys can give an indication that management is comfortable that they have enough cash to survive the current extreme liquidity drought.

Final Thoughts

Last Wednesday the Senate passed the coronavirus stimulus package and sent it on the House where it will be voted on Friday.

The package now includes such provisions as:

  • $367 billion for small-business loans ($350 billion in loans and $17 billion to cover interest and principle amounts on existing loans). The new loans will be 100% guaranteed (NEWT sells this portion and makes much of their income doing so).
  • $500 billion loan program run by the Treasury Department to assist businesses struggling to stay afloat.
  • $150 billion for state and local aid.
  • $130 billion for hospitals.
  • Broader eligibility for unemployment benefits and $600 more in payments. $3.8 billion for the MTA.
  • $1,200 checks for those making under $75,000, up to $3,400 per family. Payments zero out at $99,000 for a single tax payer, $198,000 for a married couple and $218,000 for a family of four or more.

Much of this much needed aid will help the economy in general and BDCs and their portfolio companies in particular (for instance the SBA loans). With leaders of both parties and the president committed to providing additional aid through legislation as needed, we see this as a positive sign. We remain bullish on higher quality BDCs at the current prices. We particularly like ARCC, NEWT, and MRCC. Another solid dividend stock in the same sector is Main Street Capital (MAIN) that investors should consider at the current price.

For fixed income investors, we have been encouraging our members to invest in several “baby bonds” issued by BDC companies. “Baby Bonds” are quite similar to the regular bonds, but much easier to trade. This is because “Baby Bonds” trade on the stock exchanges (just like stocks), rather than on the bonds exchanges. Examples of two baby bonds we have been buying include:

  • Newtek Business Services Corp., 5.75% Notes Due 8/1/2024 (NEWTL) and
  • Newtek Business Services Corp., 6.25% Notes Due 3/1/2023 (NEWTI)

Both bonds are incredibly cheap at the current prices given that they carry much lower risk than their common stock counterparts.

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Disclosure: I am/we are long ARCC, NEWT, SAR, PNNT, MRCC, MRCCL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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