3 Largest Business Development Companies Take Steps To Increase Returns (BDCBuzz).

Apr. 3, 2018 3:38 PM ET|79 comments  | About: Ares Capital (ARCC)FSIC-OLDPSEC, Includes: MRCC

BDC Buzz

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Over the last few days, the largest BDCs have released SEC filings showing that their Boards are seeking to take advantage of the recently relaxed regulations for the sector.

I believe that this sends a strong message and the other ~40 BDCs will likely follow suit over the coming weeks.

I have recently been buying additional shares of higher quality BDCs, especially given the oversold conditions driving higher yields.

Well-managed BDCs will likely be able to increase dividends while improving their risk profiles (or at least maintaining).

Most BDCs will benefit from changes in regulations and rising interest rates, and insiders having been actively purchasing shares.

This idea was discussed in more depth with members of my private investing community, Sustainable Dividends.

Over the last few days, the largest business development companies (“BDCs”) have released SEC filings showing that their Boards are seeking to take advantage of the recently relaxed regulations for the sector. I believe that this sends a strong message and the other ~40 BDCs will likely follow suit over the coming weeks. Most BDCs will benefit from changes in regulations and rising interest rates, and insiders having been actively purchasing shares. Current BDC share prices are oversold, especially given the potential for improved (or at least maintained) net interest margins and dividend coverage in 2018.

As mentioned in “BDC Buzz Begins Purchases Of Higher Quality BDCs,” I have recently been buying additional shares of higher quality BDCs especially given the oversold conditions driving higher yields. Over the coming months, I will be focused on some of the positive changes in the BDC sector, including:

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Ares Capital (ARCC):

As mentioned in the articles linked above, I’m expecting increased BDC pricing bifurcation. Well-managed BDCs that continue to prudently manage their capital structures and portfolios will have the ability invest in safer assets, likely at lower borrowing rates, driving higher net investment income (“NII”) per share over the coming quarters. There’s a chance that these BDCs will increase dividends while improving their risk profiles (or at least maintaining).

On April 2, 2018, ARCC announced that it plans to recommend a path for approval of a certain provision contained in the recently passed Small Business Credit Availability Act (“SBCAA”) that was signed into law on March 23, 2018. The SBCAA includes a provision that permits BDCs to seek approval to operate with higher leverage ratios and provides certain securities reforms intended to improve offering flexibility.

“We anticipate the SBCAA will enable BDCs to provide more capital to middle market companies while improving portfolio diversification and capital markets access for the BDC industry,” said Michael Arougheti, Chief Executive Officer and President of Ares Management, L.P. and Co-Chairman of Ares Capital. “The passage of this legislation provides BDCs a choice to operate with greater flexibility and meaningfully enhances the growth prospects for our industry.”

“We believe this legislation can significantly enhance our growth opportunities by permitting us to invest in a segment of the middle market comprised of lower risk and lower yielding loans that were previously not economic for Ares Capital,” said Kipp deVeer, Chief Executive Officer of Ares Capital. “After a careful analysis, we believe that the increased financing flexibility will be good for our shareholders and we look forward to further communications on this matter once we announce our plans.”

“If approved, we plan to manage Ares Capital in the same thoughtful and disciplined manner that we have over the last 13 years,” commented Penni Roll, Chief Financial Officer of Ares Capital. “While the SBCAA may allow the industry to access additional financing, BDCs will continue to have modest leverage relative to other financial institutions or vehicles.”

Source: ARCC Press Release

BDCs with Senior Loan Funds and JVs that use off-balance sheet leverage will have increased capacity to add or grow additional funds. It’s important to remember that these funds typically invest bank-like higher quality loans at lower rates but 2 to 3 times leverage.

This is good news for ARCC that recently expanded its Senior Direct Loan Program (“SDLP”) to $6.4 billion (was $2.9 billion). AIG (AIG), an existing investor in SDLP, increased its capital available to the program by $500 million to $2.75 billion and another leading global insurance company newly made available $2.0 billion. ARCC and Varagon have agreed to make available an incremental approximately $1.0 billion on a pro rata basis based on their respective ownership of subordinated certificates in the SDLP.

During 2017, the SDLP made $1.1 billion of new financing commitments to middle-market companies, bringing its total commitments to $2.4 billion. As of December 31, 2017, the SDLP was comprised of 19 different borrowers.

“The expansion of the SDLP reflects the compelling market opportunity for scaled lenders to provide creative financing solutions for sponsors and management teams of high quality middle-market companies,” said Mitch Goldstein, Co-President of Ares Capital. “Together with Varagon, by partnering with a well-capitalized and sophisticated new institutional investor, we expect to grow our invested capital in the SDLP and ultimately drive attractive risk-adjusted returns for our shareholders.”

“These sizeable commitments from two highly-reputable global insurers validate the SDLP’s competitive position in the market and the strong risk-adjusted returns it delivers to our investors,” said Walter Owens, Chief Executive Officer of Varagon. “We look forward to continuing our partnership with Ares Capital and providing flexible financing solutions that meet the needs of our borrowers and sponsors.”

Source: ARCC Press Release

As mentioned in previous articles, dividend coverage should continue to improve over the coming quarters due to:

  • Ramping of its SDLP joint venture for higher portfolio yield and fee income
  • Increased leverage and portfolio growth
  • Continued rotation out of non-income producing equity investments

It should be noted that there has recently been a small amount of insider buying:

Source: GuruFocus

Prospect Capital (PSEC):

Clearly, there are additional risks associated with additional leverage and the other proposed changes especially for poorly managed BDCs that constantly maximize their 30% “non-qualified” investment bucket as well as investing in higher risk assets, reaching for yield. However, this has always been the case, and now, these BDCs would be that much more risky, especially during a general downturn.

One of my primary concerns for PSEC is the amount of leverage needed to support the current dividend which is likely why the Board is seeking to reduce its asset coverage requirements recently disclosed in its SEC filings:

“Our Board of Directors have approved decreasing our asset coverage requirement under the 1940 Act from 200% to 150%, effective March 25, 2019, which will allow us to increase our leverage. Increasing our leverage exposes us to additional risks, including the typical risks associated with leverage and could adversely affect our business, financial condition and results of operations.”

“Historically, under the 1940 Act, a business development company was generally not permitted to incur indebtedness unless immediately after such borrowing the business development company had asset coverage for total borrowings of at least 200% (i.e., the amount of debt could not exceed 50% of the value of the business development company’s total assets). The Small Business Credit Availability Act, which was signed into law in March 2018, modifies this section of the 1940 Act and decreases this percentage from 200% to 150% (subject to either stockholder approval or approval of both a majority of the board of directors and a majority of directors who are not interested persons). On March 25, 2018, our Board of Directors approved the application of the modified asset coverage to us, which will decrease the asset coverage applicable to the Company from 200% to 150%, effective March 25, 2019. As a result of this, we will be able to incur additional indebtedness and therefore your risk of an investment in us may increase. In addition, since our management fee is calculated as a percentage of the value of our gross assets, which includes any borrowings for investment purposes, the management fee expenses will increase if we incur additional indebtedness. Please see, “Risk Factors-Risks Relating to Our Securities” in the accompanying prospectus.”

Source: SEC Filing Form 497

S&P Ratings issued PSEC a rating of BBB- with a negative outlook for the reasons discussed below.

“The negative outlook primarily reflects that Prospect Capital Corp.’s (NASDAQ:PSEC) leverage is toward the high end of what S&P Global Ratings views as consistent with the ratings. We believe certain of PSEC’s investments may have more volatile valuations than typical BDC investments, particularly its investments in CLO residual interests, online consumer loans, and real estate, which we think may contribute to more volatility in its leverage metrics than typical BDC loan investments. We expect that PSEC will limit portfolio growth in the near term, maintain reported debt to equity of about 0.80x or less, and maintain losses over the next 12-24 months that are comparable to BDCs we rate investment grade.”

Source: S&P Ratings

We could lower the ratings over the next 12-24 months if:

  • Reported debt to equity rises to 0.85x or higher and we do not expect leverage to decline below 0.85x on a sustainable basis in the near term; or
  • The investment portfolio’s performance deteriorates, as indicated by rising realized and/or unrealized losses or nonaccruals.

We could revise the outlook to stable over the next 12-24 months if:

  • Reported debt to equity declines to 0.75x or less on a sustainable basis, which would provide more cushion against our threshold for a downgrade; and
  • The investment portfolio losses and non-accruals remain consistent with other BDCs we rate investment grade.

I consider PSEC to have a higher risk portfolio due to the previous rotation into higher yield assets during a period of potentially higher defaults and later stage credit cycle concerns, growing CLO exposure to 17.3% combined with real-estate 13.3%, online consumer loans of 6.1%, consumer finance of 10.0% and energy, oil & gas exposure of 3.1%. As mentioned earlier, S&P Ratings also considers the CLO, real-estate and online lending to be riskier allocations that currently account for almost 37% of the portfolio, up from 35% the previous quarter due to recent markdowns discussed earlier.

Source: SEC Filings & BDC Buzz

John Barry has recently been buying additional shares:

Source: GuruFocus

FS Investment Corp. (FSIC-OLD): FS KKR (FSK-NEW)

“On March 29, 2018, the board of directors (the “Board”) of FS Investment Corporation (the “Company”), including a “required majority” (as such term is defined in Section 57(o) of the Investment Company Act of 1940, as amended (the “1940 Act”)) of the Board, approved the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act, as amended by the Small Business Credit Availability Act. As a result, the Company’s asset coverage requirements for senior securities will be changed from 200% to 150%, effective as of March 29, 2019.”

Source: SEC Filing 8-K

Reduced asset coverage ratios could help capital constrained BDCs trading at meaningful discounts to book value to actively repurchase shares even while growing the portfolio. This could have a large impact on NII per share even if investing in lower yield safer assets.

FSIC is currently trading at a 22% discount to book value/net asset value (“NAV”) per share. In February 2018, FSIC’s board of directors authorized a stock repurchase program to repurchase up to $50 million in outstanding common stock at prices below the current NAV per share.

“The timing, manner, price and amount of any share repurchases will be determined by FSIC, in its discretion, based upon the evaluation of economic and market conditions, FSIC’s stock price, applicable legal and regulatory requirements and other factors. The program will be in effect through February 21, 2019, unless extended or until the aggregate repurchase amount that has been approved by FSIC’s board of directors has been expended.”

Source: SEC Filing 10-K

Management has been working to reduce the amount of non-income producing equity investments that decreased to 13% of the portfolio (previously 14%). Also, the amount of first-lien continues to increase from 57% to 64% over the last few quarters as management has been focused on “investing at the top of the capital structure”.

Source: FSIC 2017 Q4 – Results – Earnings Call Slides

There has recently been insider purchases from multiple members:

Source: GuruFocus

FSIC held a special meeting on March 26, 2018, at which a quorum was present where stockholders were asked to consider and act upon the following proposals:

  • Proposal No. 1 – to approve a new investment advisory agreement, by and between the Company and FB Income Advisor, LLC (“FB Income Advisor”), and a new investment advisory agreement, by and between the Company and KKR Credit Advisors (US) LLC (“KKR Credit”), pursuant to which FB Income Advisor and KKR Credit will act as investment co-advisers to the Company (the “Investment Co-Advisory Agreements Proposal”); and
  • Proposal No. 2 – to approve a new investment advisory agreement, by and between the Company and FS/KKR Advisor, LLC (the “Joint Advisor”), a newly-formed entity that will be jointly operated by an affiliate of Franklin Square Holdings, L.P. and KKR Credit, pursuant to which the Joint Advisor will act as investment adviser to the Company (the “Joint Advisor Investment Advisory Agreement Proposal”).

Source: SEC Filing 8-K

Other BDCs

In upcoming articles, I will discuss other BDCs that are seeking to reduce their asset coverage ratios, including Monroe Capital (MRCC):

“On March 27, 2018, the board of directors (the “Board”) of Monroe Capital Corporation (the “Company”), including a “required majority” (as such term is defined in Section 57(o) of the Investment Company Act of 1940, as amended (the “1940 Act”)) of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, the asset coverage ratio test applicable to the Company will be decreased from 200% to 150%, effective March 27, 2019.”

Source: SEC Filing 8-K

To be a successful BDC investor

  • Establish appropriate price targets based on relative risk and returns (mostly from dividends).
  • Identify BDCs that fit your risk profile (there are more than 50 publicly traded BDCs, please be selective).
  • Diversify your BDC portfolio with at least five companies.
  • Be ready to make purchases during market volatility and look for opportunistic buying points.
  • Closely monitor your BDCs, including dividend coverage potential and portfolio credit quality.

The information in this article was previously made available to subscribers of Sustainable Dividends, along with:

  • Target prices and buying points
  • Real-time changes to my personal BDC positions
  • Updated rankings and risk profile
  • Real-time announcement of changes to dividend coverage and worst-case scenarios
  • Suggested BDC portfolio

Disclosure: I am/we are long ARCC, FSIC. 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.