BDCs Benefit From Less Bank Competition
Business development companies are benefiting from less bank competition in leveraged loans driven by higher regulatory capital requirements and increased oversight of leveraged loans by bank regulators.
Overall we believe the return environment for new capital put to work by business development companies (BDCs) is positive, with credit spreads widened to normal levels from very tight conditions over a year ago, and a slow-growth U.S. economy that supports interest coverage and relatively low defaults. Some worry spots include relatively high debt leverage on new investments and existing investment portfolio exposure to the oil and gas industry. We believe these risks are more than priced into the shares today.
We are initiating coverage of six BDCs, with Buy ratings on Ares Capital (ticker: ARCC ), BlackRock Capital Investment ( BKCC ), FS Investment (FSIC), PennantPark Investment ( PNNT ) and Solar Capital ( SLRC ), and a Neutral rating on Apollo Investment ( AINV ). BDCs invest in U.S. middle-market companies, primarily via leveraged loans, and act as pass-through vehicles required to pay out at least 90% of taxable income in the form of dividends to avoid corporate tax.
Recent global macro concerns have helped push credit spreads wider this year, closer to the long-term average. We believe this should help alleviate yield compression that we saw over the prior couple of years. Additionally, many of the higher-yielding loans from older vintages have already been repaid, so we expect BDC portfolio yields to be relatively steady going forward.
BDCs are limited to 1:1 debt-to-equity ratio and most target a ratio of around 0.65 times-0.75 times. Only two BDCs in our coverage are below those levels today — Solar Capital and BlackRock Capital. As these companies deploy leverage over time it should provide upside to net investment income per share. While the other BDCs are somewhat constrained by a relatively full leverage level, most books are well seasoned and can provide repayments to recycle into new investment activity.
BDC balance sheets have shifted in favor of floating-rate senior secured loans, while shifting debt liabilities towards fixed rate. While London Interbank Offered Rate (Libor) floors limit the first 100 basis points of rate hikes, accretion from a 300 basis-point increase in short-term rates can add as much as 30% to some of our 2016 net interest income (NII) per-share estimates.
We expect dividends to remain steady with our NII estimates covering the dividends. If oil and gas investments sour, that could mean dividend cuts for those with heavier exposure, but we think it is priced into the shares already (in some cases more than priced in). The combination of low expected credit defaults and fairly steady originations should provide stable net investment incomes for BDCs in our view.
Non-accrual rates for BDCs continue to run below the long-term leveraged loan default rate of 3.2%. While not a fast pace, the moderate growth in the U.S. economy should remain supportive of loan credit quality. That said, pockets of weakness in the energy sector due to the low price of oil may drive additional defaults ahead.
Managements are focusing on potential share buybacks below net asset value. We believe this makes sense for most BDCs and should be accretive to book value and earnings. We would caution investors to expect too much in terms of buybacks as reducing its equity capital drives up leverage and limits the ability to take advantage of pockets of opportunity ahead (e.g., recent spread widening).
The BDC industry has been pushing to remove some limitations for their business, most notably increasing the leverage limit to a 2:1 debt-to-equity ratio from 1:1 and making financial-company investments qualified under BDC rules. We see low odds for these items to be passed by Congress over this year and possibly not next year. That said, if political winds swing in their favor, we believe shares would react positively with the potential for expanded returns and dividend payouts. We view legislation as a free call option for the sector given that it is not priced into the shares.
-- Arren Cyganovich
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Crossroads the value proposition is no longer there and management has no clue how to marke the product in the US. See Bed Bath reviews.
This is a market phenomena. This stock and many others are caught up in a panic. TCAP is at book value now, where you really get what you pay for. If it goes lower I will continue to add.
Tcap has had it's problems with some bad loans. It's executive compensation is rich though overall expenses are low. However it is now trading at book value and the overall expense ratio is low. The dividend appears safe and is now historically rich. There is room for more bottoming but not much absent a crisis. Hoping for a bounce on which I will unload my more expensive block and lower my cost. Otherwise I will just enjoy the dividend.
The contrary view is that BDCs will have even more investments to choose from that will need financing and that this sector is being thrown out on fear rather than a real reason.
The fear in the market for all of these businesses that depend on debt financing is that the ease of credit is drying up and they will have to pay more for financing if they can get it at all. For example KMI pays its dividend from financing rather than free cash flow. If the collapse of a credit bubble occurs, the dividends are gone and the value of the stock is? The concern is so great that there is indiscriminate selling. The contagion in the energy market is going to hurt banks and the spread into other industry.
The one where I called a sell off in Reits, BDCs and MLPs? Where is the bottom? Not here yet. The market is a tool for the brokers to make money. They are going to flush the market and make money on their options and shorts while us little people get crushed. It's a big game where their computers will gladly take your $.
SAFM uses buyback to offset dilution from its generous employee stock bonus plan. Very executive and employee friendly, not so much for share holders.
I think Cold's comment was pointed at me as much as anyone. With respect Burgh, Sheppard worked his way through the Coke management chain to president of Europe before becoming Cott CEO. His credentials aren't perfect with a lot of turn over, but look at how well GMCR is doing with their fresh CEO?
This is the kind of talent Soda needs and if this guy replaced Birnbaum I think the stock would go up 20%. But kudos to Birnbaum for bringing in somebody with more experience and connections than he has. Please get the ball rolling for crying out loud. Time to rebuild the U.S. business and repair damage with investors.
I still have half my position and will buy back on any dips. Given the large drop in this stock and many others I think it is prudent to get ahead of the tax loss selling. Also, I would rather sell before the ex dividend date which was giving the stock some support.
The good news for Soda investors would be for Pepsi to take over Soda. I say that regretfully realizing that the current leadership isn't capable of marketing the product in America and much of the rest of the world where value matters to the consumer.
Sold almost half my position to harvest tax losses. The remaining position is in the green. I hope to buy back the shares I sold in 31 days. I hate selling at a loss but look at it as a long term strategy to lower my cost basis and minimize taxes.