The small and midsize businesses that business development corporations finance are under duress during the coronavirus crisis. Here, a sign of the times in a restaurant window in New York City on a recent day.
Photograph by Cindy Ord/Getty ImagesFund investors know that a good money manager can be the difference between gains and losses during volatile and uncertain times. That’s especially true now for income-hungry investors looking at business development corporations and their double-digit yields.
The entities, known as BDCs, are essentially funds that provide financing to small and midsize companies, most often (but not always) in the form of loans. Most are publicly traded, though they borrow money from banks and tap the bond markets as well. Like real-estate investment trusts, BDCs are required to pay out 90% of their net income to investors in the form of dividends to get preferential tax treatment.
Now, an array of BDCs are starting to adjust their payouts and share-issuance policies as investors prepare for what could be the sharpest economic slowdown in modern American history.
Some, such as Golub Capital (ticker: GBDC) and Gladstone Capital (GLAD), have pared their dividend payments. Others could follow Prospect Capital (PSEC) and start paying out a significant portion of their dividends in the form of stock, not cash. Golub has also launched a rights offering to raise additional capital.
More dividend cuts and shareholder dilution could be in store, analysts say. In a note earlier this month, Raymond James analyst Robert Dodd estimated that 12 of the 21 BDCs he follows will cut their payouts at some point this year.
Most of the 41 publicly traded BDCs tracked by consulting firm Cliffwater yield between 10% and 22%; the firm’s BDC Index was yielding 15% on April 21.
Picking and Choosing BDCs
Investors should look for low leverage, sizeable discounts, and steady dividends.
Note: Leverage is the ratio of a BDC's debt to its equity. Market data as of April 22.
Sources: FactSet; KBW; Raymond James; company reports
BDCs have another draw besides yield: They are one of the few ways individuals can invest in portfolios of debt run by money managers that specialize in lending to (or buying debt from) small to midsize companies as well as private companies. Similar “direct lending” or “private debt” funds have become popular among institutional investors.
The downside to private lending now is that the companies BDCs focus on are expected to face the greatest risk from the coronavirus pandemic, as Americans limit their public interactions and halt a large share of their spending at small businesses and retail shops. More of the companies in which BDCs invest are expected to miss loan payments as economic growth slows. Analysts at Raymond James forecast that 10% of loans in BDC portfolios, on average, could miss payments.
Investors began to recognize the risks last month, and the value of BDCs’ loan portfolios across the sector slid amid a broad selloff in risky assets. That selloff may have put some BDCs at risk of breaching regulators’ and lenders’ rules that require the vehicles to have a certain amount of equity compared to their debt. BDCs’ stock prices are correlated to the market value of the investments they hold, though it’s not a one-to-one comparison because loan markets are opaque.
The Securities and Exchange Commission took action this month to address the risks. The regulator said that BDCs can use their net asset values as of Dec. 31—when valuations hadn’t yet been hit by the coronavirus crisis—to determine whether they’re in compliance with U.S. securities laws. Such a move must be approved by BDC boards and be announced publicly.
Prospect Capital and a couple of other BDCs have taken advantage of that allowance. But most BDCs face separate requirements from their banks that limit their leverage, according to Fitch Ratings. They could be forced to renegotiate contracts with their lenders, and it will likely come at a price, says Fitch analyst Meghan Neenan.
That is all the more reason for investors to take care when choosing BDC managers. More conservative investors may want to consider Owl Rock Capital (ORCC), which has low leverage and doesn’t pay management fees to a third-party manager, unlike many of its peers.
For more risk-tolerant investors, fund managers with experience investing in distressed debt could be worth a look, given the recent decline in loan prices and crunch on midsize companies’ financing.
Those conditions could give Oaktree Specialty Lending (OCSL) and Ares Capital (ARCC) an advantage, because they manage separate distressed-debt funds. The two BDCs are trading at roughly 51% and 64% of their Dec. 31 net asset values, respectively, with manageable leverage as well.
“Everybody’s going to have losses, everybody’s going to have defaults,” says Ryan Lynch, an analyst with KBW. “But you’re going to want to have guys who can work through those and not have too much strain on their platform.”
Write to Alexandra Scaggs at alexandra.scaggs@barrons.com
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