HRZN - BDC Weekly Review: BDCs And NAV Mark-To-Market Concerns

2023-05-13 02:57:23 ET

Summary

• We take a look at the action in business development companies through the first week of May and highlight some of the key themes we are watching.
• BDCs finished the week lower as risk sentiment remained fragile.
• We discuss some of the criticisms of not fully marking assets to market in the private asset space.
• And highlight earnings from HRZN and FDUS.
• This week, we rotated back to FDUS from GBDC on the back of its recent price underperformance.

This article was first released to Systematic Income subscribers and free trials on May. 6

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company ("BDC") sector from both the bottom-up - highlighting individual news and events - as well as the top-down - providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the first week of May.

Market Action

BDCs ended the week down around 2.5% despite a rally at the end of the week and fairly strong earnings. TPVG led to the downside with a 17% drop.

TPVG has been underperforming the sector over the last few years so it was a mystery to us why it continued to trade at an elevated valuation. Its current 17% discount to book and a 7% discount to the sector average valuation (83% to 90%) seems much more sensible in our view.

The sector is fairly flat year-to-date though the variation around this return is very wide.

BDCs finished the week at a valuation of around 90% after dipping to a fairly attractive sub-90% range mid-week which caused us to marginally up our allocation.

Market Themes

It seems like marking-to-market is the theme du jour as many banks are caught up in a situation of large mark-to-market losses on assets they intended to hold to maturity.

Marking-to-market is a theme that also comes up in the context of private asset managers like BDCs that manage private credit and PE firms that manage private equity.

Specifically, there is a lot of skepticism about the valuation of private assets, less so in the good times but more in the "bad" times. For example, while BDCs had a NAV drawdown of less than 10% during the COVID quarter in 2020, loan CEF NAVs fell more than 20%. This is despite BDCs carrying higher leverage levels than loan CEFs as well as holding higher-beta assets lower down the capital structure such as warrants, common shares and preferreds. In this section we focus on a few criticisms posed by BDC NAV skeptics.

Many investors view the lower-beta profile of BDCs as an attractive feature. This is not just because a smaller drawdown is comforting; it also helps BDCs operationally. Specifically, a lower drawdown translates to a smaller mechanical rise in leverage which lowers the risk of a forced deleveraging and creates more room for the BDC to add new assets and grow the portfolio at attractive valuations when spreads rise.

However, there are also some potential downsides of this lower-beta NAV profile. One is that once investors recognize the lower volatility of BDC NAVs, that might push a lot of new capital into the asset class, lowering future returns. Investors may also demand a lower level of return going forward, expecting the risk profile of BDCs to be significantly lower than their public credit counterparts.

The second criticism is by failing to mark down the value of their holdings, BDC managers are collecting a higher level of fees than they "should". Specifically, because the management fee is earned on total assets (less cash), the lower the NAV drawdown, the higher the fee retained by managers. Moreover, a smaller NAV drawdown also potentially increases the net capital gain incentive fee.

The third problem is that credit issues are not recognized by investors until they have to be recognized. This means that often marks can go from par to 50% over a given quarter. This almost never happens in public markets because markets do a better job of sniffing out problem assets. Over the past year we saw large and sudden drops in valuations of certain assets across a handful of BDCs.

Fourth, failing to recognize lower NAVs, management deprives investors of adding new capital at a better price.

Fifth, it also keeps valuations overstated (at the same price level), suggesting that the sector is much better valued than it would be had NAVs been appropriately marked lower. This attracts capital to the sector and pushes prices even higher.

Sixth, it prevents companies from issuing new shares at prices that are more accretive to the NAV.

These are all perfectly valid criticisms in our view and investors should recognize them if they are honest about it.

Net net, however, these factors don't make BDCs uninvestable, not even close. A lower-beta NAV profile allows BDCs to run at a higher leverage and deliver more income to investors. It also mitigates forced deleveragings - something we saw a lot in the CEF sector over the past year but not so much in BDCs. And we haven't yet seen evidence that BDC returns have suffered (even adjusting for a higher-quality profile over time).

That said, this is all we need to keep an eye on as BDC investors to make sure a feature doesn't become a bug.

Market Commentary

Horizon Technology Finance Corp ( HRZN ) put together a decent Q1. Total NAV return was 1.8% as the NAV fell around 1%. Net investment income rose about 15% from Q4 (a smaller 6% from Q3). Dividend coverage remains very high at 140%. HRZN has performed pretty well over the past year however it has been inconsistent with an underperforming stretch in 2020-2021, ironically exactly when its valuation zoomed up to an unsustainable level.

The stock closed at a 102% level which is about 12% above the sector average, still fairly rich. It has occasionally dipped down towards valuation parity with the sector so that would be a good entry point.

Fidus Corp ( FDUS ) had a very good Q1. NAV fell marginally. Net income rose 18% and the company increased the supplemental dividend. FDUS has been a very consistent outperformer. It also enjoys an unusually low level of interest expense, having fixed most of its debt at a good time and having practically no credit facility borrowings. The gap between its asset and liability yields is more than 10% - a very high figure (sector average is 7%).

The stock's valuation relative to the sector has fallen from above 10% to about 5% when we decided to increase our allocation. It closed out the week at a 7% premium to the sector average valuation.

Stance and Takeaways

This week rotated back to FDUS from GBDC, reversing the previous FDUS to GBDC move in mid-March. Since the original switch, FDUS underperformed GBDC by around 6%. With another strong quarter behind it, a more attractive valuation and a higher dividend, we find FDUS once again a compelling asset.

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