SAR - BDC Weekly Review: Canary In The Coalmine SAR Is Showing Signs Of Fatigue

2024-01-20 01:22:36 ET

Summary

• We take a look at the action in business development companies through the second week of January and highlight some of the key themes we are watching.
• BDCs were flat on the week, consolidating after a run-up late last year.
• The early-to-report Saratoga Investment Corp released Q4 results with a drop in net income and NAV.
• We marginally reduced our BDC position in light of fairly rich valuations in the sector.

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 second week of January.

Market Action

BDCs were roughly flat on the week as the market appears to be consolidating after a sharp run-up late last year. Month-to-date, the sector is up around 2.5% so far.

BDC valuations pushed above their historic average to around 106%.

Market Themes

Saratoga Investment Corp (SAR) has reported Q4 results. Recall, SAR is the "canary in the coalmine" of the BDC sector as it reports much earlier due to its unusual quarterly schedule which provides investors with a sneak peek covering two months (in this case October and November) past the previous calendar reporting period used by nearly all other BDCs.

The news is that the canary is showing signs of fatigue. SAR adjusted net income fell around 6% from the previous quarter. The NAV also fell close to 4%.

Some of this is optical as, for example, the drop in net income was primarily due to the dilution from a new share issuance - SAR issued 1.2m shares over the quarter. Issuance-driven net income dilution is a temporary phenomenon and can be made up in short order once the new capital is leveraged and put to work.

The drop in the NAV, on the other hand, was "real", driven by a 4.8% unrealized depreciation as a result of markdowns across several positions. One additional position was moved to non-accrual alongside the markdown as well.

This is not a great result however it's mitigated by a couple of factors. One, SAR has an unusually high level of leverage in the space so any portfolio issue gets magnified. Two, some of the markdowns were across equity positions which are going to be more volatile than debt holdings. Three, markets continued to rally since the end of November and this would normally have a positive impact on BDC NAVs which is not captured in the SAR figure.

Ultimately, SAR portfolio issues are worth keeping an eye on but it's too early to say if they are indicative of broader issues across BDC portfolios. BDC portfolios have held up relatively well over the past couple of years however short-term rates may be finally hitting the pain point which could drive significantly more non-accruals in the sector. This tipping point remains a key risk for the sector.

Stance And Takeaways

This week we marginally downsized our BDC allocation in light of fairly rich valuations and tight credit spreads. We continue to favor floating-rate allocations across income portfolios due to the strongly inverted yield curve as well as a large number of rate cuts already priced in by the market. We expect BDCs to offer more attractive entry points through the year.

For further details see: