HTFC - BDC Weekly Review: Early Q1 Guidance Is Positive

2023-04-29 06:17:34 ET

Summary

• We take a look at the action in business development companies through the third week of April and highlight some of the key themes we are watching.
• BDCs were flat over the week. The sector has underperformed the broader income space since the start of the bank tremor in early March.
• Early Q1 guidance from a number of BDCs have been positive, supporting our view of solid Q1 results.

This article was first released to Systematic Income subscribers and free trials on Apr. 22

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 third week of April.

Market Action

BDCs were slightly lower this week despite some sizable moves over several days. Month to date, the sector is fairly flat as well with BBDC and TRIN underperforming and HRZN in the lead, alongside two BDCs - CSWC and MAIN - that have provided positive Q1 guidance.

Sector valuation has remained in a fairly narrow range of 89-93% over the last month or so after the sizable drop in early March on the back of the bank news.

Market Themes

BDCs have started providing some guidance ahead of the Q1 earnings season. Capital Southwest ( CSWC ) is guiding NII in the range of $0.64-0.65, an uplift from $0.62 in Q4. NAV is projected to be in the range of $16.30-$16.40 also up from $16.25 from Q4.

Main Street Capital Corp ( MAIN ) chimed in that it set new quarterly records for net income and NAV which is good news.

Elsewhere, the Golub Capital BDC ( GBDC ) said it made $157m of new originations in Q1. This is pretty low given its past track record but isn’t necessarily good or bad and could just reflect a low level of repayments which keeps capital tied up in existing loans and/or the desire by the company to keep leverage contained. Total investments increased by $34m which also doesn’t provide a lot of info in the absence of what happened to the debt but is suggestive of reasonably stable NAV.

Horizon Technology Finance ( HRZN ) said it originated $47m of new loans and $18m on a net basis. The combination of positive net new investments as well as replacing older with new loans should keep net income moving higher given credit spreads on private deals have risen by around 1% from 2021 levels. Apart from fairly high dividend coverage in the sector this is another factor which should cushion net income if short-term rates start to fall in the medium term.

Market Commentary

There was a question about a Wells-Fargo report on GBDC that implied there was a change in the fee structure - “The BDC now sends 20% of its pre-incentive fee NOI to the manager, roughly twice its historical level”. Basically what they’re saying is that because the company’s net income has risen (due to higher leverage and higher base rates), more of it is falling above the hurdle which accrues to the BDC as an incentive fee.

As many investors know, the way BDC fees work is that there are 3 levels of fees - the good old management fee which is applied to total assets (ex-cash), a net income incentive fee where the company takes all of the net income between X and Y% (for GBDC it’s between 8% and 10%) plus some percentage, usually 15-20%, above Y% and a net capital gain incentive fee which takes 15-20% of all net capital gains (possibly with some lookback).

WFC’s point is that because GBDC net income has risen (in part due to their proactive leverage increase) - as of Q4 it was 9.8% annualized - more of the net income is going to management i.e. the 1.8% above 8%.

That’s obviously fairly inefficient for BDC investors as they’re on the hook for higher leverage but don’t get the benefit of the higher net income (until it rises further above 10%).

That’s all true however you can make the same argument for many other strong BDC performers. Overall, it’s hard to get worked up about this as it’s a nice problem to have if the BDC is generating a lot of income which allows it to earn a higher incentive fee. The risk is if it’s doing that at the expense of asset quality. That doesn’t seem to be the case for GBDC yet (either now or historically).

Stance And Takeaways

BDCs have underperformed since the initial bank tremor in early March as the following chart shows.

A big reason for this is that interest rates have fallen across the board which has supported longer-duration sectors. Even preferreds which are the epicenter of the bank fallout, have outperformed BDCs in this stretch. Another possible reason for the underperformance is due to the drop in short-term rates and the expectation of a near-term Fed pivot (which would push net income lower) however this hasn't stopped loans from putting up positive returns in this period.

We expect the sector to put up another strong quarter over Q1, however the backdrop for the sector is turning less favorable as the positive net income impulse is coming to an end, borrower interest coverage is moving lower and bank loan defaults are increasing. We remain on the sidelines at the moment after lightening up on our sector allocation prior to the March valuation tantrum.

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