GBDC - BDC Weekly Review: Is PIK A Cause For Concern?

2023-12-22 22:28:07 ET

Summary

• We take a look at the action in business development companies through the third week of December and highlight some of the key themes we are watching.
• BDCs had a good week with a total return of around 1.5%, but underperformed the broader income market due to a low duration profile.
• The presence of PIK loans in BDC portfolios may indicate increased risk, but it's important to analyze the specifics of the PIK population.
• We highlight earnings results from NMFC, TRIN and TPVG.

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 December.

Market Action

BDCs had a good week with a total return of around 1.5%. However, the sector underperformed the broader income market as it didn't benefit from the drop in interest rates.

Month-to-date, the sector is close to a 4% gain with only one stock in our coverage in the red.

BDCs are up well north of 20% so far this year.

BDC valuations are close to their 18-month peak though well off the 2021 level.

Market Themes

Last week we got a question on the service of whether the amount of PIK loans in the BDC portfolio is indicative of increased risk of loans going bad. A PIK or payment-in-kind loan is one that, rather than repaying interest in cash, repays it in more principal by, in effect, increasing the size of the loan.

The proportion of PIK loans is a metric we track on the service and in our analysis of individual BDCs. For instance, the chart below shows the evolution of PIK income for the Golub BDC ( GBDC ) which can create a concern about its risk profile.

And in fact out of $934m of loans in the portfolio having a PIK feature (i.e. those with the feature - not necessarily being repaid as PIK), $86m were on non-accrual basis. In other words 9.2% of loans with a PIK feature were on non-accrual on an at-cost basis. This is relative to total portfolio non-accrual of 1.6% on an at-cost basis. This tells us there is an association between PIK and non-accrual so linking PIK to increased risk is not unreasonable.

However, there are several ways a loan can end up being PIK. One way a loan ends up as PIK is one where the borrower is struggling to repay cash and requests an amendment to switch to PIK. That is a signal for concern.

Another way a loan end up as PK is that it starts as PIK - several BDCS such as OCSL do this sometimes. It's better for the borrower because it doesn't require cash and it can be better for the lender because the loan grows organically (assuming the lender is happy to increase exposure) and the loan starts out at a higher rate than a cash repayment loan.

Overall, the presence of PIK is not necessarily a cause for concern. It's worthwhile digging a bit deeper to see the specifics of the PIK population. If the rise in PIK is due to credit risk issues, we should see an associated unrealized loss as well as an increase in the proportion of loans in the lowest-rated buckets. This broader understanding of the company's risk profile can help investors keep tabs on a given BDC.

Market Commentary

New Mountain Finance Corp ( NMFC ) declared a special distribution of $0.10 (in addition to previously declared $0.32 base and $0.04 supplemental dividends). This distribution is linked to a one-off net income gain from a single position. The company also said it extended its share repurchase program which is nice however it’s not clear it repurchased many shares during the previous program as its share count has grown.

Performance has been OK - longer-term total NAV returns are slightly better than the sector average. A string of net realized gains has also been good to see. On the downside, the portfolio is quite equity based with a couple of chunky positions.

Trinity Capital ( TRIN ) raised the dividend 2% to $0.50. The company added a massive 18% of new shares over the quarter via a public offering. Net income fell 5% however that was all due to income dilution from the chunky share issuance. This should normalize once the capital is leveraged and put to work over the coming quarters. Performance over the last year has been good however a string of realized losses remains concerning.

TriplePoint Venture Growth BDC ( TPVG ) remains an oddball in the sector. There is little doubt that the high yield of close to 15% (around 3% above the median BDC) attracts a lot of investors which is keeping its valuation above the sector average despite an absolutely horrific run over the last few years. The company has now underperformed the sector for 8 straight quarters and 12 of the last 13 quarters.

Non-accruals are at one of the highest levels of 11% at cost (5% on fair-value). Net realized losses keep coming - they were 7% in the last quarter. The company has underperformed the median BDC in coverage by over 7% per annum over the last 3 years in total NAV terms.

Stance And Takeaways

The new dot plot released by the Fed shows the governors expect 3 cuts next year and 4 the following year. If this transpires, it will shave off a significant amount of BDC net income.

However, there are a number of mitigants in place. One, the cuts, if they do happen, will do so over time and will feed into net income with a lag, allowing BDCs to keep generating relatively high net income for the time being. Two, BDCs were able to lock in low coupon levels on their bonds and these will take time to refinance. And three, valuations are not particularly expensive at the moment. Overall, while the Goldilocks 2023 period for BDCs is about to move behind us, the sector will still be much better positioned for shareholders than for much of the previous decade.

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