WHF - BDC Weekly Review: The Holy Grail Of A Best-Of-Breed BDC

Summary

• We take a look at the action in business development companies through the fourth week of February and highlight some of the key themes we are watching.
• BDCs were flat on the week - a good result as all other income sectors were down on the back of upside inflation surprises.
• We take a look at whether a "best-of-breed" BDC concept makes sense.
• And highlight more earnings news.

This article was first released to Systematic Income subscribers and free trials on Feb. 25.

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 fourth week of February.

Be sure to check out our other Weeklies - covering the Closed-End Fund ("CEF") as well as the preferreds/baby bond markets for perspectives across the broader income space.

Market Action

BDCs had a decent week. Although the sector itself was flat, all other income sectors were down. A string of upside inflation surprises will likely keep the Fed hiking for longer than the market expected at the start of the month, something which weighed on markets this week.

Year-to-date, BDCs have rallied close to 10%, outperforming the rest of the income space. As we highlighted previously, rising net income and dividend hikes are keeping prices well supported.

The sector's overall valuation is creeping up towards 100% - close to its long-term average. Given the rally over the past couple of months we have been downgrading our Buy positions which were acquired at much lower prices to Hold .

Market Themes

It's easy to come across commentary about "best-of-breed" BDCs which can make for compelling and comforting reading. After all, if you could just find the "best-of-breed" BDC, there is no need to do much more research, freeing up a lot more time for the links.

However, when we hear about "best-of-breed" BDCs we are reminded of H.L. Mencken's comment "for every complex problem there is an answer that is clear, simple and wrong". The main issue isn't that the suggested "best-of-breed" BDCs aren't good BDCs, it's that there is no one breed in the BDC sector.

Imagine someone saying that a given CEF is a "best of breed". That obviously sounds insane because CEFs allocate to different kinds of assets so a CEF holding stocks simply can’t be compared to a CEF holding bonds i.e. they don’t have the same breeds to use the analogy.

The story is obviously different with BDCs but not a lot different. There are BDCs that hold practically no common shares or warrants and there are others that hold 15-20% stocks. There are BDCs that tilt primarily to first-lien loans and others that are happy holding second-lien, unsecured, structured and even securitized assets. There are BDCs that hold strictly private loans and others that are happy to dip into public markets for tactical and execution reasons. There are BDCs that allocate strictly to the lower middle-market segment (FDUS, CSWC) and there are others that allocate strictly to the upper middle-market segment or even above (ARCC, OCSL). There are BDCs that are focused on the venture space and others that stick with more traditional lending.

In short, different BDCs have fairly different business models even if they are all in the private lending business. If one type of strategy was obviously much more advantageous than all the others, you would see more BDCs move in that direction, bidding it down until the advantage went away.

Another important point is that a "best-of-breed" BDCs has an implicit suggestion that investors should just hold that one BDC. This obviously runs counter to the few solid investment rules which is to diversify one's exposure. There are many examples of high-flyers which then descended, if not outright crashed.

Finally, BDCs that are widely viewed as very strong performers usually trade at elevated valuation which often strips away much of their advantage because $1 of the stock's price buys much less than $1 of NAV for a BDC trading at an elevated premium. This is one reason why tilting to cheaper BDCs that are not yet recognized as strong performers can prove more successful.

Overall, in our view, it makes a lot more sense to allocate to strong BDCs with a different focus rather than to seek out a "best-of-breed".

Market Commentary

Main Street Capital Corp ( MAIN ) released Q4 numbers. Dividend was raised 2% despite net income rising 18%. NAV also rose 3.5% - another good result for investors.

This is all very good however valuation remains an issue for the company which soaks up nearly all of the outperformance. One way to think about it is that the company has generated 14.6% in total NAV terms over the last 3 years however the valuation shaves off 5.2% off that performance, leaving investors with 9.4% (the so-called Valuation-adjusted 3Y total NAV return).

This is the price return investors will get if the company delivers the same total NAV return in the next 3 years at the same valuation. This is actually below the sector median 10.1% which suggests that investors are expecting MAIN to drive an even stronger level of performance than it has already seen. That may be right but it feels priced for perfection.

The Owl Rock Capital Corporation ( ORCC ) saw net income rise by around 10% in Q4 though the base dividend remained the same (the supplemental ticked up by a penny). The NAV rose around half a percent.

Until a couple of quarters ago the stock underperformed the sector for 8 quarters running which finally started to sink in for market participants, causing its valuation to suffer, leading to poor total price returns. At this point the stock has done OK for 3 quarters and remains about 10% below the market average valuation so it’s finally worth a look in our view.

Fidus Investment Corp ( FDUS ) declared their dividend trio: base dividend of $0.41 per share (up from $0.36), a supplemental dividend of $0.15 per share, and a special dividend of $0.10 per share - same as the previous $0.25 paid out.

FDUS is no longer trading particularly cheap - there was a long period between 2018 and 2022 when it traded at a valuation below the sector average which is when it was added to the High Income Portfolio at a maximum allocation.

This subpar valuation didn’t make sense given its strong and consistent performance. It’s now trading 9% above the sector average valuation (108% vs. 99%) which makes more sense though based on its performance, it remains inexpensive.

Stance and Takeaways

Casting an eye across the sector, there have been a number of interesting valuation moves.

Blackstone Secured Lending Fund ( BXSL ) valuation has converged with the sector average after trading at a 5-10% lower valuation over the last 6 months. The stock is less of a slam dunk now so it’s downgraded to Hold.

Barings BDC ( BBDC ) has retraced to a 20% discount vs. the sector average which is much more reasonable than the 10% discount it traded at for about half of the previous year. It continues to deliver tepid performance.

WhiteHorse Finance ( WHF ) is also worth a look at a 9% discount to sector average (90% vs 99%). Historic performance is good though it struggled a bit in 2021. Last 3 quarters have been fine.

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