HRZN - BDC Weekly Review: What Will Happen To BDCs When Rates Move Lower?

2023-08-12 07:22:44 ET

Summary

• We take a look at the action in business development companies through the first week of August and highlight some of the key themes we are watching.
• BDCs were flat on the week which was good enough for one of the best results in the broader income space.
• One question on the minds of investors is what will happen to BDCs once base rates move lower.
• We highlight results from HRZN and NMFC.

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 August.

Market Action

BDC returns were roughly flat this week, however, this was good enough to be at the top of the broader income space. Good earnings results continue to support the sector. Year-to-date, the sector is up around 17% - a great result for investors.

The sector valuation is right on top of its longer-term average of 103%. The growing consensus for a soft landing has priced out any margin of safety.

Market Themes

Short-term interest rates are tipped to fall over the next few years, as gauged by both the market consensus as well as the Fed dot plot. A question we keep receiving is what does this likely drop in rates mean for the BDC sector?

One mistake investors commonly make is to mechanically extrapolate the change in a market factor like interest rates to asset performance. If we use this logic then lower short-term rates will translate into lower interest income across the sector and this will likely pressure prices and valuations.

However, a better way for thinking about market events like changes in rates is to consider what the broader market environment will likely look like when short-term rates drop.

The answer here is more complicated. This is because there is not a single market scenario which will see lower short-term rates. If short-term rates are lower because the economy has entered a recession (i.e. the hard landing scenario) then not only would we see a drop in interest income due to lower base rates but also from an increase in non-accruals. We are also likely to see a drop in NAVs due to widening credit spreads. BDC valuations and prices would likely drop sharply for all these reasons as well as the general souring of sentiment.

On the other hand if short-term rates are lower because of a continued disinflation in an environment of still decent economic growth (i.e. the soft landing scenario) then we are likely to see something very different.

Net income may fall but not as sharply as it would in the hard landing scenario because a drop in interest income could be partly or mostly offset by an increase in fee income (green bars below for ARCC) which has been subdued for some time. Deal-making appetite could easily come back from a stabilization in activity and inflation and this would drive fee income higher.

At the same time, non-accruals and credit spreads should remain stable, leading to pretty flat NAVs. Valuations in this scenario could also be flat or even rise from current levels.

Overall, there is no mechanical throughline to what BDCs will do in case of lower short-term rates. Much depends on the actual scenario in which rates move lower. We shouldn't forget that it's also entirely possible that short-term rates remain elevated for some time or fall only a little bit. Investors who allocate to BDCs on the basis of short-term rate forecasts may be better off using current valuations (both BDC valuations as well as valuations of underlying credit assets) as their guide.

Market Commentary

Earnings continue to come out at a fast clip. Here we highlight a handful of companies that we are following.

Horizon Tech Finance (HRZN) reported a drop in the NAV of 2.4%, resulting in a disappointing total NAV return of 0.5% in Q2. Net income jumped by 17% and current coverage is 161% while the spillover is high at $1.02 - worth three quarters of the regular dividend. We should see a dividend hike or a supplemental dividend later in the year.

HRZN has been a bit wobbly in its performance. It had a nice run in 2022 but will underperform for the second quarter in a row. It had a stretch of 5 underperforming quarters post COVID as well, so it's no stranger to dry spells.

Given its middling performance, we highlighted on the service that it looked very expensive to us near its recent 120% valuation. At that level its valuation was not much different from [[TSLX]] whose performance is miles ahead of HRZN. Since then, the two stocks have diverged quite a bit on the back of a Compass Point downgrade of HRZN and a great quarter from TSLX.

New Mountain Finance (NMFC) reported good results. NAV was flat and net income rose 8%. The company is a bit of an unsung overachiever. It has outperformed the sector but often trades below the sector average valuation as it does now.

It has also achieved cumulative net realized gains, in part due to its relatively large common equity portfolio. One risk is that its largest positions are quite chunky with Edmentum around 8.5% of NAV which creates some idiosyncratic risk.

When we first reported on its results, we noted that the 5% valuation differential to the sector (97% for NMFC vs. 102% for the sector) was quite attractive. At that level, the valuation spread percentile was 27%, meaning the company's valuation spread of 5% below the sector average has only been wider (i.e. 6% and more below the sector average) 27% of the time. Since then NMFC closed the gap somewhat to 3%. We would wait for a pullback to add to the name.

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