HRZN - BDC Weekly Review: Why Do BDCs Bother With Special And Supplemental Dividends?

2023-11-10 19:54:18 ET

Summary

• We take a look at the action in business development companies through the first week of November and highlight some of the key themes we are watching.
• BDCs experienced a sharp bounce with the sector rallying around 7% on the week.
• Many BDCs pay out base, supplemental and special dividends - we discuss why this complex trio of dividends is used.
• Horizon Tech attributed a 6% drop in NAV to "stressed investments".

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 November.

Market Action

BDCs enjoyed a sharp bounce as the end-of-Fed-hikes theme pervaded the market, lifting all major income sectors. All BDCs in our coverage finished the week in the green with the sector jumping around 7%. Much of the rally happened in November, driving the sector return on the month to nearly 6%.

The sector spent only a short while trading at an average valuation in the low 90s before returning quickly to 100%.

Market Themes

This week there was a question on the service of why do BDCs bother with supplemental and special dividends. Many BDCs pay out all three types of dividends. For example, the Fidus Investment Corp ( FDUS ) has paid all three types over the past year.

There are no hard and fast rules but for many BDCs the base dividend is roughly what the company expects to pay out through the cycle regardless of where rates are. The supplemental / special is intended for any net income over and above this base run-rate and includes any one-off capital gains.

BDCs don’t like to cut dividends - they are aware that they are used by retail investors as quasi pensions. MAIN and ARCC, for example, have never cut the base dividend and this is something they take seriously and highlight often. To mitigate the likelihood of dividend cuts, BDCs resort to various techniques such as carrying high levels of coverage and using supplemental / special dividends.

Carrying high coverage alongside supplemental dividends is what allows them to keep the base dividend level despite net income being sensitive to short-term rates. If net income moves lower, the BDC can cut or cancel the supplemental while claiming that it has continued to pay out the same base dividend.

Obviously, this is somewhat smoke-and-mirrors. Ultimately, what protects the dividend is maintaining a high level of portfolio quality which minimizes portfolio losses. This focus on underwriting quality is the key criterion of BDC allocation.

Market Commentary

Horizon Tech ( HRZN ) released results. The company declared the same base dividend of $0.11 monthly but also added a supplemental of $0.05. The NAV tumbled 6% which the company attributed to "stressed investments".

HRZN has consistently traded at a considerable premium to the sector which remains a bit of a mystery given its middling performance and is one reason why it's never been in the Income Portfolios.

The last year or so has been particularly hard on it as it had seen a series of substantial net realized losses, including the most recent quarter.

This consistent level of portfolio losses is likely a result of flaws in the underwriting process. However, it could also be due to bad luck since the company’s debt portfolio is unusually small at just 56 loans - about a third of the sector average.

A handful of issues due to bad luck is certainly possible. This is why larger BDCs like ARCC, which has 490 loans, can provide a cleaner read in a "law of large numbers" kind of way as to its underwriting process. This can give investors a better read on how the company’s underwriting process works and what they can expect in the future.

Stance and Takeaways

The attractive BDC environment did not last very long unfortunately. Earlier in the week we managed to sneak in a top-up to our BDC allocation in the form of Ares Capital ( ARCC ) as well as a couple of relative value rotations, all of which are so far in the green. If this rally continues we will have to pare our allocation once again while holding out for a better entry point. Q3 earning results have, so far, been fairly positive so we wouldn't be surprised by further gains through November.

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