BIZD - BIZD: Negative Growth May Hinder Shareholder Return

2023-08-30 02:32:35 ET

Summary

• Business development companies are likely to face negative financial growth in the coming years, which could hinder shareholder return.
• Rate cuts could result in a substantial decrease in earnings for BDCs, while muted portfolio growth exacerbates the challenges.
• Financial projections offer limited support for the share price, leading to a high risk of underperformance on total returns.

In previous articles , I consistently praised the performance of business development companies and their ability to generate substantial returns due to favourable conditions and floating-rate portfolios. So far in 2023, business trends and investor sentiment have remained stable, with the VanEck BDC Income ETF ( BIZD ) generating a total return of 15% compared to the S&P 500's return of 17%. However, one emerging trend that requires attention is negative growth in the near to mid-term, which I believe could have a significant impact on investor returns.

Negative Growth Drivers

When the outlook signals sustainable financial growth over the long term, it means the business is performing well, end markets are strong, trends are favourable, and returns for investors are likely to increase. Rate cuts and muted portfolio growth are two factors that are likely to create negative growth for BDCs in the future.

• Rate Cuts:

After steady growth in the last decade, BDCs' financial growth amplified in the past four quarters due to the fastest rate hike spree in the past 40 years. However, it appears that the growth is likely to fade in the near term and turn negative in the mid to long term because rates have peaked and are likely to steadily move back to normal levels.

As rate increases have significantly accelerated income and earnings over the last four quarters, rate cuts would also have a negative impact. Ares Capital ( ARCC ), one of the largest BDCs with a 73% floating rate portfolio, could experience an 8.5% drop in earnings in the case of a 100 basis point rate cut. Companies with a higher percentage of floating loans are likely to take a significant hit. For instance, Carlyle Secured Lending’s ( CGBD ) 98% floating rate portfolio is likely to take a 12% earnings hit on a 100 basis point cut.

Some believed the Fed would begin cutting rates in early 2023, while others believe it will begin in mid-year. It makes no difference whether rates begin to fall two months earlier or later; what drives the market is investor sentiment, which is built on future growth trends. Investor confidence in the market declines when there is a downbeat growth outlook for any company or industry. The recent stock market trends are the best example of how markets react to perception well before those good or bad events actually occur. For example, the S&P 500 regained all of its 2022 bear market losses in the first half of 2023 due to optimism that the Fed will soon shift from a tightening policy even though there has been no official indication about the shift in policy. BDCs have also started underperforming compared to the S&P 500 due to a fading outlook. Year to date, BIZD shares are up only 8% compared to the S&P 500's gain of 15%.

• Muted Portfolio Growth

Portfolio growth is critical for long-term income and earnings growth. In particular, portfolio growth of BDCs gain more importance in the near to mid-term because a new revenue stream can help offset the impact of lower income due to rate cuts. However, it appears that the challenging market conditions and the increasing non-accrual risk have forced the majority of BDCs to adopt a defensive stance and be very selective about new opportunities. For instance. BIZD’s largest stock holding, Ares Capital’s portfolio value came in at $21.49 billion at the end of the June quarter, compared to $21.7 billion at the beginning of the year. The company made net commitments of only $80 million in the June quarter, compared to $2.2 billion in the year-ago period. Moreover, net funding was around $132 million, compared to $1.7 billion. Similarly, BIZD’s second-largest holding, FS KKR’s ( FSK ) portfolio value, plunged from $16 billion in June 2022 to $14.7 billion in June 2023. The decline is attributed to slower new investment activity and higher opportunistic portfolio sales and repayments. It invested only $363 million in new opportunities, compared to $803 million in the year-ago period. Prospect Capital ( PSEC ) ended the June quarter with a portfolio value of $7.6 billion, compared to $7.70 billion at the beginning of the year.

On the positive side, BDCs involved in venture lending continue to experience robust income and portfolio growth trends. For instance, Hercules Capital ( HTGC ) recorded an all-time high first-half gross funding of $834.8 million in 2023, an increase of 5.6% year-over-year. Overall, portfolio growth rates remained muted in the first half of 2023 as BDCs sought to retain money to avoid volatility in the event of economic instability and faster rate cuts.

Financial Projections

Financial projections for the BIZD’s top 10 holdings, which represent 74% of the portfolio, clearly show limited financial upside in the second half and negative growth in the following years. For instance, Ares Capital is expected to experience both year-over-year and sequential earnings declines in 2024. Moreover, forecasts show that the downtrend will accelerate in 2025, with expectations for an almost double-digit percentage decline from the 2023 level. Ares earned a C grade on growth factor, according to SA quanta analysis. Similarly, Wall Street expects FS KKR to report a mid-single percentage decline in 2024 earnings. Its non-accruals of 3.32% are also significantly higher than the industry average of 1.16%. Based on SA Quant analysis, it received a D+ grade for growth factor. Wall Street expects Blue Owl Capital Corporation ( OBDC ), Main Street Capital ( MAIN ), and Prospect Capital Corporation to report negative earnings growth in the coming years.

A High Risk of Underperformance on Total Returns

So far, BIZD has performed well when it comes to total returns. Its double-digit dividend yield helped offset the impact of share price underperformance. Its share price soared 9% year to date compared to S&P 500 gains of 16%. I anticipate limited share price upside potential in the following months of 2023 due to fading growth and increased downside volatility in 2024 due to negative growth. The share price performance of any stock or fund is linked to its future fundamentals and growth rates. In the case of BDCs, fundamentals and growth rates are likely to deteriorate. Share price drivers such as profitability, portfolio activity, and net asset value are all likely to worsen in the coming year.

However, there is still a low risk to BIZD’s dividends. The massive earnings growth in previous quarters would offer room to sustain dividends. Moreover, a large number of companies have adopted a strategy of maintaining base dividends at a lower level while sharing high profitability through special and supplementary dividends. This strategy enables the continuation of base dividends even in the event of greater-than-expected financial deterioration. For instance, Hercules Capital's second-quarter earnings provided 132% coverage of its newly increased base distribution of $0.40 per share. Ares Capital and Golub Capital ( GBDC ) also kept their base dividend payout ratio in the 80% range to net investment income.

In Conclusion

I’m not predicting a steep share price selloff in the near to mid-term, but I anticipate it might not be easier for BDC to generate market-beating returns. Fear of slow growth may be a major barrier to share price performance in the following months and years. The potential decline in other key metrics, such as profitability, non-accruals, and portfolio growth, is also likely to negatively impact the price's performance. Therefore, I’m downgrading my rating for BIDZ from buy to hold.

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