TCPC - BlackRock TCP Capital: Best Of Breed In BDC Segment

2023-12-13 01:15:53 ET

Summary

• BlackRock TCP Capital is a BDC focused on achieving high total returns through current income and preservation of principle.
• The BDC segment is expected to benefit from a relatively restrictive interest rate environment and higher demand for private lending.
• The merger with BCIC will enhance TCPC's scale, reduce management fees, and improve its financial profile, while still persevering in a close match between asset and liability profiles.
• Despite its very conservative structure, TCPC currently offers a more attractive dividend (11.2%) compared to the BDC peer universe which is strongly backed by the underlying cash generation.
• In my opinion, TCPC's structure and its fully covered dividend should contribute to a meaningful alpha performance provided that the interest rates do not rapidly drop to very accommodative levels.

BlackRock TCP Capital ( TCPC ) is an externally managed business development company (or BDC) with an investment objective to achieve high total returns mainly through current income and preservation of principle.

As many of my readers have noticed, I have lately been actively covering BDC segment by exploring different players and ETFs in this segment. All in all, introducing some exposure to BDC factors in portfolios makes perfect sense in the context of current market dynamics.

The key tailwind that should provide structural support for BDCs is a relatively restrictive interest rate level for a longer period of time. While currently the market seems to price in some initial rate cuts in 2024, the overall trajectory of future Fed Fund's rate indicates that a scenario of falling back to extremely accommodative levels in the foreseeable future is limited. This is positive for BDCs as higher interest rates warrant higher spread capture and more pronounced demand for private lending.

The fact that the overall BDC segment has managed to outperform the S&P 500 over the historical 3-year period is a clear testament that during an environment of higher inflation and constrained access to conventional credit, there is a notable merit of injecting BDC exposure into investor portfolios.

With this backdrop in mind, in my view, TCPC is one of the most attractive names, which could serve the purpose of capturing BDC risk and return characteristics.

Thesis

Before we explore TCPC it is critical to take into account the recently announced merger with its affiliated BDC - BCIC. As a result of this merger, TCPC will ultimately enhance its scale (e.g., secure higher AuM volumes) and internalize the management process, which should lead to more optionality in the debt financing space and optimized operating costs.

For BDCs having a large scale is critical as typically these companies tend to embody a material concentration risk in specific issuers or sectors of the economy. Plus, considering that the underlying mechanism of how BDCs create value is by borrowing "cheap" and lending "expensive", the delta between the cost of capital and yield levels from channeled loans is key. By saving even a couple of basis points in the cost of capital front, the net effects should be quite meaningful given the sheer volume of transactions, which are supported by external leverage.

In terms of the management fee specifically, after the merger there will be a reduction from 1.50% to 1.25% for assets equal to or below 200% of the net asset value; which again should provide a direct benefit to the bottom line of TCPC.

Now, as a result of this merger and its materially of it, when assessing TCPC we should look at pro-forma figures .

In my view, one of the most important aspects of TCPC is almost nonexistent reliance on equity or mezzanine-type instruments as 91% of the total portfolio is placed in fixed-income products. This means that TCPC does not run a meaningful risk of potentially mismatched cash flows between assets and liabilities. Looking at the overall BDC peer landscape, we do not see this often, when the pure-play debt financing component is so dominant.

In terms of the fixed vs floating loan ratio, TCPC is also nicely positioned as the lion's share of the portfolio is comprised of loans, which are tied to SOFR or other variable pricing mechanisms. Carrying an exposure towards floating rate loans as a part of the asset base comes in extremely handy during high-interest rate environments, allowing TCPC to better capitalize on the spread between its cost of capital and loan yields (as the cost of capital for BDCs is significantly lower than those of mid-cap companies, which cannot access financing via conventional means).

After the merger, TCPC will carry an asset base of $2.4 billion consisting of 156 companies. Average investment in one single company falls below 1% of the total portfolio and looking at the individual sector exposures we do not see any major concentration risks. Granted, there are some more pronounced biases towards, for example, software and diversified financial services, but certainly not to a similar extent which tends to be embedded in other BDC vehicles.

Most importantly, post-merger TCPC is set to become a more deleveraged entity going from 1.01x in net leverage ratio to 0.96x. Plus, TCPC will possess $1.6 billion of leverage capacity and a combined available liquidity of $418 million (which includes cash component as well).

The fact that there is a combination of improved cost of capital and lower leverage base will benefit TCPC from two angles:

1. It will provide financial capacity to satisfy the incoming demand and thus continue to increase the underlying portfolio value in an organic fashion from which like-for-like EPS could be increased.
2. It will help keep the cost of financing as low as possible in the event of the first debt maturity, which is set to take place in August 2024. It is clear that TCPC will have to incur higher interest costs after this refinancing event considering that the relevant $250 million note is based on a 3.9% fixed interest rate, but, again, enhanced scale and improved balance sheet should offset some of the pressure. Otherwise, there are no debt maturities until 2026.

Finally, after the merger, TCPC will manage to further strengthen its dividend coverage due to the benefits associated with fee savings and lower financing costs. Plus, by deploying part of the available liquidity the underlying earnings should also continue to improve providing an additional boost on the coverage side.

As we can see in the table below, TCPC has constantly managed to accommodate its ~11.2% dividend with sufficient earnings generation, whereas in the case of too deep coverage, separate decisions have been made on tactically distributing special dividends.

The ~11.2% yielding dividend could be deemed as very satisfactory not only in absolute terms but also in the context of the average yield of BDC peers (e.g., ~10% The VanEck BDC Income ETF ( BIZD )) and solid dividend coverage levels.

The bottom line

Against the prevailing interest rate and macroeconomic backdrop, the overall BDC segment (including TCPC) is set to benefit from tailwinds that are associated with higher SOFR (contributing to higher portfolio loan yields) and constrained access of SMEs to regular financing (contributing to higher demand for TCPC products).

In a nutshell, TCPC embodies very interesting characteristics, which should help achieve alpha performance on a go-forward basis. The most important aspects are a truly diversified portfolio, a close match between assets and liabilities, and a strengthened financial profile stemming from enhanced scale after the merger with BCIC. On top of this, TCPC also offers ~11.2% dividend which is backed by already robust cash generation implying a meaningful layer of safety and relative attractiveness compared to the BDC space.

Finally, before going long investors have to be cognizant of TCPC's sensitivity to the interest rate dynamics, which as of now provide a favourable ground, to capture lucrative spreads between the cost of capital and portfolio yields. Nevertheless, in case the interest rates suddenly drop in an aggressive fashion and converge back to accommodative levels, TCPC just like most of the BDCs would be subject to serious downside volatility (as driven by exposure to floating rate loans, which will adjust to lower SOFR levels accordingly).

I rate TCPC as a buy.

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