SLRC - SLR Investment Is Well-Positioned To Face Volatility

2023-09-21 00:35:00 ET

Summary

• SLR Investment is well-positioned to perform well in challenging conditions for the BDC industry in 2024 and beyond.
• Its portfolio expansion, financial flexibility, and a mix of floating and fixed-rate investments contribute to its potential to maintain financial and dividend growth.
• It might be the right time for investors to adjust their BDC holdings, given the potential for financial deterioration in the industry.

Despite the increasing risk of financial deterioration for the BDC industry in 2024 and beyond, SLR Investment ( SLRC ) is one of the companies that is well-positioned to perform well even in difficult conditions. Its portfolio expansion, financial flexibility, and a combination of floating and fixed-rate investments would help it sustain financial and dividend growth. Low accruals, greater portfolio diversification, and a strong risk-adjusted return for its loan categories would all contribute to future growth trends. Therefore, I am maintaining my buy rating for SLR Investment.

Challenging Conditions for BDCs

BDCs have performed exceptionally well in recent years due to increased demand for direct lending. The growth trend has accelerated in the last year as their floating rate portfolio has benefited from Fed rate hikes. However, as I explained in a recent article , these trends are likely to reverse due to potential rate cuts as well as defensive portfolio growth strategies.

For example, Carlyle Secured Lending ( CGBD ), with a 98% floating rate portfolio, is likely to see a $7.2 million negative impact on its net investment income from a 100 basis point rate cut . Furthermore, its portfolio value has been declining over the last two quarters due to a defensive investment strategy and high accruals. Wall Street anticipates a mid-single-digit earnings decline for Carlyle Secured Lending in 2024 and 2025. Similarly, Ares Capital ( ARCC ) made net commitments of only $80 million in the June quarter, and net funding was at $132 million, down massively from $2.2 billion and $1.7 billion in the year-ago period. Ares earnings are also expected to decline in the following years, according to Wall Street.

BDCs have not only raised their base dividends in the past few years but also offered healthy supplemental dividends. However, moving ahead, the majority of BDCs might find it difficult to provide supplemental dividends. For instance, CION Investment's ( CION ) dividend coverage ratio is likely to fall in 2023 and may reach a 100% level in 2024, compared to 179% in 2022 and 165% in 2021. There may be no room for supplementary dividends if the dividend coverage ratio falls below 100%. Overall, market fundamentals are likely to become difficult for BDC once the Fed begins to lower rates in 2024.

How is SLR Investment Positioned to Outperform?

With interest rates expected to decrease starting in 2024 and potentially normalize over the following years, it is critical for BDCs to implement portfolio growth strategies to mitigate the impact of these cuts on their earnings. SLR Investment seems to be in a favourable position to manage this impact and maintain positive growth due to its proactive investment strategies, a combination of floating and fixed-rate investments, and strong financial flexibility. Let's take a look at its portfolio strategies, portfolio credit condition, and financial flexibility:

Portfolio Growth Strategy

While many other BDCs have adopted a defensive strategy and their portfolio values are declining, SLR Investment continues to invest in growth opportunities. The company invested $393 million in the June quarter of 2023, up from $249 million in the previous quarter and $274 million in the year-ago period. It is also important to note that the June quarter investments are among the highest in the past year. This is because the company seeks to fully capitalize on attractive risk-reward opportunities arising as a result of economic uncertainty and turmoil in the regional banking industry.

For example, during uncertain economic times, demand for asset-based lending generally rises, and regional banking turmoil has made those opportunities more appealing. This is reflected in SLR Investment's weighted average asset yield of 14.6% on asset-based loans in the June quarter. The company invested $114 million in asset-based loans in the June quarter, increasing the asset-based loan value to just around $1 billion. Another important loan category for the company, sponsor finance or cash flow business, continues to produce solid results, with yields remaining around 12 to 13% compared to 7 to 8% in the prior year. In the June quarter, it made a $115 million sponsor finance investment in upper mid-market companies in noncyclical businesses with an average EBITDA of over $140 million.

The second-largest loan category in SLR's investment portfolio is equipment finance, with total investments just under $1 billion. Although equipment loans have lower yields than other loan types, strong credit ratings and the fixed rates on these loans are likely to benefit SLR when the Fed begins cutting interest rates. The company invested almost $150 million in equipment financing loans in the latest quarter, with investments in the pipeline increasing from the prior quarter. Overall, its fair portfolio value has been steadily increasing quarter over quarter due to its aggressive investment strategy.

Low risk and High Investment Flexibility

The company's portfolio management and strict underwriting policies have been contributing to lower accruals and steady portfolio growth. As of the end of the June quarter, only 0.3% of its investments were rated in category 4, meaning these companies stopped paying interest. Meanwhile, 99% of portfolio investments were performing above or according to expectations.

Furthermore, the company has significant financial flexibility to continue investing in growth opportunities. The co-CEO stated during earnings that its speed and execution in investing $150 million in an opportunity give it greater pricing power and influence. It also appears that SLR's funding profile is strong, with approximately $350 million in cash and cash equivalents and no debt maturities until the end of 2024. Furthermore, SLRC had approximately $600 million in available credit facilities to capitalize on the growth opportunities.

Investment Income Growth Prospects

The company has been generating robust income and earnings growth over the past two years, thanks to strong demand for direct lending and high fed rates. In the June quarter of 2023, its investment income and net investment income of $56 million and $22 million increased significantly from $42 million and $20 million in the year-ago period. Moreover, Wall Street estimates show that the company is likely to witness year-over-year earnings growth of 14% for 2023. Although the growth rates are likely to decline to a low single-digit percentage in 2024, its performance still looks impressive considering the negative growth from the majority of peers. Overall, portfolio growth and investments in high-yielding opportunities are likely to add new interest income and help offset the negative impact of rate cuts.

Quant Rating

With a quant score of 4.51, SLR Investment received strong buy ratings. The company earned solid grades on the majority of quant factors. However, its valuation score outperforms the other quant factors. Its stock is currently trading at around $15, which is down around 15% from its book value of $18. Moreover, the improvement in stock price momentum in the past few months demonstrates that the company's growth strategies and robust financial growth continue to attract investor interest. Although it received a C plus on the growth factor, the grade is still better than many industry peers who received C, D, or even F grades. For instance, Prospect Capital ( PSEC ) and Cion Investment received an F grade on the growth factor, while Ares Capital earned a C grade and FS KKR Capital ( FSK ) received a negative C grade.

In Conclusion

I believe it might be the right time for investors to make adjustments to their BDC holdings, given the potential for financial deterioration in the industry. Whereas BDCs with low accruals, healthy financial flexibility, and smart portfolio growth strategies are well-positioned to navigate these challenging conditions and generate healthy returns for investors. SLR continues to expand its portfolio at a healthy rate, and an aggressive investment strategy would open up the possibility of new revenue streams to help offset the effects of low interest rates.

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