2023-11-14 10:00:00 ET
Summary
- Business Development Companies (BDCs) with predominantly floating rate portfolios will benefit from higher interest rates, bringing in extra income.
- Golub Capital is a conservative BDC with a focus on first-lien loans and a well-diversified portfolio. Additionally, they trade at a slight discount to their NAV price.
- Sixth Street Specialty Lending and Hercules Capital are also strong BDC options with first-lien focus and solid financials.
- BDCs, once considered to be risky investments, have strengthened their credit profiles over the years, making them attractive investments for the long term.
- In a higher for longer environment, many BDCs will likely continue to face headwinds with rises in non-accrual loans.
Introduction
It's apparent now that investors believe the FED when they stated that interest rates would be higher for longer. They've been singing this tune for a while now but it is now starting to resonate throughout the market. And while some businesses may not enjoy this, there are some that will. Those that will are Business Development Companies, or BDCs. The main reason is their predominantly floating rate portfolios. Most know they borrow at fixed rates and lend to their portfolio companies at floating rates. So while rates are higher for longer, these BDCs will benefit, bringing in extra income. They've enjoyed this over the last year and this has caused some of their prices to appreciate or at least avoid a decline in share price.
I wrote an article last week where I ranked 5 BDCs on their chances of surviving an economic downturn. To be clear, all 5 are high-quality but someone has to be number one. So I tried to do my best ranking them accordingly. Maybe some took this as I didn't like the lower rated ones. That's the furthest from the truth as I hold positions in four of the five. So, for this article I decided to do it differently, and not rank them. Instead list 3 additional ones that investors looking to benefit from the macro environment can buy, or add to their watchlist. So while some companies may be struggling and continue to while interest rates are elevated, these companies will only continue to benefit.
#1 GBDC
I've decided to list these BDCs based on their first-lien focus. As holders of business development companies, first-lien focus a very important metric when looking at investing into them. Golub Capital ( GBDC ) actually reminds me of Ares Capital ( ARCC ) a bit. One reason for this is they also appear to be fiscally conservative. As many BDCs have paid out their extra income in specials and/or supplementals, GBDC has only paid a supplemental once since the start of rate hikes.
Several peers like Blackstone Secured Lending ( BXSL ) & Capital Southwest ( CSWC ) paid out several over the same period. One thing GBDC has done since the start though was raise its dividend by double-digits twice. The first time by 10% from $0.30 to $0.33, and another 12% raise to $0.37. While they don't seem to be as shareholder friendly as others, I actually prefer those who are more conservative.
Call me biased, but I'm a conservative person myself, so I enjoy this. ARCC is similar because they prefer to rollover spillover income into the next year. Then use this to cover their dividend while retaining more income to prepare to roll it over the next year. This is very important because they can use this to cover its dividend, or the extra can be used to make new investments.
With the exception of appearing more conservative, GBDC differs from ARCC quite a bit. The biggest difference is their focus on first-lien loans. 94% of GBDC's portfolio is invested in first-lien, senior secured debt. They're also invested in wider range of industries as well. As of the 3rd quarter, GBDC had a total of 333 companies across more than 40 industries. Their total portfolio of companies is much higher than the BDC average of 181 (companies), so GBDC is well-diversified. Additionally, this diversification has given them the lowest volatility of quarterly loss rates at less than 1% compared to the rest of the BDC industry.
Like many of its peers, GBDC also has a large portion of its portfolio invested in the Software and Healthcare Providers & Services sectors. Additionally, they also have 40 industries accounting for less than 3% of their portfolio, showing their diversification.
They've also posted some strong growth this year. During last quarter, adjusted net investment income grew nearly 5% from $0.42 to $0.44 quarter-over-quarter. NAV also grew $0.10 from $14.73 to $14.83 over the same period. So as you can see, the BDC has been safely covering its dividend, even with the supplemental of $0.04. In Q4, which the company reports later this month, NII is expected to grow between 11% to 16% to $0.49 to $0.51. NAV is also expected to grow as well to $15.00-$15.04, which is very impressive. So while they've elected to be more conservative with the specials and supplementals, they're expecting some double-digit growth to go along with those double-digit dividend increases.
However, as I mentioned in the previous article, BDCs biggest risk is non-accrual loans. As rates rise, sometimes non-accruals experience a rise as well. At quarter end they had 9 companies on non-accrual status and this is expected to remain the same when they report Q4 earnings. This is an increase from 8 that they had in Q1 of this year, but this only represents 1.5% of their portfolio, well-below the BDC average. But in a higher for longer environment, this number could rise further.
GBDC's balance sheet is also conservative. They have well-laddered debt maturities and significant available liquidity, making them very capable of navigating the macro environment. They have $500 million in debt due in April of next year. This has a weighted-average interest of 3.375% so they will likely have to refinance at a higher rate. But with their $898 million in total liquidity and IG ratings from all 3 rating agencies, GBDC will be just fine. Furthermore, they have $100 million in debt maturing in 2025 and a weighted average cost of debt of 5.1%, lower than the peer average of 6.3%.
#2 TSLX
Second on the list is Sixth Street Specialty Lending ( TSLX ). They're a little smaller than their peer GBDC with a market cap of $1.8 billion. They also a total of 131 portfolio companies with 91% of them being first-lien. Like many other BDCs, they also have a focus in the Internet, Business, and Retail & Consumer Products. Nearly all of these are floating rate investments at 99.7%, similar to GBDC who has 100% floating rate portfolio. So as you can see, these two have benefited significantly from the macro environment.
Over the past year TSLX has been growing its portfolio at a steady pace; growing from 118 a little more than a year ago to now, an increase of 11%. NAV has also grown from $16.74 to $16.90 quarter-over-quarter. One way BDCs do this is by out-earning their dividend, generating excess NII. TSLX grew its NII from $0.53 to $0.57 from Q1 of this year to Q3, and from $0.47 year-over-year. Although in Q3 NII did drop a penny from Q2, this was well-above their dividend of $0.46, and the supplemental of $0.07. Adjusted NII was $0.03 higher at $0.60. This difference was a non-cash expense related to the accrued fees on unrealized gains.
Non-accruals are also minimal at just 0.7% of their total portfolio value. But as I mentioned earlier, this will continue to be a headwind for BDCs going forward. During earnings, management stated they expect the lagged impact of higher rates to play out across portfolios, likely causing an increase in defaults. One way to combat this is by having ample liquidity. TSLX had nearly $1 billion on a secured revolver. Furthermore, they have well-laddered debt maturities as well with none due until late next year. In November they have $348 million in debt due with a weighted-average interest rate of 3.875%, so like GBDC, they'll likely have to refinance at a higher rate.
Besides November of 2024, they have no debt due until 2026. One thing of note is BDCs have done a great job of strengthening their credit profiles over the years, and reducing their leverage. TSLX's debt-to-equity ratio stood at 1.15x, below the regulatory limit if 2.00x. With this and the tighter standards for banks, this will only continue to benefit them in the future. Many investors deem BDCs as risky investments, but they're as strong as ever now. And in my opinion this will attract more investors down the line, especially if banks continue to experience stricter capital requirements.
#3 HTGC
Lastly, I discuss Hercules Capital ( HTGC ) with 87.3% of its portfolio concentrated in first-lien loans. They also have a lower percentage of floating rate loans compared to the other two with 95.5%. A huge difference between HTGC and others in the sector is they tend to focus on the Technology, Life Sciences, and Sustainable & Renewable Technology industries. Second-lien senior secured debt accounts for 10.4% of their portfolio, and 95% of this HTGC has the right to buy out the first-lien holder. At the end of the quarter their portfolio companies stood at 106. They also have warrant and equity holdings in companies like Palantir Technologies ( PLTR ), Lyft ( LYFT ), and DoorDash ( DASH ) to name a few.
Like its peers, HTGC has also benefited from the environment growing its total investment income. Year-over-year this grew from $84.229 million to $116.744 million, up over 38%. Additionally, during Q3 earnings, they beat analysts' estimates by $0.03 and by $4.19 million. Net investment income was up 58% over the same period, a company record of $76.8 million. This was the fourth consecutive quarter of HTGC delivering record NII. Furthermore, HTGC out-earned its $0.40 dividend and $0.08 supplemental. Also, during the quarter the BDC added one company on non-accrual, bringing the total to 2. This accounts for only 0.8% of their total portfolio value, which is impressive considering the environment.
Additionally, HTGC is the only BDC on this list to report a decrease in NAV. During Q3 they experienced a slight decrease to $10.93 from Q2, but up from the beginning of the year.
HTGC also has a strong balance sheet with IG credit ratings from Fitch & Moody's. They only have $105 million in debt due next year and $900 million in liquidity. They also have debt due in 2025. 2025's total is slightly higher at a total of $130 million and this had an average interest rate of 4.28% and 4.31% respectively. 2024 is slightly higher at 4.77%. So as you can see BDC balance sheets remain strong with most being well-positioned to navigate the macro environment.
Valuation
Many BDCs have experienced their prices rise over the last year, causing them to trade at premiums to their NAV. TSLX was recently downgraded due to their valuation, as analysts' see limited upside from here. At the time of writing GBDC is the only one trading at a slight discount to its NAV. HTGC trades at the larger premium at nearly 46% while TSLX trades at a near 22% to its NAV price. All three offer single-digit upside to their price targets, leaving no margin of safety for investors.
I expect this to continue as we go into 2024 and while rates remain elevated. However, long-term investors may consider dollar-cost averaging in at these prices. Like I previously mentioned, BDCs are now stronger than ever, and not the risky investments they once were deemed to be in my opinion. But as rates are expected to decline sometime in 2024, so I do see their prices coming down as many rotate out into other sectors. If you're looking for a 15% to 20% margin of safety, I suggest you wait, and add on any signs of share price weakness.
Bottom Line
BDCs have benefited from the current macro environment causing many to trade at significant premiums to their NAV prices. I expect this to continue going into 2024 and many to continue rewarding shareholders in the process. Due to tighter capital requirements from banks, and BDC strong liquidity profiles and debt maturities, I consider these to be long-term investments, and not the risky ones they were considered once before. When rates do eventually get cut, I expect many BDCs to eliminate their supplementals and/or specials while maintaining their regular dividends. With the higher for longer environment, several BDCs may experience additional rise in defaults, so it's very important for investors to do their due diligence, and invest in those who are well-diversified, with strong balance sheets. For income oriented investors, these offer stable, and growing dividends for the long-term. And those looking to invest into the sector should add on any signs of weakness.
For further details see:
3 High-Quality BDCs For A Higher For Longer Environment