2023-09-01 07:00:00 ET
Summary
- BDC reach has expanded to include more opportunities and potential clients.
- Almost any size and type of company can now benefit by working with a BDC.
- BDCs lend to companies that cannot readily access traditional lenders for some reason or another.
- In exchange for that financial access, these companies pay LIBOR +500 to +1,000 in annual interest expense.
This article was coproduced with Williams Equity Research.
Thursday, Aug. 24, 2023, started out on such a bright note for the U.S. stock market.
The S&P 500 was in the green. The Dow was in the green. The Nasdaq was in the green.
The Russell 2000, admittedly, was not. But who pays attention to small stocks anyway? Especially when Nvidia ( NVDA ) just reported amazing results.
Long live the future filled with AI-driven profits! Right?
Expectations for the graphics chip giant were already immense. Yet when Nvidia released its second quarter data after the bell on Wednesday, it still managed to stun.
To quote Yahoo Finance on the subject:
"The company reported revenue of $13.51 billion, a 101% jump from last year, while adjusted earnings came in at $2.70 per share, up 429% from last year. Analysts had expected revenue to come in at $11.04 billion, with earnings per share [totaling] $2.07, according to data from Bloomberg."
Moreover:
"Nvidia also issued current quarter revenue guidance of $16 billion, plus or minus 2%, far outpacing Wall Street's already lofty expectations for $12.5 billion in revenue."
It therefore shouldn't be any surprise that "shares of the graphics chipmaker rose as much as 9% in after-hours trading on Wednesday to a record high of $515 per share."
It was still in the green by the time the actual market session closed on Thursday, but only by so much. We're looking at a price of $471.63, up just 0.10% over its pre-announcement price.
Why the curbed enthusiasm?
You can thank the Fed for that.
High Hopes and Fed Focused
The stock market has certainly been filled with overall optimism this year concerning the Fed's rate-hike policies.
"It's going to pause."
"It's going to stop!"
"It's going to retreat!"
Those (and, yes, AI) have been the mantras pushing the stock market forward in 2023. But then there are those days when that optimism runs dry, especially during a month that has shown much more sour than sweet.
To quote another Yahoo Finance article:
"Stocks reversed lower on Thursday as another blowout quarterly earnings report from Nvidia… couldn't overcome new comments from the Federal Reserve suggesting interest rates will need to remain elevated for a long period of time to bring inflation down…
"In an interview with Yahoo Finance's Jennifer Schonberger on Thursday, Boston Fed president Susan Collins said it is 'extremely likely' the central bank will need to hold interest rates high to bring down inflation."
The result of those remarks sent the:
- S&P 500 down 1.35% to 4,376.31
- Dow down 1.08% to 34,099.42
- Nasdaq down 1.87% to 13,463.97.
As for the Russell 2000, it was down 1.27% to 1,846.28, in case anyone cares.
I say that tongue in cheek because I'm about to address another area of the market that receives little comparative attention: Business development companies, or BDCs. These financial organizations don't tend to make the headlines as a general rule. But…
They're also less likely to climb sky high based on hopes and dreams, only to come crashing down hard later when some external source says something undesirable.
Basically, BDCs are safe, stable, "boring" investments, which sounds pretty nice right about now. Better yet, they're dividend stocks, which means they'll keep paying you regardless of whether the markets are up or down.
And best yet? Like the real estate investment trusts (REITs) I normally write about, BDCs must pay out 90% of their profits to shareholders.
Need I say more?
Explaining BDCs Before I Recommend Them
Don't worry. That last question was tongue in cheek again. Of course I need to say more, starting with the exact ins and outs of what a BDC is.
For that, let me describe this type of investment as:
"… an organization that invests in small- and medium-sized companies as well as distressed companies. A BDC helps the small- and medium-sized firms grow in the initial stages of their development. With distressed businesses, the BDC helps the companies regain sound financial footing."
In the beginning of their existence, this financial recourse was really only for a limited number of companies. But like the definition of a REIT, BDC reach has expanded to include more opportunities and potential clients . Almost any size and type of company can now benefit by working with a BDC.
Probably not giants like JPMorgan Chase ( JPM ), Ford ( F ), Eli Lilly ( LLY ), or the aforementioned Nvidia. But a lot of businesses, nonetheless. Basically, BDCs lend to companies that cannot readily access traditional lenders for some reason or another. In exchange for that financial access, these companies pay LIBOR +500 to +1,000 in annual interest expense.
For those of you unfamiliar with LIBOR, it's actually being phased out, and is nothing more than the rate global banks use to borrow money from each other.
Thanks to Dodd Frank and other legislation, as well as ramifications from the Great Recession, a very large swath of U.S. companies cannot readily access bank loans. As a result, BDC assets under management ('AUM') has risen dramatically.
And with that growth comes a lot of investor potential as well.
BDCs Income for Life
In case you missed it, I wrote about REIT Income For Life a few days ago and that article performed well with many interested readers.
In that article I highlighted three of my favorite REITs: Realty Income ( O ), Agree Realty ( ADC ), and Mid-America Apartment Communities ( MAA ). So, without further ado, let's get started with BDC Income For Life.
Blue Owl Capital Corp ( OBDC )
Formerly Owl Rock Capital Corp., Blue Owl's ( OWL ) BDC has a lot going for it. Blue Owl Capital Corporation's loan portfolio is 72% first lien senior secured loans and 14% second lien.
As a reminder, first lien is equivalent to "first rights" to a company's assets. Compared to owners of corporate bonds, lenders of first and second lien loans have considerably more control over the company. That's one reason why the better BDCs have loan losses significantly below that of high yield bond benchmarks.
This is interesting to us as investors for two reasons.
First, using the SPDR Bloomberg High Yield Bond ETF ( JNK ) as the benchmark, first and second liens and the BDCs that originate them currently yield 50% higher . Second, good BDCs like Blue Owl Capital Corp have lower loan losses than those same benchmarks. Less risk with more reward isn't easy to find in the markets.
The stats improve further with the best BDCs. We call these "Tier 1" and provide subscribers a list of all Tier 1, 2 (mid-grade) and 3 (low quality) updated at least quarterly.
These Tier 1 BDCs have loan losses similar to the lower end of investment grade bonds. Historically and today, the loans most BDCs own yield 80% higher than the lower end of investment grade bonds. This is one reason why both retail and institutional investors have increased their exposure to private credit, of which BDCs play a big role.
The remaining 14% of Blue Owl Capital Corp's portfolio is spread across unsecured debt, preferred equity, and common equity investments. These are generally higher risk, higher reward opportunities that aim to boost the share price long term.
Of all BDCs, Blue Owl Capital Corporation has one of the most conservatively built portfolios thanks to its nearly 90% exposure to the safest loan types. The advantages don't stop there.
The portfolio is 98% floating rate . As interest rates go up, so does the interest charged on the loans Blue Owl Capital Corporation makes to private U.S. companies. As you can imagine, this has been extremely beneficial recently.
Blue Owl Capital Corporation is the third largest BDC by market cap and is well diversified. Its top 10 positions are less than a quarter of the portfolio. Industry diversification also is strong with the top three - Internet software and services, Insurance, and Food and beverage - totaling less than 30% of the portfolio.
This isn't by accident. Blue Owl Capital Corporation had a similar strategy going into the pandemic. Few of its loans had serious issues, and it was able to keep making hefty dividend payments when many other companies were forced to cut their dividends.
The portfolio stood at $12.9 billion at the end of last quarter with 187 private U.S. customers as borrowers.
Cash Flow and Dividend
The company's $1.32 per share annual dividend equates to a 9.7% yield at the current share price around $13.50. Including special dividends, it's a little over 10%.
Net investment income ('NII') is a popular way to measure BDC cash flow. NII was $0.48 per share in Q2, up from $0.45 at the end of Q1. I've been following Blue Owl Capital Corporation since before it was even a public company. It has never missed or reduced a dividend payment.
Management achieved that great track record by following two rules. The first is building a conservative portfolio designed to stand the test of time. The second is a prudent payout ratio.
In Q2, for example, the regular dividend was $0.33. While it's not necessarily unsafe for a BDC to have a near 100% payout ratio, Blue Owl Capital Corporation's dividend results in a 69% payout ratio. What happens with the extra money?
The board of directors periodically pays bonus dividends to investors. Just last quarter, the Board approved a $0.07 per share bonus dividend. Overall, OBDC has one of the safest dividends in the BDC sector.
Blue Owl Capital Corporation does something not many other BDCs do. It consistently buys back shares at attractive prices. Given how high the dividend yield is, buying back stock can make a lot of sense.
In the first half of the year, the company bought back $75 million of common stock. It's rare that management of public stocks are good traders, but Blue Owl Capital Corporation is the exception. Its average stock buyback price was $12.22 per share, or 9.5% below current levels.
Balance Sheet and Risk
As of last quarter, a total of three portfolio companies were on non-accrual. That means they had issues paying interest or debt in full and on time. That's only 0.9% of the portfolio by fair value.
Blue Owl Capital Corporation's debt to equity ratio finished last quarter at 1.14x. Anything below 1.20x is a conservative number historically and vs. peers. The company is one of only a handful of BDCs with four investment grade credit ratings from the major rating agencies. It's at the bottom of investment grade, but that still ties the other top BDCs for first place.
There's yet another area that Blue Owl Capital Corporation stands out. Its liquidity was $1.8 billion last quarter, or approximately one third of its entire market cap. And that's not cash it needs to pay off any near-term debt.
In fact, the company has no maturities left in 2023 and only a small amount in 2024 and 2025. This is a very smart move as there's a good chance interest rates will be lower by the time a large percentage of Blue Owl Capital Corporation's debt needs to be paid off or refinanced.
This is yet another way that the company benefits if interest rates move higher. The floating rate loans immediately start generating more income, but most of Blue Owl Capital Corporation's debt is fixed rate and not maturing for several years.
Valuation
There are two ways to value a BDC. The most popular is the discount or premium to net asset value ('NAV') per share.
NAV per share finished last quarter at $15.26 compared to the current stock price around $13.50.
That's a 12% discount to NAV. In normal times, a high quality BDC like Blue Owl Capital Corporation trades at a 1.1-1.3x premium to NAV.
The other valuation method uses the amount of income generated at NAV.
Blue Owl Capital Corporation has increased the amount of income it's generating per share at NAV from 8.3% in Q1 2022 to 10.5% last quarter. That is exactly what we want to see.
Since OBDC trades at a discount to NAV, the company can pay us a nearly 10% yield with a safe payout ratio. What are Blue Owl Capital Corp's weaknesses?
There aren't many, but one is sentiment. All other things equal, the market tends to award OBDC a lower stock price compared to NAV.
That's why it's critical to get a good entry point like the stock presents today. The other is length of track record. The parent company was founded in 2016 by seasoned Wall Street executives. They've done a solid job, but many people prefer the longer track records of some peers.
Blackstone Secured Lending ( BXSL )
BXSL is a lot like OBDC but just a few years younger. It's also managed by a respected Wall Street firm, in this case Blackstone ( BX ).
Also like OBDC, this fund was originally developed for high net worth and institutional investors. After building out the portfolio, it needed to have an initial public offering to give those early investors liquidity.
Blackstone leaned toward a conservative portfolio construction with 98.4% first lien senior secured loans. The portfolio is among the largest in the industry at $9.3 billion.
Blackstone's effectively unmatched scale allows it to diversify into many industries and companies. Just like other top tier BDCs, Blackstone knows that software, healthcare, and professional/business services tend to hold up best in hard times.
Partly out of necessity, Blackstone focuses on lending to larger companies. They believe these offer similar return profiles with lower risk. The data confirms this in most but not all circumstances.
BXSL's dividend started out at $0.50 and has recently accelerated to $0.77 per share. In recent quarters, based on my knowledge, BXSL has had the fastest growing dividend in the BDC sector. Given it has a very conservative loan portfolio and a huge portfolio, how has it possible? I'll explain.
Before rates moved much, the quarterly dividend was 8.4% on NAV with 102% distribution coverage. That's fine for a BDC, but not great. Earnings grew from $0.51 in Q2 2020 to nearly $0.70 by the end of 2021. By the end of the near year, they were $0.80 per share. Most recently, they were $1.06.
Since the board didn't decide to raise the regular dividend materially until Q3 2022, distribution coverage became extremely conservative. As a side note, BXSL did pay out some serious special dividends along the way we aren't counting here.
To get the dividend back to BDC norms, the board moved it from $0.53 in Q2 2022 to $0.7 in Q1 2023 to $0.77 just recently. That's 45% growth in just over a year while still maintaining a very safe payout ratio.
Non-accruals are negligible at 0.1% of cost. BXSL has $1.8 billion in total liquidity with about $2.5 billion in maturities between now and Q3 2026. Blackstone still has considerable dry powder, but it's not quite as much as other investment grade rated peers. The BDC has BBB- ratings by the rating agencies, which is the last rung on investment grade.
BXSL's NII growth of 14% year-over-year and 151% dividend coverage for Q2 2023 are top scores, as are its low non-accrual rate. But what about valuation? Is the market making us pay dearly to get a piece of Blackstone's empire?
For a good while, BXSL was trading way lower than it should have been. The market caught on, and it's no longer a steal. But it's still a good deal. With the most recent market of $26.30 per share, that's a minute 3% premium to NAV (or 1.03x).
Anything below 1.1x is reasonable for a BDC of this quality, with any discount to NAV a great buy. Given the market is still a little unsure of this newcomer (late 2021 IPO), I'd lower that to 1.0x as a good entry point and below 0.9x as a great buy.
For those looking for fast dividend growth, BXSL is a strong contender . For the best underwriting track record and portfolio management, you can't go wrong with TSLX, although you'll have to pay a premium.
For slower growth but a high-quality portfolio available at a discount, OBDC's 10% yield beats almost every other income investment from a risk-adjusted return perspective.
Sixth Street Specialty Lending ( TSLX )
Sixth Street is consistently one of the best managed BDCs, in my view. In many years, I consider its underwriting, portfolio management, and loan workouts to be best in class.
TSLX's $1.75 billion market cap and $3.1 billion gross portfolio value means it's considerably smaller than the heavyweights like OBDC, Ares Capital Corp ( ARCC ), and FS KKR Capital Corp ( FSK ). But it's large enough to satisfy the rating agencies. TSLX is among the elite group with four investment grade credit ratings.
Sixth Street has effective voting control on 89% of its investments with approximately two covenants per loan. It takes the already strong rights of BDCs to another level.
Like Blue Owl's BDC, Sixth Street focuses on the safest loan types. 91% of the portfolio are first lien senior secured loans. Also, like OBDC, 98% of the portfolio is floating rate.
Industry diversification is excellent and focused on non-cyclical industries like internet software, business services, and HR support services. As an interesting side note, you may recognize "IBM Watson" within the top 10 borrower list. You can read more about that portfolio company's story here .
TSLX's prudent portfolio construction also helped it navigate the pandemic without reducing its regular dividend. That brings us to an important point about TSLX and BDCs in general.
Skeptics of BDCs tend to use the share price alone to gauge if it's a "good" investment. Since most BDC share prices tend to stay flat over time, they dismiss them. Or they see the near 10% yield and automatically believe it's too good to be true. Like most assumptions without research, it's not a great investment strategy.
As shown above, TSLX has been growing the value of its business markedly and consistently over time. A huge amount of value has been paid out in regular and special/supplemental dividends. That doesn't show up in a stock chart. It shows up where it counts: Investors' brokerage accounts .
If TSLX retained those earnings instead of distributing them to investors, the company's NAV would be $38.30 per share. Keep in mind the stock trades at $20 per share today. Stated another way and including ratios to NAV, long-term investors in TSLX has received its entire principal amount back in dividends and made a modest capital gain.
From a risk perspective, TSLX outperforms. In March 2023's assessment by Fitch , the major rating agency noted that the BBB investment grade rating was supported by the BDC's unusually low 0.1% non-accrual rate by fair value. I expect that'll move closer to 1% over time, but the fact it was that low for even a short period of time is extremely impressive.
TSLX is well prepared for any downturn. It has a total of $648 million in debt maturities between now and 2027. Total liquidity is just under a billion, which is more than twice the amount needed to satisfy all liabilities for the next 2-3 years.
TSLX is clearly a phenomenal BDC, so what's the catch? It usually trades with a notable premium to NAV. Working the opposite of a discount to NAV, a premium dilutes investor returns. The company's yield at NAV is around 13%, but since it trades at a premium, owning the stock gives you a 9-9.5% yield.
At the same time, there is a reason many of the best BDCs consistently trade at premium to NAV and deliver exceptional results to investors. Like Real Estate Investment Trusts (REITs), BDCs have to issue shares to raise capital. Since TSLX trades at a premium to NAV, it receives "free money" proportional to the premium every time it does so. This gives it the ability to finance its growth more cheaply.
So just how high is the premium?
The recently published NAV per share was $16.74, but we need to reduce that by $0.06 since a special dividend was declared. That works out to a 19.5% premium to NAV. That's at the upper end of what I consider reasonable for TSLX. The stock becomes a great buy at 1.0x NAV, or $16-17 per share. 1.0-1.2x is a "good" buy that is still highly likely to generate compelling long-term returns.
In Closing
A few weeks ago, I wrote on Main Street Capital ( MAIN ), the most popular BDC that now yields around 7.0% with a P/E multiple of 10.4x.
I currently own MAIN and I'm looking to enhance my BDC holdings, which of course is another reason that I asked Williams Equity Research to assist me with this article.
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Our focus is income...
But not just income...
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BDC Coverage List
Let me know if there are any BDCs that you would like us to cover.
Stay tuned for Energy Income For Life .
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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BDC Income For Life