2023-07-08 05:28:27 ET
Summary
- We take a look at the action in business development companies through the last week of June and highlight some of the key themes we are watching.
- BDCs had a good week, capping off a great June with a 6% rally.
- Our view remains that the opportunity from additional lending due to potential regional bank pullback is less than commonly advertised.
- And highlight our recent top up of the OCSL position.
This article was first released to Systematic Income subscribers and free trials on Jul 1.
Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company ("BDC") sector from both the bottom-up - highlighting individual news and events - as well as the top-down - providing an overview of the broader market.
We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the last week of June.
Market Action
BDCs had another great week as the evidence for an immaculate disinflation took shape. A number of macro activity indicators came in strong while inflation fell more than expected. BDCs enjoyed a terrific June with a gain of over 6% - one of the best results across the broader income space.
Sector valuation bounced higher and is trading close to its post-bank tantrum high. A sector valuation in the low 90s has tended to be a support for the sector over the last 9 months or so.
Systematic Income
Market Themes
There was a flurry of excitement a few months ago by some BDC investors who saw the stress in regional banks as an exciting opportunity for BDCs to step in and eat the regionals' lunch, so to speak. Our own view was that this development was very unlikely to offer a strong benefit to BDCs, at least nowhere near the scale that many thought.
This view has been recently echoed by BDCs themselves who have addressed this issue in their management calls. Let's review a number of challenges to the view that BDCs are going to hugely benefit from stepping into regionals' lending shoes.
First, the broader bank situation appears to have stabilized. A number of regionals' bank deposits have actually grown and the recent stress test has added confidence to the sector. This suggests whatever lending pullback we see may not be as large as many thought.
Two, any pullback by regional banks will also be reflected in a lending pullback to direct lenders themselves. Although most of the lending to BDCs (i.e. BDC credit facilities) is done by the larger banks, regionals like Key Bank are also players. Obviously, a drying up of lending to BDCs will make it more challenging for BDCs to drive new lending. Separately, a worsening situation across regional banks will also likely impact liquidity across public markets and make it more challenging for BDCs to issue on that market as well.
Three, prepayments are running at a relatively low pace while BDC leverage is fairly elevated. These two factors means it's not at all straightforward for BDCs to either drive a lot of organic lending (by recycling capital from repayments) or to add new lending with borrowings as that would simply increase leverage.
Four, BDCs, at least the larger ones which control most of the capital in the sector, do not generally compete with regional banks. This is the gist of comments made by the [[ORCC]] CEO on their call. It's a good comment so it's worth including it in whole.
In terms of opportunities from the banking sector, I'm pretty balanced about this. I've been asked it a lot. I think that we do upper middle market, private equity-backed deals. That's generally not where we're competing with regional banks. We're generally competing with other direct lenders, and we're competing with the syndicated markets and the large banks that are arranging but not holding loans. That's what we compete with. So when the regional banks are pulling back, that's not really in our bread and butter. It stands to reason that these regional banks, if they're pulling back, that there may be companies who are non-sponsored companies that just have a harder time getting financing. And if there's any of them out there that are listening, you should give us a call and we'd love to talk to you. But I would say I don't expect a tremendous amount of that because regional banks are generally not doing non-investment-grade loans for the most part, there's pockets.
A final point that we mentioned immediately in the regional bank fallout in March is that BDC investors should be careful what they wish for. A massive pullback by regionals will imply a massive drop in economic activity (through the combination of confidence, markets and lending channels).
This means that sure, there could be a tremendous amount of new lending opportunities but it will come as a side dish to a big jump in portfolio defaults and a large fall in BDC NAVs. Choosing between a well-functioning economy with few if any additional opportunities from regionals and vice-versa, we know what we would choose as BDC investors. The CEO of ORCC agrees with us, saying simply "overall, I prefer a functioning banking system and a strong economy, and I hope we get to that."
Market Commentary
Occasionally, we like to check in on what BDC insiders are doing with their money. We had a look at market trades of BDC investors and it's all fairly encouraging. There has been widespread buying across a number of institutions as the extract below from our service BDC Tool shows.
[[CGBD]] stood out with steady buying by the CEO. Part of this is that as a new CEO he needs to establish some "skin in the game" as otherwise it wouldn't look great if he didn't hold any shares. So on this count there is probably less here than meets the eye but it's still good to see.
Stance and Takeaways
This week we pared our CGBD allocation and rotated, in part, to [[OCSL]] when the valuation differential moved below 10% (OCSL at 96% vs. CGBD at 87%). While we still like CGBD, the valuation convergence looked a bit tight. OCSL maintains a very high-quality portfolio and its conservative marking methodology means there is also more upside in the NAV than for the average BDC.
Systematic Income
For further details see:
BDC Weekly Review: Opportunity From Regional Bank Pullback Less Than Advertised