2023-04-01 00:40:56 ET
Summary
- We take a look at the action in business development companies through the fourth week of March and highlight some of the key themes we are watching.
- BDCs gained 2% over the week, outperforming the broader income sector.
- The stress in the banking sector will cause a drop-off in bank lending, creating more opportunities for some BDCs.
- HTGC increased the size of its letter of credit facility, perhaps gearing up to take advantage of new venture debt lending opportunities in the wake of the SVB failure.
This article was first released to Systematic Income subscribers and free trials on Mar. 25.
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 fourth week of March.
Market Action
BDCs had a good week with a 2% total return. Month-to-date, the sector is still down around 6%. Interestingly, the returns are bookended with venture-debt focused BDCs, [[HTGC]] on the left with a nearly -20% return and [[TPVG]] and [[TRIN]] on the right, with [[HRZN]] not far behind. As we suggest below, venture-debt focused BDCs could be the beneficiaries of the SVB (SIVBQ) fiasco, which was the largest venture debt lender.
Sector valuation has improved to around 91%. Over the last year or so, valuations of sub-85% or so have been good opportunities to add to the sector. The sector has enjoyed strong net income gains over the past year which has supported prices. At current levels of short-term rates, BDCs face an asymmetric risk of lower net income given significantly less upside to short-term rates and much more downside.
Market Themes
The recent rush for the exits by uninsured depositors across a number of banks has already had a number of consequences for the bank sector as well as the broader economy. One consequence particularly relevant for BDCs is that with banks much more focused on maintaining liquidity they will likely pull back on corporate lending. This should open additional lending opportunities as well as lead to higher spreads on new loans.
An interesting question is which BDCs stand to benefit from this dynamic? A first order guess is that because bank lending is typically focused on larger companies, it is those BDCs that directly compete with banks that should benefit the most from additional lending opportunities. That means BDCs that operate at the upper end of the middle-market segment such as [[ARCC]], [[OCSL]] and [[ORCC]].
Regional banks are likely to cut back on lending disproportionately and these banks have a larger share of their assets in small business loans. This suggests that small businesses will particularly struggle to get financing. However, small businesses are not the focus of the BDC sector and so this dynamic is unlikely to have a strong impact on it.
Another dimension of the ongoing bank crisis is that venture debt lending may also fall with the failure of SVB which was the largest venture debt lender. Unless the acquirer of SVB picks up the slack, there could be additional lending opportunities for BDCs focused on venture debt such as TRIN, HTGC, HRZN and TPVG.
At the same time, we need to keep a bigger picture in mind which is that a general lending pullback by the banking sector is not a good thing for the broader economy and, by extension, BDC borrowers. If the economy does go through a credit crunch, we might see additional stress put on BDC holdings which is likely to lead to additional non-accruals and NAV markdowns. A reversal of the rate hikes by the Fed would also lead to lower net income which could further pressure prices.
All in all, the overall impact of a potential credit crunch could very well be negative, though the uncertainty over the path of the sector over the medium term is very high.
Market Commentary
Hercules Capital announced it increased its committed letter of credit facility by $75m to $175m. For investors keeping score at home this doesn't look to be the same as the SMBC Credit Facility which was $225m in committed capacity and $72m outstanding as of Q4. The letter of credit agreement facility with SMBC was established in January this year with a size of up to $100m and this was just increased to $175m. The MUFG facility maximum revolver was decreased to $400m from $545m at the same time.
Overall, this adds significant capacity for HTGC. However, we don't expect the company to significantly increase its pace of lending given its leverage is already at the upper end of its range over the last couple of years. Any further pressure on the NAV will only cause it to move higher.
Stance And Takeaways
This week we took advantage of the bounce in BDCs to marginally trim exposure to common shares across a couple of select names that are trading at fairly elevated valuations. The Fed will pivot eventually, and this will likely benefit longer-duration, higher-quality sectors in our view, particularly if the pivot is partly due to a further deteriorating macro picture. That said, valuation is king and another sizable drop in BDC valuations would make a new capital allocation to the sector more tempting.
For further details see:
BDC Weekly Review: Will BDCs Benefit From A Pullback In Bank Lending?