2024-01-10 22:36:04 ET
Summary
- Crescent Capital BDC's growth potential may be hindered by headwinds in the BDC sector due to interest rates.
- The merger with First Eagle Alternative Capital BDC emphasized the floating-rate focus, which is less advantageous in a falling-rate environment.
- The central bank's plan to lower short-term interest rates in 2024 could impact Crescent Capital's ability to achieve positive net investment income growth.
Crescent Capital BDC, Inc. ( CCAP ) is a well-managed business development company, but headwinds to the BDC sector with respect to interest rates could hurt the company’s growth potential as it focused heavily on the creation of a floating-rate investment portfolio.
The BDC’s merger with First Eagle Alternative Capital BDC accentuated this floating-rate focus which in a falling-rate environment is obviously less of an asset. The central bank has made clear that short-term interest rates are set to fall in 2024 which could impact Crescent Capital’s ability to squeeze out positive net investment income growth this year.
As a consequence, I am modifying my stock classification on Crescent Capital to Hold and think that the BDC’s stock should be avoided for the time being.
My Rating History
Crescent Capital merged with another publicly -traded business development company First Eagle Alternative Capital BDC at the beginning of 2023 which created a larger floating-rate focused BDC with considerable net investment income growth potential in a rising-rate environment.
Taking into account that the backdrop for floating-rate business development companies has since changed after the central bank announced its interest rate shift in December 2023, I think that the strength of the underlying investment thesis with respect to Crescent Capital has eroded. Thus, my new stock classification of Hold.
Crescent Capital’s Portfolio And Originations
Crescent Capital is a First Lien-focused business development company that experienced a jump in portfolio value after the acquisition of First Eagle Alternative Capital BDC closed in the first quarter.
Today, Crescent Capital has a portfolio mainly consisting of investments in Senior Secured and Unitranche First Liens, which made up the majority (89%) of the BDC’s investments as of the end of 3Q-23.
The total portfolio value, including complimentary investments in Senior Secured Second Liens, Unsecured Debt and Equity was $1.56 billion.
Since the acquisition of First Eagle Alternative Capital BDC, the portfolio, however, has declined marginally. Crescent Capital also suffered a drop in new originations as floating-rate debt became more expensive throughout 2023, resulting in softer demand for new capital.
As far as portfolio diversity goes, I think Crescent Capital does not stand out from the BDC crowd in one way or another. The business development is mostly focused on providing capital to business sectors that have stable revenues and cash flows, such as Health Care, Software, Professional Services and Insurance.
Since Crescent Capital acquired First Eagle Alternative Capital BDC, which itself had a 98% floating-rate focus, the new portfolio also has a very high percentage of its assets exposed to short-term interest rates: 99% of Crescent Capital’s portfolio was floating-rate which I increasingly view as a risk for CCAP and which I think could lead to a lower margin of safety in a falling-rate environment.
I Expect A Declining Margin Of Dividend Safety
If you ask if Crescent Capital’s dividend is at risk of immediately getting gutted, the answer is no. The business development company has quite a moderate pay-out ratio and consistently earned its dividend with net investment income in the last year.
The twelve months pay-out ratio was 74% (82% when including supplement dividends totaling $0.17 per share), but it has trended lower consistently throughout the year which has been made possible by growth in Crescent Capital’s net investment income.
This growth was supported by the BDC’s large floating-rate debt portfolio that profited from higher rates pushed up by the central bank. Crescent Capital’s net investment income per share, on a YoY basis, climbed 14%, but I fear that these profit tailwinds are falling by the wayside in 2024 as the central bank is going to make shift away from its rate-hiking cycle.
Taking A Look At CCAP’s Valuation Multiple
I look at business development companies through the lens of net asset value since this is a value that aggregates the fair values of its underlying debt and equity investments contained in a BDC’s investment portfolio.
Crescent Capital’s net asset value as of September 30, 2023 was $19.70 per share, reflecting thus a net asset value discount of 13%. The higher-than-average discount to net asset value might be related to the BDC’s high floating-rate percentage.
I do see headwinds for the entirety of the BDC sector in 2024, not just for CCAP, but I am particularly cautious about the BDC when taking into account its aggressive floating-rate posture.
The Central Bank And Other Risks
The central bank’s interest rate shift announced late 2023, is probably the biggest potential headwind for those business development companies that have positioned themselves as floating-rate BDCs. As such, I don’t think that Crescent Capital can repeat its strong net investment income growth performance of 2023 which yielded (as of 3Q-23) a 14% increase in per share net investment income.
More muted net investment income growth prospects may also lead to a lower margin of dividend safety and, possibly, a higher discount to net asset value. These are very real concerns that I think passive income investors at this stage of the interest rate cycle should take very seriously.
My Conclusion
Crescent Capital is a specialty finance business development company with strong portfolio and net investment income growth, but short-term interest rate headwinds are making business development companies with aggressively positioned floating-rate portfolio much less attractive as yield investments in a falling-rate environment.
Though the acquisition of First Eagle Alternative Capital BDC has boosted Crescent Capital’s investment portfolio, the BDC is very much dependent on its floating-rate debt investments which, as I said, right is just not that big of an asset anymore.
Since we are obviously heading toward a rate-adjustment period, I think that Crescent Capital no longer deserves a Buy rating, and I am modifying my stock classification to Hold.
For further details see:
Crescent Capital: This BDC's Dividend Is Getting More Risky (Rating Downgrade)