Some Misconceptions About BDCs

This is an extract from an earlier article at Systematic Income Premium.

It’s always interesting when income sectors popular with retail investors get a look in the financial press. The other week, an FT newsletter highlighted BDCs as a window into the relatively opaque and larger private debt market.

Its conclusions were in part on the basis of the following selection of the larger BDCs – the screenshot below is from their (possibly paywalled) commentary. The goal here was to “get some sense of how the market assesses the riskiness of private debt”.

FT

The FT’s first conclusion by looking at this subset is to say that because some of these BDCs trade at “meaty” discounts to NAV suggests “some anxiety about credit quality in the portfolios” as do dividend yields north of 8%.

As most BDC investors know, the BDC market is about an order of magnitude larger than this sample, making it pretty unrepresentative even if it does cover the larger BDCs. This makes it very difficult to get a sense of the broader BDC space, much less the much larger private debt space, from such a small window.

Specifically, when this commentary was published, the average BDC valuation was around 98% which suggests very little concern, in aggregate, about BDC portfolios.

And as it happens, two of the five BDCs, (FSK) and (AINV), in the sample above are some of the worst historic performers, which explains why they continue to trade at significant discounts to NAV. (ORCC) does not have a long track record as a public entity, but it has also significantly underperformed the sector over its short public life. (GBDC) has put up strong longer-term returns, but has underperformed over the last few years, primarily because of its rights offering during the COVID crash. (ARCC) is the only clear outperformer in the sample.

It’s also important to point out that making conclusions about the BDC sector on the basis of valuation snapshots is not very strong analysis. For instance, the newsletter suggests that ARCC is a strong BDC because it trades at a premium. However, as recently as just a few weeks ago, the ARCC valuation dipped as low as 93% before recovering. An “analysis” on the grounds of a 93% valuation might have concluded that investors are seriously worried about the ARCC portfolio, which would have been incorrect.

The other comment had to do with yields being north of 8% as indicative of anxiety about BDC sector portfolio risk. The fact is that for a loan portfolio that is leveraged 2x (i.e. debt / equity = 2x) it doesn’t take a very high yield on underlying assets to generate net investment income of 8%. For an average BDC, that requires a yield of around 7.5% on its underlying assets. This is pretty much where the high-yield corporate bond market trades. And while it’s true that this yield is above the current yield of the publicly traded loan space, it obviously doesn’t include the fact that BDCs often work closely with their borrowers to drive performance, something which obviously doesn’t happen in public markets.

The conclusion of the newsletter was that we should look to the weaker BDCs to anticipate any broad-based weakness in the world of private credit. However, the performance of weaker and stronger BDCs have not been very well aligned over the past while – weak BDCs performed poorly in good and bad markets while strong BDCs have performed very well in strong markets and fell but eventually recovered during downturns. In short, there is no direct link between weaker and stronger BDCs. Clearly, a massive downturn will hit everyone (though to a different degree) but that’s not an interesting insight.

Overall, our view is that there are better ways to track potential challenges in the BDC space, such as via unrealized / realized losses and increases in non-accruals and PIK income, among others.


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