12-Mar-2022
A common way in which investors decide on their BDC allocations is, in part, through an analysis of historical performance of various companies in the sector with the key question being – how much value have managers delivered to investors over time?
This is obvious however gauging BDC performance can be surprisingly difficult. This is why most investors rely instead on proxies of underlying performance. These proxies include total price returns, NAV changes, dividend changes and others. All of these metrics are useful; however, they don’t really get to the heart of the matter which is the historic ability of a given BDC to generate returns on investor capital.
Let’s go through these proxies to show how they are not always up to the task.
Total price returns (i.e. including dividends) and net price returns (i.e. excluding dividends) tend to be very common gauges of BDC performance. The trouble with these is that they are mostly driven by valuation since valuation tends to be the most volatile component of price returns. The chart below shows disaggregated total price returns for Q4 with red bars showing the impact of valuation changes on total returns.
Another problem with valuations is that they tend to be mean-reverting. The chart below shows the quarterly valuation figure for the Ares Capital Corp (ARCC) whose valuation is not unusually volatile but has tended to move in a 30% valuation range (85% – 115%) most of the time outside of exceptional periods. This means the “best” BDC can often be the “worst” the following month or quarter.
The dividend trajectory is a useful indicator but they are far from the entire story. BDCs have different dividend policies – some distribute right around 100% of NII while others have very high regular dividend coverage levels and then push spillover income and realized gains into large specials at the end of the year.
Many analysts like to show net NAV returns which exclude the impact of dividends. However, as most admit, this is a flawed metric as it totally ignores dividends and doesn’t account for the impact of large specials.
Our own focus has been on total NAV returns which include the impact of dividends and, in our view, are the best gauge of the manager’s ability to deliver value to investors, particularly if viewed from a through-the-cycle lens. However, even total NAV returns don’t give us the whole picture for the simple reason that investors don’t actually earn total NAV returns on their capital since they buy the stock at its prevailing market price which can be below or above the NAV.
Where this becomes relevant and how it differs from total NAV return has to do with what happens to the dividend. Specifically, the dividend of a company that trades at a sub-100% valuation is, effectively, enhanced by the valuation and vice-versa. For example, a company with a $1.60 annual dividend on its $20 NAV – equivalent to an 8% yield on NAV – will see its yield on price reduced to 6.4% if it trades at a 125% valuation i.e. the $1.60 annual dividend on a price of $25 is 6.4%. This 20% reduction in the yield is the tax levied by its above-100% valuation. Obviously, there are often very good reasons to hold BDCs that trade at premiums but it’s always a good idea to gauge the impact of the valuation on its yield as well. The question is – at which point is the valuation tax too high for what the company can actually deliver sustainably. Or alternatively, when does the valuation seem too low i.e. when is the benefit from the additional dividend boost provide a sufficient margin of safety for the BDC’s potential risks?
This is why we like to combine the historical total NAV return with the stock’s valuation (along with a dozen other metrics) as a better gauge of the company’s ability to continue to deliver attractive returns on investor capital in the future.
Apart from optically comparing total NAV returns and valuation, another way to gauge a given company’s return is to simply strip out the impact of valuation on price returns. Again, it’s not that valuation is irrelevant. Rather, valuation is the most volatile driver of returns and is arguably the one performance driver that is least under either management or investor control., at least on a quarterly basis. And because it is typically volatile and mean-reverting it adds a lot of noise to returns.
The second, perhaps more important, reason this is helpful is for investors to be able to compare and anticipate potential returns on their capital going forward outside of the impact of valuation.
We do this by focusing on the three other sources of returns:
- NAV changes
- Dividends on NAV
- Dividend adjustment due to the current valuation
The first two drivers of returns are very familiar. The third driver is simply the positive or negative dividend adjustment due to the impact of valuation i.e. a dividend “boost” for valuation below 100% and a dividend “tax” for valuation above 100%.
The chart below shows what this looks like for the TCG BDC (CGBD) which has tended to trade at a sub-100% valuation. This positive dividend adjustment in this case is shown in yellow bars and called “DIV Valn” in the legend.
Specifically, the company’s typically sub-100% valuation has added between 0.4% and 1.2% to the company’s quarterly returns. This may not sound like much but it’s close to 3% annualized.
If we check how this compares to the broader sector we see that the company has generated above-sector returns in the post-COVID period, helped by this dividend boost from the sub-100% valuation.
The key takeaway here is that while valuation is an important it can add more noise than signal to BDC return analysis. By stripping it out from historical price returns, investors can get a cleaner signal of the value delivered by the company to investors over a given period.