We are still in the BDC earnings season and so getting a lot of management commentary and quarterly presentations. One thing that is important for investors to understand is that companies will, unsurprisingly, tend to either focus on the stronger aspects of their performance and/or they will tend to put the best kind of spin on a given portfolio feature.
There is nothing wrong with this – in fact, it would be odd if it were otherwise. However, the key point for investors is that management commentary or presentations should not be the sole basis for investment in a particular company or allocation in the sector. The corollary here is that the type of analysis that relies exclusively on company presentations to tell a story of a given company is obviously insufficient as it will tend to gloss over some of the key details that investors need in order to get a full picture.
Let’s see how this works in practice, taking as an example the large BDC FS KKR Capital (FSK). We will focus on just a few headline issues from either prepared management comments from the latest earnings call or the last presentation.
The CEO kicked off the call by commenting that the company had originated $2.8bn of new investments. That’s a big number by any count even for a large BDC like FSK and is 18% of its total investment portfolio. However, it ignores things like sales and prepayments and it’s the net number that really matters from an income perspective. As it happens, the net number was $0.98bn, which is still a healthy level but well below the gross number. The CEO also kicked off the Q1 call citing the $417m gross new investment figure however, that quarter, the net figure was similar but with a different sign: -$460m. A positive net number will tend to add to NII, all else equal and ex the one-off prepayment fees, whereas a negative number will subtract from it.
The takeaway here is that the gross figure typically sounds great, but it’s irrelevant for BDC investors focused on income generation who care much more about the net number.
Among the highlights in the first paragraph of the transcript, the CEO also highlighted that the company was able to deliver a 1% increase in the NAV. A 1% increase is pretty good, however, as with anything, we need to put things in perspective. As it happens, a 1% NAV increase is below the median level for the companies in our coverage that have reported Q3 results so far and well below the average as the chart below shows.
The key point for investors when given a piece of data from a certain BDC is to ask what does the rest of the sector look like. It’s very hard to tell on a standalone basis (unless you are a BDC Rain Man) whether a given company metric is good, bad, or neutral without checking up on what the rest of the space is doing. This is typically not something a BDC will do for investors (unless it looks exceptional on that given metric), so it’s incumbent on investors (or BDC analysts) to always place a given metric in context.
The CEO went on to cite GAAP NII of $0.71 for the quarter. The unrounded number appears to be $0.705. The rounding up of NII overstates it by less than 1%, so it’s really not a big deal in this case. Because the convention is to round to two decimal points, the company is not under an obligation to provide more decimal points, however, it can be a larger issue for companies with lower NII levels, say, around $0.20-0.30 per share where the rounding up (or down for that matter) can be a larger issue. For instance, both $0.246 and $0.254 will round to $0.25 but the difference between the two is a hefty 3.25%.
The CEO went on to cite that the company had $2.5bn of available liquidity and no “meaningful near-term debt maturities”. That may sound great; however, FSK investors would very much prefer it to have near-term maturities which it could refinance at much lower rates than it is paying now. A number of its unsecured notes have coupons north of 4% whereas the company has recently issued debt with coupons at 1.625% and 3.125%. Being able to refinance these much more expensive bonds at current levels would be a huge boost for the company’s NII.
Another key issue is how the NII will be affected by a rise in rates. Investors looking at the latest 10-Q may feel like there is very little to be worried about since it shows only a 1.8% drop in NII for a 1% rise in rates.
The trouble is that BDC portfolios are highly non-linear to a rise in short-term rates because of Libor floors on the asset side (i.e., on the loans they hold) and no Libor floors on the liability side (i.e., on their credit facilities). And because most Libor floors tend to be in the region of 0.5-1%, most BDCs will have a much larger drop in NII for a rate rise below 1%, which will then reverse closer to 1%.
A BDC that shows a more granular impact is the Goldman Sachs BDC (NYSE:GSBD) which breaks it down into 25bp chunks (i.e., equivalent to each Fed hike). It shows that its drop in NII is much larger for rises of 0.5% and 0.75%. And GSBD is far from alone here.
Elsewhere and looking at the presentation, the second slide features an impressive metric showing FSK as a “leading BDC” in terms of AUM – just after Ares Capital (ARCC), which is a very good company indeed.
A slide that you won’t find, however, is this one which shows the 5Y total NAV performance which is far from “leading”. Investors in FSK would probably rather trade its size for improved historic performance.
The key takeaway here is that it’s important not to use management commentary or presentation as the basis for allocation in the sector. The company won’t say anything that is untrue or even misleading, but investors will certainly not get the full picture going by the company-provided information alone. It also means that investors that follow sector analysis that limits itself to management commentary and/or presentation screenshots will likely get the wrong end of the stick.
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