An important question for BDC investors is how to think about valuations. It is obvious for any participant in the sector that valuations are not random. Some BDCs enjoy consistent sky-high valuations while other BDC valuations remain stagnant.

A common view is that BDC valuation is simply a function of the dividend yield. The reality is precisely the opposite, however. If anything, higher valuations are associated with lower regular dividend yields. 

Arguably, we should be using the total dividend yield which also includes special or supplemental dividends. However, this doesn’t provide a clear relationship either. Investors also know that BDC valuations don’t swing around wildly by 50-100% whenever a company declares a large special dividend. 

A metric that is much better linked to valuations is historic total NAV returns. Intuitively, it makes a lot of sense – BDCs can deliver returns over and above their income levels through their gains in common equity and warrant holdings with the better companies historically delivering total returns close to double of their income yields.

The chart below shows that it is these companies with the stronger total NAV returns tend to trade at higher valuations. 

This relationship is not perfect and, from the looks of it is not totally linear. The outliers on the low and high valuation side suggest valuations tend to be floored around 70% or so (at least in our BDC coverage universe) and 5-year total NAV returns don’t go to the moon but are below 20%. This means a cubic spline would fit the data better but that’s likely overegging it for our purposes here.

Obviously, there are a lot of other moving parts in BDC analysis and historic returns are not a sole determiner of valuations but they certainly appear to be much more tightly linked to valuations than to dividend yields. This is particularly relevant since returns are often persistent in the BDC sector – strong companies often to continue to deliver strong returns while weaker companies continue to deliver poor returns due to persistent portfolio credit issues with lots of room in between. 

The key takeaways for investors is that valuations are pro-cyclical in the sense that companies with an improving return profile should also benefit from a valuation re-rating. This suggests that it makes sense to look at BDCs from a total return mindset rather than focusing exclusively on yields. 

The other takeaway is that valuations can vary significantly for BDCs with a similar historic return profile. This suggests that investors can tilt to companies with a stronger margin of safety without potentially giving up much in terms of forward returns. Obviously, as the disclaimer goes, past returns are no guarantee of future returns, and investors need to do due diligence with prospective performance in mind. 

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