19-Mar-2022
Recently we came across some third-party commentary that suggested that 7 of 9 BDCs by largest net assets and 8 of 10 BDCs by largest market cap are “best of the best” – something that didn’t make a ton of sense to us. Surely, 80% of the largest BDCs can’t possibly be “best of the best” otherwise the phrase “best of the best” loses its meaning, even if we include the entire BDC space of 40+ entities.
Ultimately, “quality” is what most income investors are after in their portfolio allocation. However, because there is no one objective quality metric, most often investors have to turn to proxies of quality. In this section we take a look at some of these proxies and see whether they can provide a reasonable approximation of “quality”.
Even if we don’t agree with the quantum of the conclusion above let’s see if looking to size in gauging quality BDCs is a sensible way of going about it. There is some intuition to support this. Larger BDCs will tend to have larger staff to analyze new deals and help their portfolio companies. They should also have a larger network to identify attractive opportunities. And historic success would have allowed them to grow their asset base more easily via unrealized and realized gains as well as more readily received public offering of new stock.
However, if we look at the chart of BDCs by net assets (x-axis) vs. 5Y Total NAV returns below we struggle to make out any pattern at all. It is true that a number of BDCs that are commonly regarded as “better” do tend to fall into the larger bucket such as ARCC, MAIN, GBDC and others, however there doesn’t seem to be an obvious pattern in this plot linking size to better book value (including dividends) returns. If there were, the scatter plot would be diagonal – running from lower left (smaller size / lower historic returns) to upper right (larger size / higher historic returns).
Some investors may quibble with using 5Y Total NAV returns as a sanity check here but it surely can’t be useless. In other words, a BDC that is regarded as “one of the best” should also have delivered strong book value returns (including dividends) over the past 5 years.
And, in any case, if we look closely at the BDC sorted by size then within the top five BDCs we see PSEC and FSK that are regarded by many investors as uninvestable (outside of tactical allocations, perhaps). What this tells us is that gauging any kind of quality characteristic from BDC size is too inconsistent to be very useful so we can discard it.
Another suggestion is to use valuation. The idea here is that the “best” BDCs trade at significant premiums. If we glance at the chart of valuation (x-axis) vs. 5Y total NAV returns there does look to be a clear association – BDCs with higher 5Y total NAV returns tend to boast higher valuations.
However, what’s interesting is that this association is not terribly consistent. For example, MAIN at a 159% valuation has delivered the same 5Y total NAV return as FDUS which trades at a 96% valuation and CSWC which trades at a 146% valuation has underperformed ARCC which trades at a 107% valuation by 1.7% per annum in total NAV terms. The underperformance on price would have been even worse because of the valuation impact on historic dividends if purchased at current valuations.
Of course, there are, arguably, other reasons for the elevated valuation of MAIN and CSWC besides total NAV returns. However, the focus on valuation doesn’t really answer the question of how high a valuation is too high? Is the MAIN valuation gap of 54% (i.e. 159% vs 105%) relative to the average BDC too high or too low or just right? And if everything is priced “just right” why are we even going through the motions of trying to allocate to the “best” BDCs if everything is priced correctly by the market. Hanging our hat on valuation doesn’t really get to the heart of the quality question since it doesn’t tell us how much is too much to pay for quality (is MAIN at 200% too high?). Plus, it also has a circular feel to it – the price is high because the quality is high and the quality is high because the price is high.
NAV growth (i.e. ex-dividends) is often pitched as a key metric to follow, however, it’s skewed by different dividend policies of BDCs as well as the size of the equity allocation. BDCs with more conservative dividend policies will tend to retain more income and, hence, show a higher NAV trajectory. Moreover, the timing of special dividends will make a big dent in the NAV. Whenever tracking NAVs are recommended by other analysts it always comes with a disclaimer of “except ignore BDCs A, B, C, D and E because of large specials” which is not particularly useful. Separately, moves in equity markets will often filter into marks of private equity positions so a BDC with a relatively high equity allocation will look better during an equity market uptrend and worse during a downtrend – not exactly the consistency we are going for.
Coverage ratio is sometimes carted out as a key quality metric but it’s obviously skewed by a discretionary choice of where to set the dividend. A way to show a great coverage ratio is to simply drop the dividend. A feature of the BDC that is entirely at the discretion of its managers surely can’t be a great measure of quality.
Diversification is another metric of quality often highlighted by analysts. However, the experience of the last few years surely shows that it is BDCs with lower allocation to cyclical sectors like Retail and Energy (i.e. those that are, arguably less diversified) that have moved through 2020 with fewer dings in their portfolios. Diversification can also easily lead to overdiversification where managers are adding low-conviction positions to the portfolios. Finally, a BDC like PSEC that holds not just first-lien loans but has also “diversified” into real estate and CLOs is, arguably, much more diversified relative to the average BDC and yet few investors would put it at the top of the quality list.
Ultimately, in our view, there are no simple answers to the quality question. Gun to our head we would highlight metrics such as through-the-cycle total NAV returns, NAV resilience over market shocks, cumulative unrealized and realized gains, historic non-accrual levels and several more. In short, investors have to rely on a number of different metrics to gauge BDC quality. This may be more difficult, however, the upside of the process is that it should result in higher-conviction portfolios.
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