BDC Market Snapshot: Week Ended April 28, 2023
BDC prices remain in a relatively narrow 5% range established following the failure of Silicon Valley Bank (SVB), beginning March 13, 2023. This price chart for BDCZ - the exchange-traded note which owns most public BDC stocks - tells the story:
Using closing prices, BDCZ ended Friday 28, 2023 (7.1%) behind its level on March 6 when the SVB drama began to take hold. Admittedly, that's better than the (10.6%) drop that occurred right after - on March 13 - but hardly a return to the rally that had begun in mid-December 2022 and was going strong till we got the bad news out of San Francisco.
Now another famous Frisco bank has needed to be rescued (and by JP Morgan no less) amidst ringing reassurances that the U.S. banking system is sound.
The sentiment is echoed by Jamie Dimon, who said the banking system is "very, very sound". (We can think of three sets of shareholders and bondholders who would beg to differ).
The question now is whether the markets - including the BDC sector - will believe the "all clear" signal from the Fed and get back into rally mode. For our part, we remain skeptical. The structural damage to the financial system caused by the sudden switch from very low-interest rates to very high-interest rates is only beginning to show up. We've got a host of banks besides the three initial casualties that are effectively insolvent but for a suspension of GAAP rules about the recognition of losses of assets held for the long term. Then there's the ineluctable shift of deposits out of the banking system to higher-paying alternatives and the longer-term loss of faith many bank investors must be feeling about being involved in a sector where you can go from being a top institution to a sad headline - and a complete loss - in a matter of days.
Then there's the likelihood of major credit losses headed this way for banks from a secular shift in the real estate market compounded by the challenge of contending with higher rates. If we get the much-promised recession, there will likely be outsized losses in loans to consumers and businesses - both of whom are hanging in there to date. One day the war on inflation will succeed and will bring down rates, but how many lenders will be left standing when that happens several years from now?
The Flip Side
Anyway, we'll be curious to see how BDC investors react to all this in the weeks and months ahead. At the moment, though, those SVB-triggered concerns mean any investor with a long-term outlook continues to have a wealth of buying opportunities, going by our 5-year projections and assumptions. In fact, this week offered the second-best prospective returns we've seen all year.
As has been the case for weeks, the current market uncertainty and the higher level of risk-free rates have kept BDC price multiples low. We calculate that the latest price to expected 2023 earnings (essentially Net Investment Income) is only 7.2x versus historic highs that have been around 12.0x-12.5x in the past. No wonder the Expected Return model sees BDC prices ultimately increasing by an average of 64% from their current level. Just to reach its price height achieved in March 2022, BDCZ will need to increase by 23% and by 43% to match its lifetime-year high set in 2017.
Although we are looking a long way out - much further than the analysts at the big firms and on sites like Seeking Alpha and Motley Fool - we constantly check our projections against every BDC's most recent performance to ensure we're being reasonable. This week we heard from Ares Capital (ARCC) and Capital Southwest (CSWC), albeit in different ways.
ARCC - still the biggest BDC out there and one of those with the most gray hair in this sector - reported its IQ 2023 results. This resulted in much analysis, both of earnings and credit results at both our sister publications - BDC Reporter and BDC Credit Reporter. In a nutshell, we found that the BDC had pulled in its horns in the quarter - slightly reducing its portfolio size and materially de-leveraging while raising new equity. As a result, earnings were lower than the prior quarter and lower than what the analysts expected. Nonetheless, year-over-year "Core EPS" was still up 35%; underperforming assets remained way below any sort of concerning level and the BDC remained armed with a boatload of liquidity to take advantage of any credit dislocation ahead.
We were disappointed - but not surprised - that ARCC's management did not offer shareholders a "supplemental" dividend of any kind in the IIQ 2023 and just stuck for a third quarter in a row with a quarterly "regular" distribution of $0.48. To reach our projected payout of $2.3000 per share in 2023, ARCC will need to make $0.3800 per share of "supplemental" in the second half of this year. We still believe that's the likely outcome, or that 2024's payout will be higher than the $2.1600 total payout we're projecting. After all, the BDC had $1.1900 per share of undistributed taxable income at year-end 2022 burning a hole in its pocket. That surplus has probably grown even larger but will eventually need to be paid out. By the way, the analysts - famously conservative in their earnings projections - are estimating ARCC will book Core EPS of $2.3400 in 2023, above our own dividend projection.
As a result, we did not make any changes to our projections, Target Price of $27.00, or our Total Return formula. As of April 28, 2023, an investment in ARCC promised a 109% Total Return (including a 12.7% 2023 yield if we're proven right on the payout). That's a return higher than the BDC has achieved over the last 5 years and at a time when the price has - unusually - dropped below net book value per share.
CSWC had previously disclosed estimated earnings and net book value results for calendar IQ 2023. This week, the BDC went ahead and announced its distributions for the April-June period: a "regular" quarterly distribution of $0.54 and a "special" dividend of $0.05. The regular was $0.01 higher and the special was unchanged. Management is trying to differentiate its distributions by what earnings are expected to be after the Fed reverses its rate increase policy and what might be more ephemeral. We are not taking the distinctions too seriously as nobody - including CSWC - knows how the rate levels will play out.
However, in aggregate terms, the CSWC announcement supported our view that the BDC will manage to pay out $2.4000 this year. Through the first half of the year, $1.1700 has been paid or promised. That's a $2.3400 annual pace, just (2.5%) below our own number. With rates expected to rise in May and the BDC projected by the analysts to earn $2.5400 in FY 2024, $2.4000 per share in total distributions seems pretty sound. We said as much in an Update on April 27, 2023.
Explaining Ourselves. Again.
Shockingly, we are projecting CSWC will return 164% over 5 years, or 32.7% per annum. That's one of the highest returns out there. We spent a good deal of the aforementioned Update justifying the 15.0x multiple of the dividend we used to get to that lofty return (a Target Price of $36.00 for a BDC that closed Friday at $18.13). That's admittedly high, but reflects the ability of the BDC - and proven on multiple occasions - to generate both recurring income from loans AND from realized gains on equity investments. Down the road, this double-barrelled capability could generate both superior earnings and multiples).
This week we get a great deal more earnings releases. We'll be kept busy reassuring ourselves that the BDcs involved are performing as we anticipated while taking the temperature of the markets in a new month and in the new post-First Republic sale environment. While all this happens, long-term BDC investors will continue to have an almost unequaled array of outstanding investment opportunities if they are ready to see beyond the current uncertainties. Hard to do, but as our Expected Return Table hopefully shows, potentially very rewarding.