BDC Market Snapshot: Week Ended March 17, 2023
When we wrote the Market Snapshot last week, the futures markets were all in the green - excited about the Fed's promise of a new Bank Term Funding Program (BTFP) to bolster the liquidity - if needed - of the banks. If only for a brief time, the crisis triggered by the very sudden failure of Silicon Valley Bank seemed to have passed. We - innocently - bemoaned the BDC price rises likely to come when the market opened, which would have rolled back the very high prospective Total Returns on offer brought on by the big losses of that week.
Of course, we now know that the markets took a deeper look at the BTFP and decided that the government was seeking to solve this crisis with half measures. As a result, with deposits still flowing out of regional banks and into the largest institutions - cratering the former's stock prices - our bank crisis rolled on. Coincidentally, this was occurring as a long-simmering drama over in Switzerland - but with global implications due to the inter-connected amounts involved - came to a head with the failure of Credit Suisse. The banking giant has now been acquired by another banking giant - UBS. However, stateside nothing has been resolved.
In a move that confuses more than reassures the Biden Administration is leaning on a nonagenarian - Warren Buffett - for advice, while the regional banks are asking that all their deposits be insured by the government - for two years. Remarkably - given the amounts that would be involved - this is not being dismissed out of hand. It could be that the banking system is about to undergo a transformative moment, which will have all sorts of unintended consequences in all sorts of places - including the BDC sector. (There's a good chance that the BDC sector - with its stable balance sheet and no reliance on short-term deposits - may emerge even more in demand than before for borrowers everywhere, but we're getting ahead of ourselves).
Speaking of BDCs, we did not get that price bounce back expected. The sector's overall price increased by a meaningless 0.1%, although there were plenty of individual BDC price increases and decreases. The bottom line, though, is that the long-term BDC investment opportunities - going by our projections and assumptions - remain at record levels. Let's do the numbers:
Incredible as these potential returns might seem, they make sense given that we're seeing both a sharp pullback in prices - with several new 52-week lows reached this week - and record-high earnings and distributions forthcoming from the BDCs. In regards to earnings, the Expected Return Table - which constantly updates the analyst EPS consensus for every participant - indicates 2023 will see an increase of 10.7%, with three-quarters of BDCs posting better numbers than in 2022. Our own dividend projections for 2023 estimate a 9.1% jump over 2022 and after a similar gain in 2022 over 2021's performance.
Now it's true that the analysts are also beginning to offer up 2024 EPS projections. We've not yet featured them because the coverage is spotty. In most cases, the analysts' models are leaning towards lower results in 2024 than in 2023, but only modestly so. We imagine the estimates are based on lower base rates and - possibly - higher credit loss assumptions. We project, though, that distributions will only drop (1%) in 2024, as earnings booked this year get released with a lag as BDCs seek to maintain a stable payout profile.
Even further down the road (2025-2027), you'll see we've deliberately maintained BDC distributions at a new plateau, not dropping back to the 2019-2021 levels. That's because we believe that interest rates - even if they fall from their highest heights - will not be returning to their absurdly low levels of yesteryear. We anticipate base Fed Funds rates of 2%-3%. In addition, loan spreads have greatly widened all year and that process continues in 2023. Many of those more profitable loans will be on BDC books for years to come, even as the world normalizes.
Changing Income Mix
Also, BDCs will eventually get back to earning juicy fees for both booking and existing loans when buyout activity picks up again in 2025-2027. That source of income has been greatly curtailed of late. Then there's the possibility of net realized gains on equity stakes owned - a significant source of some BDCs distributions during good times.
Let's Talk About The Elephant
The biggest unknown that could undo some of the above - even in the latter half of 2023 - would be a material spike in credit losses. Clearly, that's what many BDC investors are providing for in these BDC price pullbacks. That's natural enough, and we've seen this phenomenon in 2008-2009, 2011, 2013, 2016, 2018, 2020, and - this time round - since April 2022. However, the market is not some infallible crystal ball of collective wisdom - it's more a matter of collective caution. In 2011, 2013, 2016, 2018 and even 2020 prices eventually moved back up without outsized credit losses occurring. The only time the rush to the exits proved warranted was in the GFC, and even then investors greatly overreacted as BDC losses were nowhere near as awful as the sometimes (90%) drop in stock prices predicted.
Hanging In There
We're not blind to the prospect of higher credit losses but the facts have not yet changed enough to cause us to change our projections. In many cases, our estimates already have some credit deterioration booked in. For the predictions to require material amendment we'll need to see 10%-20% of BDC book value getting written off from failed debt and equity investments. That entails 20%-40% of BDC assets getting "into trouble" as a rule of thumb. We're not anywhere near there, nor expect to be, but will keep an open mind as the fallout from this changing financial landscape occurs - a process likely to take several quarters.
From Big Picture To The Mundane
During the week and over the weekend, we've been tidying up the Expected Return Table as best we can. With the BDC IVQ 2022 earnings season all but completed, we're trying to ensure that our projections for every BDC are up-to-date. In many cases that includes writing an Update and offering a link to the article involved, explaining why we've changed our forecast. Sometimes we write an Update to explain why we've NOT changed our projections. In every case, we're trying to make our analysis timely and actionable for anyone in sympathy with our assumptions.
Also, be aware that we're constantly updating the analyst EPS projections for 2023 - whether fiscal or calendar year - and the actual Net Investment Income Per Share (either the GAAP version or the non-GAAP equivalent) and dividend payouts for 2022. This gives the reader a sense of the recent earnings and distribution track records for every BDC featured. The dividend data goes back to 2019 and the earnings to 2021. Even if you disagree with our projections, the historical data should be of interest to anyone investing. (Just be aware that there's a huge amount of data to corral and occasionally we make mistakes. Please let us know if you find any errata by writing to firstname.lastname@example.org).