BDC Market Snapshot: Week Ended March 31, 2023
As we discussed in the BDC Reporter in our weekly article to all readers, BDC sector prices moved up for a third week following the big drop caused by SVB's demise (do we even need to spell out who we're talking about ?). However, investors remained cautious, looking around in every direction for any sign of further SVB-like situations. As a result, the BDC sector has effectively given up all the price gains achieved in 2023 and prices have been rolled back to where they were in the first week of this year. However, BDC bulls will point out that the S&P BDC Index never dropped during this recent episode below its level in December 2022 when the most recent rally began and was well above the lowest low of September 2022.
Where We Are Now
If our projections - both for distributions and for terminal values down the road - are close to being accurate, this remains a very good time to invest in any number of BDCs. Given that the malaise in the stock market is very general and most stocks - not just BDCs - are trading at very low multiples (see for yourself in the Expected Return Table which has 2 columns of price-to-earnings and price-to-dividend data) there are many, many attractive choices available.
Words Of Warning
The immediate risk to this rosy picture that we can envisage - starting in the first half of 2023 and going on thereafter - is that we've greatly under-estimated upcoming credit losses at the BDCs. This is a constant concern of ours which we address regularly in the BDC Reporter where we write a weekly credit recap for subscribers and which we monitor daily in the BDC Credit Reporter. Our current assessment is that the number of troubled BDC-portfoio companies has risen sharply in 2023 BUT remains well within "normal" levels. In our case that means any impact on earnings or distributions has already been factored into our estimates.
In the last 2 years, the public BDC sector as a whole has recorded net realized gains, with the harvesting of equity stakes; selling new shares above net book value and repurchasing shares at a discount offsetting realized credit and other losses (like early repayment of debt). That begun to shift in the IVQ 2022 and should continue in 2023. However, we don't expect those net losses to amount to more than 2% of the sector's net asset value - or just over ($1bn). If we see losses accelerating and reaching much beyond that billion dollar level, we'll have to re-assess.
Another variable that will affect our projections is what the Fed does about interest rates. We've been assuming the Fed Funds rate remains in the 4.5%-5.0% in 2023, and only drops marginally in 2024 and slumps back to 3.0%-3.5% thereafter. Rightly or wrongly, we don't see a return to rock bottom reference rates. We listen to the never ending debate about what level rates will reach and when, but there was nothing definitive enough said this week in the zeitgeist to cause us to change our prognostications.
We Are Not Alone
All in all, we are comfortable with our attempts to quantify both distributions and long term values but only time will tell. The analysts are coming to grip with the same uncertainties as we are in their earnings projections. This week we updated every "analyst earnings consensus" for 2023 in the Expected Return Table and added the estimates now being made for 2024. (All but two BDCs in the Expected Return Table have estimates for both years).
A Two-Fer ?
The analysts seem to be comfortable mostly raising projected earnings for 2023 over what they were penciling in previously. Overall, 2023 should see BDC earnings increase by over 12% compared to 2022, with three-quarter of our coverage universe expecting higher profitability than last. If true, that would represent two years in a row of a broad-based earnings surge in the BDC sector. Thank-you Chairman Powell for gift that keeps on giving, albeit after more than a decade of artificially tamping down the cost of borrowing.
2024 is a different kettle of fish where earnings projections are concerned. The analysts expect two-thirds of BDCs in calendar or fiscal 2024 to reduce their recurring earnings (i.e. Net Investment Income Per Share). Our numbers show a (9%) projected drop over the 2023 estimate. On the dividend side, we are more optimistic than the analysts in 2024. Our educated guess is that the analysts earnings projections will be subject to upward revisions. Furthermore, BDCs will have plenty of undistributed earnings left over from 2022-2023 to subsidize shareholder payouts in 2024 and beyond. We expect 32 BDCs to report unchanged payouts in 2024 and even 2 to increase.
Also noteworthy this week is that we re-set our projections for Logan Ridge Finance (LRFC) - a BDC that has just begun paying a regular diviodend again after a long hiatus. We also wrote an Update for anyone interested in this tiny BDC with a complicated history. We can now report that every BDC in the Best Ideas coverage universe has been updated and the projections reflect all the latest information available to us, most notably the year-end 2022 results.
Not Quite Yet
While the projections are current for every BDC, we have not written a full Update in each case. That's our next task: ensuring we explain what's behind our thinking for every BDC for our readers to agree or disagree with. We hope to be fully caught up by the end of April.
We know that the IQ 2023 was full of volatility where the BDC market was concerned and that could well be our fate in the next quarter and throughout the year. That's the nature of investing these days. However - looking back over the last few months - virtually every BDC we track has performed more or less as we had expected in all the categories investors care bout: assets under management; earnings; distributions; credit and strategic direction. Frankly, it's been some time since we've been truly shocked by a BDC press release or while digging through the filings. Even the unexpected switch of manager at Horizon Technology Finance (HRZN) to a Monroe Capital affiliate (still underway) fits within that bigger theme of BDC consolidation we've been droning on about for some time.
We may be tempting fate by saying so, but the BDC sector seems to be headed just where our numbers suggest, with a great deal of players reporting ever higher earnings and distributions, and only a modest loss in net book value. There are only a few names that might not be here 5 years from now - either because of a flawed business model or swallowed up by a bigger player. The sector is benefiting from several preceding years when balance sheets were fixed (3.0% fixed rate unsecured medium-term notes !); loans were increasingly made high on borrowers balance sheets and portfolio diversification was emphasized.
No Flash In The Pan
What nobody foresaw - but remains the critical element in our expectation for the sector's growth - is that the Fed would drastically improve the economics of leveraged lending in its still-incomplete campaign to combat inflation. Our view is that this represents one of those "secular shifts" which - by definition - happen only occasionally and will be ultimately reflected in "permanentely" higher BDC returns on equity and valuations.