After a week of the greatest percentage price increase for the BDC sector all year - when all but two BDCs were firmly in the black - the number of buying opportunities for the long term investor has shrunk. At the end of October 21, 2022, there were 30 BDCs that we had identified as offering an annual return of 20% or more over the next 5 years. Now there are 21. However, the number in the 15%-20% range has expanded.
All in all, with the BDC sector down (16%) by one measure for the year and (19%) below the 2022 high point, there are still plenty of BDC investing ideas. In 2022 only 3 BDCs have managed to increase their price over the level at December 31, 2022, and no BDC is trading within 5% of its 52 week high and only 1 between 5%-10% of the top price. See the free article in the BDC Reporter recapping the week's activity.
Looking down the list of BDCs with 100% plus projected returns, we notice that all BDC segments are represented: large cap lenders, middle market, lower middle market venture and hybrid (multi-strategy). For anyone constructing a portfolio, there's still the ability to pick names doing very different things and whose credit performance should not correlate.
We should note that since our last Market Snapshot, we've done a great deal of research into credit issues at a number of BDCs. In at least a couple of instances, we've come away more concerned about eventual credit outcomes and increasing risks to earnings and distributions than we were before. This might result in a reduction in our 5 year projections for the BDCs involved, but we're waiting for the IIIQ 2022 results before acting. This, however, serves as a heads up. Because of space constraints we're going to discuss only one BDC about which we're concerned. Look for more disclosure in future article.
We were disappointed by our full fledged review of CION's portfolio as of the IIQ 2022. For some time we'd been asked why the BDC trades at a much lower multiple to earnings and a bigger discount to book than most BDCs of the same size addressing the middle market. Our first assumption was that the recent transition from a private to a public BDC status might be responsible as many shareholders might be jumping ship when the opportunity arises to sell. We've seen this phenomenon on many prior occasions as private BDC shareholders - after years of being "stuck" - suddenly have the chance to move on.
In The Past ?
From a credit standpoint, we recognized that CION had tripped up multiple times over the years and still had several non performing companies on the books. However, these were mostly "old stories", essentially written off and unlikely to cause much more damage to income or asset values. The BDC's own rating system showed total underperforming assets amounted to 10% of the total portfolio, slightly better than the quarter before and well within the 15% we use as a rule of thumb to judge if credit risk is tolerable. Moreover, that percentage is down from 30% at the height of the pandemic.
Nonetheless, when we undertook a CION Credit Review of our own, we were taken aback by how many of the 121 companies on the books were underperforming to varying degrees: 22. By itself that's not a decisive factor but we were also alarmed that one third (7) of the names were added to the underperformers in 2022 - i.e. recently. Half the valuations were trending downward, going by the latest numbers - also cause for concern.
Eye Of Beholder
More subtly - and a matter of opinion - but as we reviewed each troubled company in turn we were under-impressed by some of the underwriting choices made along the way - often where CION was the only BDC lender. To get what we're talking about you'd have to read the Company File and the BDC Credit Reporter articles we've written. There are 9 companies already covered in the BDC Credit Reporter, but we'd recommend looking at Harland-Clarke; Homer City Generation and Heritage Power. The first company is in an industry in secular decline (and highly leveraged) and the last two are fossil fuel fed power plants, with all the macro challenges you might expect. One of these borrowers has been through Chapter 11 twice already since 1969.
Maybe. Maybe Not.
So maybe some of CION's price weakness may be due to the market already recognizing these credit weaknesses. CION trades at a (41%) discount to net book value versus a BDC average of (11%) currently and a price to earnings multiple of under 7x. Maybe any excess credit losses are already baked into the price ? We know from experience, though, that should there be a marked increase in reported losses at some point down the road, many investors who did not get the memo can bail, causing the stock price to reach even lower. In any case, we're being more careful with CION, especially as there are so many other high quality, long standing BDC names with which we are much more familiar still available at bargain prices.
Speaking of the devil, we were impressed this week - but not surprised - by ARCC's excellent earnings for the IIIQ 2022 and its third dividend increase this week. (See the BDC Reporter's annotation of the conference call transcript).The leading BDC is always reluctant to up its regular distribution - sensibly worried about how investors might react should they ever have to roll back the payout. So when ARCC increases its quarterly dividend by 12%, we pay attention. At least one analyst on the quarterly conference call seemed to worry about whether this now annual pace of $1.9200 a year in quarterly payouts was sustainable, but we're not.
ARCC's earnings - and BDCs generally - are headed higher for a very long time because of the Fed's anti-inflation, anti easy money policies. These are policies that will take years to play out and rates - in our view - will not be going back to the 0%-02.25% level of the past. In fact, even when the Fed does eventually bring rates down, the lowest level is likely to very much resemble what BDCs and borrowers were contending with in the IIIQ 2022, or maybe what's coming up in the IVQ 2022.
Anyway, in ARCC's case there is a large reservoir of undistributed income that shareholders have yet to receive which should boost payouts for some time. No wonder then that we revised upward the ARCC dividend projections through 2027 on October 27, 2022, as discussed in an update article.
That might explain why the BDC - even though trading at a premium to net book value per share - still promises a 110% 5 year return in our model. By comparison - and just updated - ARCC's historic 5 year total return as calculated by Seeking Alpha is 93%.