BDC Market Snapshot : Week Ended February 4, 2022

MARKET CONDITIONS

The past week was a positive one for the BDC sector and most BDC common stocks. As we wrote in the BDC Reporter, the sector was up 2.63%, and closed Friday just off its 52 week price high. Using the BDC Wilshire BDC Index "total return" calculation, the BDC sector was actually at an all-time high intra-week. Intriguingly, BDC performances outmatches all the major indices recently.

Reason Why

We're presuming that this BDC "re-rally", which followed a brief slide in the second half of January, has much to do with investor expectations that all the talk of higher short term rates (4 hikes ? 5 hikes ? in 2022) will translate into higher income in 2023 and beyond. Match that with BDC borrowing costs that are in most cases largely fixed thanks to an abundance of unsecured notes raised in recent years and you've got a recipe for higher earnings and dividends. As we wrote about in the BDC Common Stocks Market Recap this week, that's a plausible scenario and good reason to be optimistic, but only one of several possible scenarios over the next few years.

Holding Off

We're not yet integrating any assumption about higher rates in the 5 year dividend projections of the 45 BDCs we track. (By the way, that number will shortly drop to 43 as SLR Senior Investment Corp will be acquired by its sister BDC and Newtek Business Services will cease to be a BDC). If and when we do, this will add a degree of uncertainty to the numbers as no-one - including the Fed - really knows what short term rates will look like just a short time out.

OPPORTUNITIES

Same Six

Notwithstanding the increase in BDC prices, the number of BDCs which promise a 15.0% or greater annual return for the next 5 years remained unchanged this week. The promising BDCs remain the same as the ones we discussed last week: AINV, CCAP, CION, FSK, NEWT and TPVG.

Promising

Worth mentioning is that we count 25 BDCs projected to achieve annual returns between 10%-15%. That suggests, when you add the two groups together, that nearly 70% of BDCs promise a decent return to patient investors. As always with BDC investing, the bulk of the return will come from distributions received. By way of comparison - using Seeking Alpha data - over the past 5 years, 18 BDCs out of 37 (roughly half) have achieved annual returns of 10% or more. Maybe we're being unduly optimistic about the BDC outlook or we're in something of a BDC "Golden Age". Obviously, as we're the ones who have come up with these projections, we lean to the latter explanation. As in all things investing, only time will tell.

Update

The week ended February 4 was the first week of earnings season. Just 4 players reported results, adding to SAR's November 2021 quarterly performance that occurred a few weeks ago.

Of the 4, only one BDC figures in our projected out performer group - Apollo Investment (AINV). As anticipated, management used the opportunity to re-define its dividend policy after many quarters of paying a $0.31 regular and a $0.05 supplemental - both typically announced at the same time. However, as discussed in the update we wrote this week, the new policy of paying out every quarter $0.31 and the difference between that number and the prior quarter's EPS has not really changed the uncertainty about AINV's dividend. More importantly, given that AINV is currently earning Net Investment Income Per Share of $0.35 quarterly and could readily move earnings up a notch higher, we've chosen not to alter our 5 year projection. The annual pay-out remains unchanged at $1.44 (i.e. $0.36 per quarter).

Bumping Up

Elsewhere, as we anticipated Capital Southwest (CSWC) increased its IQ 2022 distribution to $0.48. We currently expect either a further 1 cent per quarter increase or some sort of special that will bring the 2022 payout to $1.98. That's way below the $2.56 CSWC paid out in 2021 when the BDC was distributing the remains of its taxable income achieved from net realized gains. As of the IVQ 2021, there was only $0.32 per share of undistributed taxable income remaining and we expect management will keep that for a rainy day or to support a secondary stock offering. Nor are we counting on new net realized gains to be achieved or distributed, as discussed in the BDC Reporter IVQ 2021 Credit Review of CSWC.

Valuation Explanation

From 2023 on - as before - we expect CSWC's distribution will level out at $2.04 per annum. That's a 12.6% return on equity using the BDC's IVQ 2021 NAV Per Share. That's high by BDC standards but not impossible given CSWC's internally managed (i.e. lower cost) status, and its substantial unused SBIC borrowing capacity at a yield just over 1%. We continue to use a 15.0x terminal multiple for the Target Price, which is $30.60. (We concur that the multiple is high, but note that we're using 16.9x for MAIN, which has much in common). As of Friday CSWC traded at $25.94 (a whopping 60% premium to net book value) and has reached as high as $28.41 in the last 52 weeks - it's all time apex. The current yield is 7.4% and the projected 5 year return a still above average 58% (11.5% per annum).

Another Bump Up

Also reporting - and increasing its regular dividend - was Oaktree Specialty Lending (OCSL). The quarterly dividend is now $0.16 - as we had expected. For the rest of 2022, we expect only half a cent average increases per quarter, for a total of $0.67. Under Oaktree's direction - and thanks to merging with its sister BDC - OCSL has been one of the great turnaround stories in BDC history. The dividend has been increased 7 times in recent years and NAV per share has jumped 11% since the end of the pandemic.

However, with the BDC reaching maximum leverage, the question is when does OCSL's dividend top out ? We've projected the payout will flatten in 2023 at $0.7000, or $0.1750 per quarter, a further 9% increase from the IQ 2022. Even that number may be controversial as the earnings consensus for FY 2022 (ending in September) is for EPS of $0.67 and FY 2023 is for $0.68. NAV Per Share growth will also likely also slow. Even in the last two quarters that metric has increased only 0.8% in each period. The ROE, using the $0.7000 dividend and the latest NAV Per Share is 9.5%.

OCSL closed Friday at $7.70, just off its $7.81 52 week high. We have a Target Price of $9.20. The current yield is 8.3% and the projected 5 year return is 66%, or 13.2% per annum.

Average

Finally, Gladstone Capital (GLAD) reported an unchanged distribution, in line with our expectations for this quarter and the next 5 years. The projections and the Target Price ($12.48) remains unchanged by what we've learned. We project GLAD will achieve a 44% return by 2026 - an average performance. Currently the BDC trades at $11.33, but has been as high as $12.58. With a $0.78 annual pay-out - in monthly distributions - GLAD yields 6.9% and trades at a 20% premium to par.

As one can tell by the premium to par, this is a very popular stock with retail investors who adore the steady monthly distribution and the 14% increase in NAV Per Share since IVQ 2019. In its own way, under CEO Bob Marcotte GLAD is also a successful turnaround story. As a result, finding an investment entry point that offers a superior long term return has proven hard.

Best Idea

With no new names in the projected 15%+ per annum category and nothing very market moving in the way of unexpected developments, there's no Best Idea this week to write a full fledged article about. Instead, we're re-iterating that AINV - where we still project a 79% 5 year return for - is still worth a look even though the stock price has increased since we first wrote about the stock on November 11, 2021.

Much will depend on the BDC - much out of favor despite its famous brand name - gaining the trust of investors and trading at a multiple of EPS/dividend more in line with its peers. Bain Capital (BSCF) - which has almost the same AUM - is trading at 11.7x its dividends and TPG Specialty (TSLX) at 13.0x. AINV - as we've discussed - is at 9.8x. In fact, when we reviewed all BDCs with AUM between $2.0bn-$3.0bn, we identified 6 players. Of that half dozen AINV trades at the lowest multiple of its distribution.

On paper, the price appreciation is huge (by BDC standards). If AINV ever traded at the TSLX 13.0x multiple of its latest annualized distribution - $1.40 - the stock would be at $18.2, 35% higher than as of Friday's close.