BDC Weekly Review: Why Are BDCs Asking To Issue Shares Below NAV?

This article was first released to Systematic Income subscribers and free trials on May 27.

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company (“BDC”) sector from both the bottom-up – highlighting individual news and events – as well as the top-down – providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the fourth week of May.

Market Action

BDCs were roughly flat, though dispersion was fairly wide at 8%. Interestingly, lower-valuation historic underperformers like BKCC, MRCC, PNNT and others were weak while higher-valuation BDCs like HTGC, HRZN and others outperformed. Month-to-date, the sector is slightly up in aggregate.

BDCs continued to trend higher after revisiting the bank tantrum low of early March.

BDC valuations have been range trading recently, unlike the previous longer-running trending behavior we have seen over the last couple of years. The sector looks to be fairly-valued in our view.

Market Themes

Lots of BDCs seem to be asking investors to let them issue shares below the NAV. Issuing shares below NAV is not great as it’s dilutive to the NAV, i.e. it reduces the NAV.

That said, there is an argument for issuing shares below NAV, particularly in a weak market environment. In this environment three things will typically happen: 1) BDC prices tend to fall, pushing more companies to trade below the NAV, 2) there are more attractive lending opportunities, given the rise in credit spreads and stronger lending terms, 3) wider credit spreads drive unrealized losses at BDCs, mechanically pushing leverage higher and reducing BDC lending capacity. Loan repayments also tend to fall as borrowers want to hunker down and keep liquid – another factor that would reduce BDC lending capacity. Issuing shares below the NAV may be desirable, as it counteracts the reduced lending capacity of BDCs in a distressed environment (caused by the mechanical rise in leverage and reduced repayments). Despite the NAV dilution, issuing shares could be a good result for shareholders over the longer term.

Because issuing shares below the NAV only really makes sense in a weak environment, it’s not something you want to see a lot of. Companies that keep issuing new shares below the NAV are likely just trying to grow their management fees at the expense of investor returns (due to the NAV drag).

Rather than issuing shares below the NAV, they ought to be spending more time thinking about how to improve their returns so that the price moves sustainably above the NAV. Issuing shares above the NAV is a win-win for managers and shareholders.

Thankfully, 9 times out of 10, BDCs, don’t act on their request to issue shares below the NAV. They request it not because they want to act on it today but because it’s a nice thing to have in the back pocket so that if a crash comes, they are not unnecessarily constrained in raising additional capital.

Market Commentary

BDC Capital Southwest (CSWC) reported good results. NAV rose by 0.7% and net income rose by 5%. CSWC continues to raise equity through at-the-market issuance, opportunistically taking advantage of the large premium to NAV. It appears to be the most aggressive share issuer in the sector.

The company sold shares at an average premium of 18% during Q1, creating an additional tailwind to NAV. CSWC has underperformed over the last couple of years as its high premium deflated significantly, and this has also reduced its ability to drive NAV returns through share issuance.

Despite the valuation compression, the stock looks to be fairly expensive relative to the kind of performance it has put up over the longer term. It’s worth keeping in mind that a big chunk of this performance is due to at-the-market issuance, which is something that can go away at any point (and has already gone away to some extent) once the premium moves towards zero.

There is some circularity here – the premium is high because the performance is good, but the performance is good in large part because the premium is high (because it drives NAV accretion through ATM issuance). Once this cycle breaks (due to premium deflation from, perhaps, a portfolio hiccup or a broad sector drawdown), then the performance will take a hit as well and then the premium could move towards 100% and stay there.

Stance and Takeaways

With the entire sector not trading particularly rich or cheap, we are keeping an eye on relative value rotations. On the slightly expensive side there is ARCC whose position we will look to pare if its valuation moves north of 10% above the sector average. The company makes frequent public offerings which pushes the stock down 4-5% which would offer a better time to add.

On the cheaper side we are keeping an eye on CGBD and OCSL which trade at fairly reasonable valuations and if their relative valuations fall further, we would look to add to our current position.