March 29, 2017 / 6:40 PM / 4 months ago

LPC: BDC sector splitting into ‘haves’ and ‘have nots’

NEW YORK, March 29 (Reuters) - The performance of Business Development Companies (BDCs) is diverging into ‘haves’ and ‘have nots’ as some platforms continue to raise capital and others struggle to perform as conditions in US middle market lending remain challenging.

BDCs are specialized closed end investment funds that lend to US private mid-sized companies. They include publicly traded vehicles, whose shares are listed on an exchange, and private unlisted, or non-traded, platforms.

In early 2016, the share prices of BDCs were trading at a 25-30% discount to Net Asset Value (NAV), which measures mutual funds’ price per share. The discount made it difficult to raise fresh equity capital without diluting shareholders.

Although the share prices of publicly traded BDCs have rallied dramatically in the last year along with the wider equity market, performance across the sector remains mixed.

Despite falling yields and excess demand for middle market loans broadly, growing funds with access to equity capital that can deploy that capital into top tier deals have a competitive advantage over their peers, analysts said.

“We do expect to see opportunistic equity issuance, but the question is can BDCs deploy the proceeds into accretive deals? Can they cover dividends without having to invest further down the risk spectrum?” one analyst said.

More than half of BDCs are now trading at NAV or above, but individual share prices reveal a wide disparity between the strongest and weakest performers. Shares of the top performing funds are trading at comfortable premiums to book value, but among the weakest performers, shares are at significant discounts.

Hercules Capital (HTGC) is trading at a 1.43 premium to NAV, Golub Capital BDC Inc (GBDC) at a 1.22 premium and TPG Specialty Lending Inc (TSLX) at a 1.24 premium. At the other end, Garrison Capital Inc (GARS) is at a 0.77 discount to NAV, KCAP Financial Inc (KCAP) is at a 0.76 discount and Fifth Street Finance Corp (FSC) is at a 0.62 discount.

“We continue to recommend BDCs that we consider the 'haves' meaning they have the ability to sustain or increase their current dividend levels, while they also have the liquidity, debt capacity and/or valuations in excess of NAV to support growth,” said equity analysts at Jefferies in a March 15 research note. The analysts are favorable on Ares Capital Corp (ARCC), Hercules Capital (HTGC) and Triangle Capital Corp (TCAP).

To Raise or Not to Raise

BDCs’ inability to raise equity in 2016 left some funds scrambling for capital and unable to take advantage of more favorable yields early last year. More funds are currently able to raise equity, which will provide increased funds for investment in 2017.

Seventeen funds are trading above book value and several have already issued equity this year, including GBDC, which priced a public offering of 1.75m shares of common stock at US$19.03 per share. Including GBDC, at least four BDCs have issued approximately US$280m of equity in 2017 so far.

But BDCs are now operating in a tougher borrower-friendly market and are facing the perennial dilemma that the best time to raise equity is not necessarily the best time for BDCs to invest in low-priced loans.

Insatiable investor demand for private credit has pushed yields dramatically lower in 2017. Yields on middle market institutional term loans have fallen to 6.16% in the first quarter so far compared to 7.33% in the first quarter of last year.

New money loans have been in short supply in 2017 and BDCs, direct lenders and alternative debt capital providers are competing aggressively for investment opportunities. Sponsored new money volume stands at just US$9.72bn as the end of the first quarter approaches, roughly 20% lower than the 4Q16 tally.

Successive refinancings are expected this year as issuers seek to secure lower spreads, putting added pressure on portfolio yields and potentially making it difficult for some BDCs to meet dividend payments to shareholders as they struggle to replace double digit-yielding paper that is refinanced out of the portfolio, a second analyst said.

Even if BDCs are able to raise equity, having sufficient scale and relationships to get a first look at the best deals is also important, as well as a conservative fee structure, he added.

“The ability to invest that capital at sustainable yields is essential as well as being positioned to absorb a drop in interest income,” the analyst said.

Developments in the underwriting environment for middle market loans is likely to drive the amount of BDC equity issuance this year as the funds struggle to balance growth prospects, intense competition and earnings pressure. (Reporting by Leela Parker Deo; Editing by Tessa Walsh)

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