BDC Weekly Review: Take (Even More) Care With BDC Screens

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 last week of November.

Market Action

BDCs were flat on the week as we pushed into December. Overall, November came in as the best month for the sector for over a year.

The BDC total returns index is near an all-time high level and around 10% above the 2022 starting level.

Sector valuations remain north of 100% – near the historic average but towards the top end of the last couple of years. A soft landing scenario is getting increasingly priced into share prices.

Market Themes

BDC screens came up on the service once again. It was motivated by a third-party BDC screen which highlighted those BDCs whose prices are above their inception levels.

We discussed the pitfalls of BDC screens in a previous weekly, specifically looking at NAV screens. To quickly recap, the main issues with a NAV screen is the arbitrary cutoff and as well as the fact that it ignores the impact of dividends. In that case, BXSL had a large special dividend which pushed its NAV lower and made it miss the screen cutoff with the conclusion being that BXSL is not a quality BDC which is obviously incorrect.

This most recent BDC screen looked at prices, which committed all the previous errors, but was even worse than looking at NAVs. The idea was that BDCs that are trading at prices above their inception levels are quality BDCs.

Of course the reason people look at prices is because that’s all they have – there are much better metrics of quality (e.g. cumulative net realized losses, total NAV returns etc.) but those metrics are harder to get your hands on. The syllogism seems to be – BDC data is useful, prices are a piece of BDC data, therefore BDC prices are useful.

What’s particularly ironic about this kind of price analysis is that it is mentioned as an alternative to buying BDCs that trade at huge premiums. Of course, as many BDC investors know, if you look at BDCs whose prices have held up well, many of them will be because their premiums have increased hugely over time. Sure enough this is what we find as all the high premium stocks end up in this screen. In other words, the screen pushes investors in the same direction that it proposes to offer a solution for.

The second problem with this analysis is, simply, data quality. It was odd to find PNNT show up in the screen (see original chart below) because, as experienced BDC investors know full well, the stock is an underperformer on an NAV basis and one that trades at a substantial discount to the NAV.

In other words, it is a very unlikely candidate for having its price remain above its inception level. What we actually find is a data error – the real price chart is below which has deflated 56% since inception.

Finally, the screen does not differentiate between BDCs that have been around for over a decade versus those that were launched more recently. It goes without saying that BDCs that have launched recently will have an easier time of remaining above their inception prices than those that were launched a while back.

Overall, investors have to be very careful in using screens that are, what we call, “quality-by-proxy”. Rather, investors should demand actual, hard quality metrics. Quality-by-proxy metrics are not only second-order metrics, they can be downright misleading and could bias investors into buying, in this case, very expensive BDCs whose valuations are not justified.

Market Commentary

Sixth Street Specialty Lending (TSLX) had a very good Q3, outperforming the sector once again with a 4.6% total NAV return.

Net income ticked higher and the NAV rose by 1.4%. The company’s 100% floating-rate liability profile has been a headwind for net income which is one reason its net income hasn’t grown as quickly as that of its competitors.

Prospect Capital Corp (PSEC) did ok with a 2.1% total NAV return (the median so far is 4%). The stock’s performance is highly procyclical – it outperformed in 2021 in the risk-on / low-rate environment and it has underperformed since 2022 in a more difficult / higher-rate environment.

This is likely in large part due to a combination of its higher-beta portfolio of REIT / CLO Equity exposure and less than perfect underwriting. PSEC has had a flat total NAV return over the last year, underperforming the sector by about 8%.

The dividend was kept flat at $0.06 which hasn’t moved in years even as other BDCs have been raising rates for a while. Current coverage of adjusted NII is 139% (adjusted for preferreds dividends) so there is a lot of room for dividend hikes. It’s not clear why they are not raising dividends – it would be a quick way to get the valuation off the floor.