Gladstone Investment: Benefits From Lack Of Rate Cuts (NASDAQ:GAIN)

Overview

The latest CPI report released, and the overall sentiment leads to a lower chance of interest rate cuts. The original probability of interest rate cuts before the March CPI report was around the 56% mark but has now dropped to an 18.5% chance of rate cuts by the end of June. While the market seems to be unpleased with this news, I think it’s a great thing for the Business Development Company [BDC] sector and companies like Gladstone Investment (NASDAQ:GAIN) will mostly benefit from a higher rate environment. We can see how the price of GAIN has an inverse relationship with the federal funds rate; GAIN’s share price rose quickly when rates were near zero, but then dropped once rates rose.

So how are higher rates a good thing? Even though the share price may not agree with higher rates, the portfolio of quality holdings sure does. As a result of a higher interest rate, GAIN can collect higher levels of Net Investment Income [NII] from the interest collected on debt investments they make. I previously covered Gladstone Investment with my article titled: ‘Remains A Buy After Price Run‘. While the price remains in the same area as my last coverage in December, my previous coverage included the outlook of a better price movement since rates were anticipated to drop. Now that the outlook has changed a bit, I believe we are likely to see even higher levels of profitability in this interest rate environment.

With a BDC like GAIN, that’s exactly what we’re here for, isn’t it? After all, higher profitability usually leads to higher distributions and supplementals in this space. Most people get involved with BDCs for the income they can provide, and I think we are primed for higher levels of income because of the way GAIN’s portfolio and investment strategy is put together.

Versatile Portfolio Growth

GAIN’s portfolio strategy is to focus on companies within the lower middle market area with an EBITDA falling between $4M – $15M. They specifically filter for companies with positive cash flow generation, they also adopt a buyout structure. They can become a primary equity investor by frequently partnering with existing management teams. They provide debt capital to companies and aim for a targeted mix of 25% equity and 75% debt. This strategy has paid off in the past when the equity portion of their investments grows to sizeable levels and can be sold at a large margin. For example, in October 2023 they announced a $0.88 special dividend with the proceeds earned from realized capital gains on the equity portion of their investment.

I bring this up because the relevance of this strategy becomes even more prominent in an extended period of high interest rates. During prolonged periods of high interest, there may be a lesser amount of portfolio companies that are willing to service a debt investment with high interest payments. As a result, we can see a rise in the portion of equity-related investments that take place. Since inception, the average buyout exit cash-on-cash equity return has been 4.0x. While this doesn’t necessarily mean an increased likelihood of special dividends again, it is a testament to how versatile GAIN’s strategy is in this environment of higher rates.

Part of their strategy includes a focus on secured 1st and 2nd lien term debt. While the portfolio growth of investments happens at a much slower rate than some other BDCs, it has been highly effective. For example, from 2019 to fiscal year 2022, GAIN has made investments in only 9 new companies and deployed $277M of new capital. For reference, I recently covered FS KKR Capital Corp (FSK) and they’ve allocated $680M towards originations of new investments in the last quarter alone.

During the same period, they’ve had 14 successful company exits and returned proceeds north of $431M. However, this growth has been highly effective, as they’ve managed to grow the portfolio at an annualized rate of 7.4%. Over the same time frame, the NAV (net asset value) has also grown at an annualized rate of 4%.

In terms of portfolio, GAIN remains very diverse in nature. The leading industry exposure is in consumer products and services at 33.2%, closely followed by industrials making up 15.3% and business services making up 14.5%. These three industries make up close to a third of GAIN’s total portfolio. While the majority exposure to consumer products and services may leave GAIN less likely to experience price upside as a tech BDC might, the current portfolio allocation allows for a more defensive stance during this current high interest rate environment.

For example, Hercules Capital, Inc. (HTGC) has a large portion of their portfolio exposure in software/tech-based companies. As a result, we can see a higher price return and higher volatility. Consumer products can typically be more defensive in nature, as they include business models that sell products and services that people will pay for, regardless of how well the economy is doing. This is why we see GAIN with a much more steady price range.

Financials & Interest Rate

Although the volume of new investment growth may be on the lower end of the scale compared to peers, it doesn’t mean it isn’t as strong. Remember, GAIN operates in a space where the size of companies is much smaller (EBITDA of $4M – $15M) so slower growth isn’t a bad thing. The investment income, however, has been very strong and consistent.

This can likely be attributed to the higher interest rates, as they are capable of now pulling in higher levels of interest on their debt investments. Other income from dividends on preferred investments and success from fees can also contribute to the growth. Since FY2020, their total investment income has grown at an annualized rate of 7%. I mean, just take a look at how the interest income and the amount of dividend and fee income grew when interest rates were hiked quickly throughout 2022. Interest income for FY24 already surpasses the full-year total for 2023. They can capitalize because almost all of their investments operate on a floating/variable rate basis.

Speaking of interest rates, I personally think we may still see 1 cut at the end of the year. The federal funds target rate has remained at 5.25% – 5.5% since last summer. If we do, I think it would likely be a very small cut. I still remain hopeful since many months are remaining in 2024. For now, chances look slim based on the latest CPI report. It doesn’t mathematically make sense for rate cuts to happen if inflation is not receding at the targeted 2% rate. It also doesn’t make sense to cut rates yet with such a strong labor market. The current unemployment rate is at 3.8%, which is below the historical average of 5.7% from 1948 to 2024. For reference, the unemployment rate reached as high as 15% during 2020. Therefore, I believe the current economic data leans toward the no rate cut direction. As a result, BDCs are likely to continue benefitting.

GAIN reported their Q3 earnings on February 6th and the results ultimately showed us more growth. Adjusted net investment income grew to $0.26 per share, up from $0.24 per share in the previous quarter. While NII grew, expenses simultaneously decreased to $13.3M for the quarter, down from $22M of the previous quarter, meaning that the margin of profit increased. Total investment income amounted to $23.1M, which can be attributed to an increase in interest income on the investments made from the quarter.

For the quarter, there was an additional $64.7M invested in further portfolio growth, broken down as $39M of secured second-lien debt and $25.7M of common equity in SFEG Holdings to fund an acquisition. In addition, we can see the breakdown of their fiscal year debt and equity invested capital. We can see that there was a lower amount of equity investments for FY2023 and currently ongoing for FY2024, but the return for these years is substantially higher at a gain of 2.1x and 7.2x respectively.

This shows how much more efficient these kinds of investments can be in an environment where the interest rate is higher. Looking back at 2022, we can see that equity invested capital amounted to $27,387, but the return was only 1.9x, when the interest rate rises were not completed yet. If rate cuts end up being delayed until next year, this would be a great thing for GAIN, as it would ultimately add to the increased opportunity for interest income growth.

Better Stability

The portfolio makeup of GAIN leans more towards defensive sectors like consumer products. As a result, GAIN offers a much better value here as opposed to some other BDCs. With the release of the recent CPI report, volatility has increased throughout the market. With higher interest rates for a longer period of time typically great for BDCs, it has also caused some of them to drop in price due to a deteriorating portfolio of debt investments.

GAIN doesn’t have this problem since they operate on almost exclusively floating rate loans and their portfolio companies have been able to successfully manage paying interest in the current environment. GAIN’s inclusion of an equity strategy also makes them more versatile compared to some peers that do not. Take a look at TriplePoint Venture Growth’s (TPVG) price movement over the last month in comparison. GAIN has offered a much smoother ride through these volatile markets, and I believe this makes it a better option right now.

TPVG’s portfolio companies are of lesser quality, with several portfolio companies having poor credit ratings. TPVG also has higher allocations towards tech-based companies, such as investments in the e-commerce space. As a result, this extended time frame of higher interest rates is making it difficult for their portfolio companies to keep up the payments. GAIN has three individual portfolio companies that have reached non-accrual status against TPVG’s 5.3% non-accrual rate and several downgrades in the quality of their investments. I go into full depth on TPVG’s downfall in my recent article.

Dividend & Valuation

As of the latest declared monthly dividend of $0.08 per share, the current dividend yield is hovering around 6.8%. The monthly dividend here adds an extra layer of appeal in this environment of higher volatility. A monthly distribution means you can reinvest the funds here within GAIN or allocate them to other areas of your portfolio where there may be more attractive opportunities.

Once again, we can see the effects of a higher interest rate here at work. Since FY2020, the regular distribution has grown at an annual growth rate of 4%. This is more than sufficient for an asset that is already yielding a high 6.8%. Not only has the base distribution grown up to an annual amount of $0.96 per share, but we can see a huge increase in supplementals during this time period. This further reinforces the incredible level of profitability here in this environment, and management has been able to efficiently capitalize on and reward us as shareholders.

Understandably, the base distribution growth has been strong in recent years, but if we look back on a greater timeline, the growth is still impressive for a BDC. For example, over the last 5-year period, the dividend has grown at a CAGR of 9.64%. Over a longer time horizon of 10 years, the dividend has increased at a CAGR of 3.82%. A quick Portfolio Visualizer backtest of an initial investment from 2019 to present day shows us extreme dividend income results. Dividend income received from an initial $10,000 investment in 2019 would have amounted to $1,146 and would have grown to $3,947 in 2023 due to the supplemental distributions and base dividend growth. While it would be hard to compete with 2023’s special distribution amount of $0.88 per share previously mentioned, I do still think the probability of more supplemental dividends is high in this environment.

These high levels of distribution and a consistent price range has helped GAIN deliver some excellent total returns. We can see how GAIN has provided a superb level of total return compared against some community favorite BDCs like Main Street Capital (MAIN) and Ares Capital (ARCC). GAIN has also outperformed the VanEck BDC Income ETF (BIZD) in total return on a 3-year time frame. This is a testament to how strong GAIN’s strategy works in a higher interest rate environment.

Since GAIN currently trades around its average 3-year premium to NAV of 8.41%, I plan to continue reinvesting my dividends here. In addition, I plan to add more capital upon any dips in price. The price currently trades at a slight premium of 8.53% which isn’t too wild compared to the high premium of 28.5% we reached at the peak of 2022. Since the current price sits near the average premium, I would say that we are pretty close to a fair valuation. While the latest CPI report has shaken up the markets and caused volatility, I understand if you wait on the sidelines for the price to reach a discount to NAV. However, I am betting that the price of GAIN stays relatively stable compared to some peer BDCs because of their portfolio makeup.

For the last 3-year period, the price has traded between the range of $10 per share to $15 per share. This makes the price range pretty predictable in nature. With a midpoint of $12.50 per share, I would say that GAIN is at the most attractive valuation near this price. While the current price level may not be as attractive at the $12.50 mark, I still believe we can capture great value here and capitalize on a higher NII return.

In a scenario where rates are cut at the end of the year, we might see a boost in price, but that means the NII may be negatively impacted. It really all depends on how large of a cut that happens. During the last earnings call, we received indication that the backlog for new opportunities has been building. Like the rest of the market, I am sure that companies are waiting for interest rates to come down a little bit. While the outlook has probably shifted since the latest CPI report, all this means is that the roadmap for new acquisitions and growth opportunities has been merely shifted, not eliminated.

Turning to the outlook, the deal flow, as we call it, appears to be picking up somewhat as the sellers who have been holding back over the past six months or so are testing the market. And we do hear from the merger and acquisition groups, the investment bankers who are our primary sources for new acquisition opportunities, that the backlog of new opportunities has been building. It seems like the last six months or so of last year were fairly slow somewhat, and deals were coming to the market and they were being taken back.

Now, it looks like there continues to be a bit of an increase in this regard, maybe somewhat as a result of interest rates perhaps coming down. But in any event, we continue working on a few new possible buyout deals, and we’re currently in that early phase of the process. There continues to be very significant liquidity in the market, meaning that our competitive situation is, of course, being challenged all the time. So we’re going to remain value-sensitive while we aggressively compete for new acquisitions. – David Dullum, President

Risk

I do think that GAIN is vulnerable with their exposure to equity-based investments. They’ve been able to successfully manage their exits in this environment and this is great, but as indicated by David Dullum on the last earnings call, deals are being taken back in this high rate environment. This can present challenges to maintain the same level of capital gains realized from these equity exits if the number of deals slow down. There may be less debt investment opportunities as the market continues to be highly volatile, and interest rate cuts are pushed back even further into the future.

It’s a double-edge sword; interest rates rise and this results in a higher level of NII income through interest and dividends. However, a prolonged period of higher rates may mean that there are fewer deals in the market and less portfolio companies willing to service a higher level of interest on their debt. This can translate into a slowing portfolio growth eventually. Also, equity-based investments for GAIN may have a higher risk level in the case of a recession throughout the US markets.

Takeaway

Gladstone Investment (GAIN) provides a unique opportunity to capitalize from this higher interest rate environment. From the latest CPI report of March, the probability of rate cuts in June was drastically lowered. As a result, we can expect a longer period of higher rates, which directly translates to a higher level of NII. Growth of NII has provided GAIN with more income captured from interest and dividends and has contributed to a growing base of distributions and an abundance of supplemental dividends being issued.

The current dividend yield sits at 6.8% and the price trades at a slight premium of 8.5%. However, I still believe this monthly paying BDC to be an opportunity to capture some consistent monthly income and hedge against higher rates. GAIN has been able to outperform peer BDCs such as MAIN and ARCC and better capitalize on the higher interest rate environment. Therefore, I maintain my Buy rating.