BDC Weekly Review: Will Dividend Coverage Ever Fall Back To Earth?

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 third week of August.

Market Action

BDCs were off close to 2% as lower stocks and Treasuries took their toll on the income space. After a strong June and July the sector is off about 2.5% so far in August.

Aggregate valuations dipped a touch below 100% after matching their historic average level.

Market Themes

It’s no secret that the BDC sector has enjoyed significant net income gains over the past 18 months or so. The chief reason for this has, of course, been the sharp pace of Fed hikes which has boosted the coupons on BDC holdings, most of which are anchored off short-term rates. Add to that a significant amount of leverage roughly half of which is in the form of fixed-rate bonds as well as relatively stable portfolio quality and we have a recipe for sharp net income gains.

The direct result of these net income gains have been dividend hikes. These have come both in the form of base dividend gains as well as additional special and supplemental dividends.

However, dividend hikes have not kept pace with the gains in net income so that many BDCs boast very high dividend coverage levels. These BDCs have been fairly stingy and have not been passing through all net income gains to investors.

The question is whether investors can expect this to change and whether the dividend coverage figures of 120%+ that most BDCs boast will revert closer to 100%.

In our view the answer is no. This is because BDCs enjoy many advantages to retaining income over and above their dividends.

First, retained income flows straight to book value, supporting it. Without this tailwind, NAVs would be lower. Although this has no impact on total NAV returns, investors like to see stable and rising NAVs. Normal frictions like realized losses and unrealized depreciation can eat away at the NAV – a completely normal process for credit vehicles like BDCs where some amount of loss is almost inevitable.

In this way retained income is more likely to lead to higher valuation of the BDC. A valuation above book value makes it easier for managers to raise capital which leads to greater scale and more management fees.

The second big advantage of retained income is that it provides cheap capital to the BDC. BXSL mentioned this explicitly on their call when asked why they are not distributing the excess net income. BDCs have to pay a 4% excise tax on retained income however this is much lower than other ways to raise capital such as through new share issuance (which would require a double-digit dividend yield rather than the 4% excise tax).

Finally, most market participants (the Fed included) expect short-term rates to top out in the near term and for them to descend slowly over the next several years. This will push net income lower. The high level of coverage is there to provide a cushion to net income and prevent the BDC from having to cut the dividend in the future. Many BDCs pride themselves on never having cut the base dividend.

Overall, we would expect BDCs to carry on with very high levels of coverage particularly in an environment of potential credit losses and lower short-term rates. Although this can be disappointing to investors, it can actually benefit the BDC and, therefore, investors themselves.

Market Commentary

Trinity Capital (TRIN) reported good results with a 4.9% total NAV return on the quarter. After 5 quarters of NAV drops, it rose marginally.

Non-accruals fell to 2% despite a big quarter in realized losses of 5.5% – the sixth straight quarter of realized losses. The company’s 1Y total NAV return of 6.1% is below the sector average.

Despite that, the stock’s valuation has risen to 109% – 11% above the sector median level. Both venture-debt focused TPVG and TRIN continue to trade above the sector average valuation despite underperformance over the past year – a combination which remains a puzzle. Whether it’s hoping for some sort of manna from heaven from the SVB collapse or the fairy dust from another venture debt BDC HTGC which has absolutely killed it, the high valuations remain a puzzle.

WhiteHorse Finance (WHF) had an OK quarter with a 1.2% total NAV return. The NAV fell around 1.4% due to unrealized depreciation. Non-accruals rose to 2.7% on fair-value – a bit higher than the sector median but not excessive after running at a near zero level for several quarters.

Part of the reason for the jump is the lack of realized losses. Some BDCs choose to restructure a non-performing loan, often realizing losses. The benefits of doing this is that it opens up the potential for future gains in excess of the original position as the restructure often flips a secured loan into equity.

It also pushes the non-accrual figure lower as common shares are not interest-paying securities and so are not counted as non-accruals. WHF hasn’t done this during the quarter so is likely one reason why the non-accrual figure has jumped up. Over the past year the stock has underperformed the sector by around 2% which also explains its valuation of 7% below the median figure. Not particularly cheap but worth watching.

Overall, the BDC sector remains in the slightly expensive range in our view considering the steadily weakening macro picture and relatively low levels of interest coverage in BDC portfolios. We are not adding to our holdings at the moment as we expect better bargains through the rest of the year.