Sean-Paul Adams, Senior Research Analyst, B. Riley Securities
Sean-Paul Adams is a Senior Research Analyst at B. Riley Securities covering business development companies (BDCs) and the broader specialty finance sector. Prior to joining B. Riley Securities, he served as a senior research associate at Raymond James, where he worked on equity research coverage of BDCs and various specialty finance verticals.
Mr. Adams holds a Master of Science in finance from the University of Florida’s William R. Hough Graduate School of Business and a Bachelor of Science in finance from the University of Florida.
He explains the current state of the BDC sector in this way:
“…We’re seeing a convergence of three different factors.
One is declines in the interest rate and the underlying SOFR curves as well as spreads.
We’re also seeing a re-evaluation of dividend run rates that have been assessed from previous highs, and that’s a natural change.
It’s good for the BDC vehicles to re-assess their dividend policies as these interest rates are coming down.
However, there have also been portfolio realizations that have been largely negative.
This has created this convergence where you’re seeing, usually in this quarter specifically, dividend policy changes, large realized losses or unrealized losses, as well as some significant portfolio marks that have been making headlines.
So it’s this convergence of three things, and there has been a lot of publication about some of these larger private credit events that have made people in general jumpy.”
The worst is past for many BDCs according to Mr. Adams.
“Right now, there’s a lot of BDCs that have taken either dividend changes or have very comfortable earnings coverage for their forward earnings versus their dividend policy.
Those BDCs are unlikely to have near-term dividend changes.
However, when you start looking at other BDCs that have not evaluated their dividend policies, where they have for the past couple quarters earned right at or under their current dividend payout rates, those are likely to cut their dividend.
As far as credit events, you have to start evaluating the historicals of the BDCs themselves and start looking at what their origination policies were or what their underwriting track record was, especially when you start looking at either 2008 or 2021.
So there’s several BDCs who have a track record of having extremely strong credit underwriting quality, very strong standards, and also very high recovery rates.
When you look at Ares (NASDAQ:ARCC) historically, they have a very high recovery rate even for credits that have gone on non-accrual.
So when you look at those BDCs in specific — BDCs like Sixth Street (NYSE:TSLX) — we expect to have optimal portfolio credit quality and for that to not significantly deteriorate or change throughout our forecast periods.
However, there are BDCs that have had changes in their earnings or significant portfolio credit updates this quarter, FSK (NYSE:FSK) or New Mountain (NASDAQ:NMFC) for example.
Those are a result of a convergence of factors. There’s been higher levels of PIK in the portfolio and there’s also higher levels of aggregate non-accrual rates.
A lot of these changes announced this quarter have been proactive, which is, “Hey, we’ve either had portfolio sales to get our PIK rates down and we’ve taken that cut immediately,” which is selling below par.
Those changes can somewhat be looked at as a benefit in that they’ve taken the hit and cut out the fat and excess.
But what led you to that point?
The PIK rate and the earnings quality has been on a decline for several quarters, and that has led to taking this loss now.
For some of those BDCs, we expect there to be either flat performance or there could be continued incremental deterioration.
However, it’s important to note we don’t believe there’s going to be outsized credit events where this is similar to the 2008 crisis.”
If the worst is over, where would Mr. Adams put an investment now?
“For my more medium-term, long-term holding, I’m a huge fan of OBDC, the Blue Owl platform.
I believe that when you’re evaluating BDCs that have had large outsized quarters, in which you’re looking at 5% to 10% drops in NAV, they are trading at that discount while having the underlying portfolio metrics at or akin to peers trading at a much higher premium.
So OBDC is trading at a discount akin to peers that have had large portfolio losses in NAV, while their actual performance was stable.
When you evaluate their current discount versus Ares, Blackstone (NYSE:BXMT), or TSLX, they are trading at a very large material discount while having ROE metrics, NAV metrics, and portfolio structure similar to their peers, while trading at the discount akin to BDCs that have had 20% or 10% drops in NAV.
I believe that’s a near-term accretion when you’re baking in a very, very large near-term portfolio risk to that platform when the underlying portfolio isn’t even outsized for technology.
OTF, the sister BDC, is traditionally oriented toward technology and software, but OBDC, the software and technology aspect of it is not outsized.
It has diversified into several different sectors.
So I believe it’s more headline risk, which for me is the most interesting because it creates true valuations where the valuations of the BDC are not trading in sync with their underlying credit performance metrics.
That’s why it’s an outsized buy.
I think when you look in the near term at other BDCs, we’ve seen that Carlyle (NASDAQ:CGBD) similarly has been affected by headline risk.
They’ve had several management changes, as I’m sure you’re aware.
That has led them to trading at a 30% to 40% discount to NAV, but the underlying credit metrics of the vehicle are quite strong.
So my take is that when you look at BDC vehicles, you have two that are trading at a very large attractive discount.
If you’re chasing those 15% dividend yields on current trading prices, you can look at either of two types of vehicles.
One, vehicles that have had very large outsized losses in the portfolio where you’ve priced in that risk — New Mountain, FSK.
Those vehicles I believe have an appropriate risk discount assigned to them.
Then there’s headline risk, which is Blue Owl and CGBD, Carlyle.
They are currently trading more on the headlines and not the actual results, and that’s more of the disparity between the retail ownership and the actual markets.”
Mitchel Penn, Managing Director and Senior Analyst, Oppenheimer & Co.
Mitchel Penn, CFA, is Managing Director and Senior Analyst covering business development companies for Oppenheimer & Co. Inc.
Prior to joining Oppenheimer, he followed business development companies at Janney Montgomery Scott.
In addition, he was an Equity Portfolio Manager/Financial Analyst at Legg Mason Capital Management from 2001 to 2012 where he specialized in financial companies.
Prior to this, he managed fixed income portfolios at Legg Mason Capital Management and Aetna.
He began his career as an accountant at Price Waterhouse in 1981.
Mr. Penn is a member of the Baltimore CFA Society and has served as president and also on the board of directors.
He holds a B.A. from Villanova University and an MBA from the University of Chicago.
This highly experienced BDC investment advisor sees alot of opportunity in the current sector.
“The BDCs right now are trading at right around 78% of book, so they’ve priced in quite a lot of bad news.
You have to be aware of that because people come out and say, “Hey, we think credit losses are going to be worse than we thought.”
Well, they’ve already priced that in.
A lot of BDCs have priced in the losses that you would typically see in a recession.
You’ve got some BDCs that are trading at 50% of book.
The other thing that’s happening is people are worried about software.
We don’t have any good data in terms of credit losses on software, but there’s a lot of speculation that AI could impact credit losses on software companies.
We do expect some spread widening in software loans in the next few quarters which would likely lead to markdowns.
As an analyst, we track credit losses every quarter, but we haven’t seen any major trends there.”
BDCs as a sector cover a wide range of possible investment vehicles.
“We cover 33 names and the market cap ranges from $80 million to $13.5 billion.
We only have nine “buys” and some of those are small BDCs and some of those are big BDCs.
So, we don’t find a correlation between size and ROE.
There are big BDCs that perform lousy, and there are small BDCs that perform lousy, and there are big BDCs that perform really well and small BDCs that perform really well.
We look at the ROE, and if you earn above your cost of equity capital, then you should trade at book or better.
If you earn below your cost of equity capital, you should trade at a discount to book.
The way to think about expected ROE is to look at historical ROEs for BDCs.
If the BDC historically earns 6% ROEs, it’s hard to predict that they’re going to earn 10% going forward.
We kind of use history as a judge.
We actually look at the five-year average ROE.
We have data since IPO for everyone but we find the best correlation between ROE and price-to-book is the five-year average ROE.
If you think about it, BDCs tend to make five-year loans.
They borrow pretty much in the five-year debt market.
So five-year trailing ROE ends up being a pretty good predictor of price-to-book and we find that the correlation is high.”
The top picks from Mr. Penn are in synch with Mr. Adams.
“Right now, we like Ares (NASDAQ:ARCC).
Ares is running its leverage at 1.1 times, which is lower than the group, with 1.2 times.
Their ROE since IPO is 11.2%, so they have a good ROE historically.
They’re trading at 94% of book, so that is very attractive.
Typically, they trade around 1.1 times book.
Another one we like is Golub (NASDAQ:GBDC).
Their ROE since IPO is 8%, but on a trailing two-year, it’s 8.7% because they recently changed their fee structure so they’re generating a slightly higher return.
They are trading at 82% of book, so they are essentially pricing in the losses that you would see in a recession.
The next one is Blue Owl (NYSE:OBDC).
They’ve generated a 9.6% ROE since IPO and 9.3% trailing two.
They trade at 77% of book.
Again, they’re pricing in the losses that you would typically see in a recession.
Those would be our top three.
If we had to add two others: Crescent Capital (NASDAQ:CCAP), they trade at 68% of book.
Their ROE since IPO is 8.5%. At 68% of book, they’ve priced in all the losses you would typically see in a recession.
And our last one is Sixth Street (NYSE:TSLX).
They are trading at 1.1 times book and their ROE since IPO is 12.5%, and on a trailing two is 11.2%.
The issue that TSLX has is they have 40% of their portfolio in software.
They’re not a tech fund, however, it’s a little higher than the average BDC, but they have a great track record in underwriting credit.”
Read these exclusive full interviews from Mr. Adams and Mr. Penn and many more only at the Wall Street Transcript.
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