TSLX Updated Projections: Strong Q4 Coming

The following information was previously provided to subscribers of BDC Buzz Premium Reports along with:

  • TSLX target prices, buying points and suggested limit orders (used during market volatility).
  • TSLX risk profile, potential credit issues, changes in NAV, and overall rankings. Please see BDC Risk Profiles for additional details.
  • TSLX dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


 

TSLX Quick Update:

  • Even if you’re not interested in TSLX, please read this update as it contains many insights and discussion for the BDC sector and plenty of comparisons with other BDCs.
  • TSLX is currently a ‘Strong Buy’ with 10% yield before upcoming specials/supplementals (discussed below).
  • Please make purchases before the company reports a strong Q4 (also discussed below).
  • As shown below, TSLX recently traded below NAV, which triggered share repurchases, as mentioned later.
  • Plenty of good news, including pre-payments of its 2 largest investments (over 6% of portfolio), American Achievement improvements, increased fee income, reduced concentration risk, increased NAV per share, etc.
  • As we enter an environment of increased recessionary concerns, these reports will focus more on risk profiles, including any changes to ‘watch list’ investments as we have done for TSLX.
  • TSLX’s portfolio is 90% first-lien with an average of 1.9 financial covenants for each debt position, 84% with call protection, and 89% effective voting control.
  • Also, TSLX has a very low amount of investments considered ‘watch list’ that remains well under 2%.

This report discusses Sixth Street Specialty Lending (TSLX) which remains one of the highest quality BDCs that perform well during distressed environments. Management is very skilled at finding value in the worst-case scenarios, including recent retail and energy investments.

TSLX often lends to companies with an exit strategy of being paid back through bankruptcy/restructuring and proficient at stress testing every investment with proper coverage and covenants.

Management has prepared for the worst as a general philosophy and historically used it to make superior returns (as shown earlier). TSLX’s portfolio is 90% first-lien with an average of 1.9 financial covenants for each debt position, 84% with call protection, and 89% effective voting control. Also, as shown later, TSLX has a very low amount of investments considered ‘watch list’ that remains well under 2%.



 Comparison of Return on Equity (“ROE”)

The following table shows the changes in NAV per share and dividends paid from December 31, 2015 through September 30, 2022, as a simple proxy for return on equity (“ROE”) to shareholders. It is important to note that many BDCs prefer not to pay special or supplemental dividends unless absolutely necessary because they directly reduce NAV per share. Also, some BDCs purposely pay lower dividends relative to their earnings, which contribute to higher NAV per share. However, this table takes these into account along with the current price-to-NAV ratios showing that investors pay higher multiples for BDCs that deliver higher returns to shareholders.

Most of the BDCs with higher ROEs have historically held higher amounts of equity investments, especially GAIN, MAIN, HTGC, FDUS, ARCC, GLAD, and CSWC. However, TSLX has relatively lower amount amounts of equity positions and much higher first-lien currently around 90% but has still delivered higher returns to investors as shown below.




Technical Pressure Related to Conversion of Convertible Notes?

TSLX is a Strong Buy at these levels and I would suggest making purchases before the company reports Q4 2022 results in early February 2023 for the reasons discussed in this report.

There is a good chance that a portion of the previous decline in its stock prices was due to the conversion of its convertible notes into 4.4 million shares. As shown below, there was a meaningful increase in the amount share sold short just before the conversion:


TSLX Portfolio Yield & Interest Rate Sensitivity Analysis

During 2013 and 2014, many BDCs experienced declining portfolio yields driven by competition for “true” first-lien and higher-quality assets. This was followed by a period of rate hikes, as mentioned earlier, which resulted in higher portfolio yields for most BDCs, including TSLX, as shown below. This had a direct impact on dividend coverage, increasing from 119% in 2016 to 147% in 2018, driving supplemental dividends paid to shareholders starting in 2017.

“In previous periods of rising interest rates, for example, from 2017 to late 2018, the reality of asset sensitivity has been called in question, given the tendency of the BDC sector to sacrifice spread in order to prioritize asset growth. Given the spread environment today, our strong relative capital base and significant liquidity, we are well positioned to retain the asset sensitivity.”

Obviously, higher dividend coverage and supplemental dividends was good news and TSLX’s stock price increased from $15.15 in early 2016 to over $21.00 by mid-2017. However, TSLX was only paying a regular quarterly dividend of $0.39 per share at the time.

As shown below, there was a meaningful increase in TSLX’s portfolio yield for Q3 2022:

 

 

Management discussed on the recent call and is expecting a meaningful increase in earnings:

“Our weighted average yield on debt and income-producing securities at amortized cost was up to 12.2% from 10.9% quarter-over-quarter and is up about 200 basis points from a year ago. The weighted average yield at amortized cost on new investments, including up-sizes this quarter was 12.6% compared to a yield of 10% on investments partially paid down. The combination of the rising rates are now well above our average floor levels on our debt investments and the shape of the forward LIBOR or SOFR curve support that expectation. The rising rates will drive incremental interest income and outweigh the increases in the cost of our liabilities. This quarter’s net investment income and the rise in our base dividend, was driven by an increase in the core earnings power of our portfolio. As we previewed in prior quarters, we’re now seeing the positive asset sensitivity from higher base rates impacting core earnings. Since we reported last quarter, the forward curve has deepened resulting in core earnings in excess of what we previously anticipated.”

Interest rate sensitivity refers to the change in earnings that may result from changes in interest rates. TSLX carefully matches assets and liabilities, including floating or fixed, term, and risk. As of September 30, 2022, around 99% of portfolio debt investments bore interest at variable rates, most of which are subject to interest-rate floors and 100% of borrowings were also at variable rates and 52% unsecured:

“Our funding mix at quarter end comprised 52% unsecured debt and 48% secured debt. Our balance sheet positioning was further enhanced post quarter end from the payoff of our positions in BioHaven and Frontline totaling approximately $146 million. Pro forma for these payoffs, which were the two largest positions in our portfolio at quarter end, we have close to $1 billion of liquidity. On top of the activity-based fees earned, these payoffs also increased our capital base by creating incremental investment capacity for new deployment opportunities into a more appealing investment environment.”

 


On the recent and previous earnings calls, management was asked about the potential impacts to portfolio credit quality from rising interest rates, inflation, and/or recessionary environments:

“We continue to have a conservative weighted average attach and detach point on our loans at 1.0x and 4.4x, respectively, and their weighted average interest coverage remained stable at 2.6 times. As of Q3 2022, the weighted average revenue and EBITDA of our core portfolio companies was $149 million and $44 million.”

“Returns for long-duration assets such as tech and biotech equities have been more meaningfully and negatively impacted by movement in rates, as small moves on results and large changes to the net present value of future cash flows. On the other hand, private credit and more specifically our portfolio, is predominantly compromise of shorter-duration assets and not sensitive to change in rates and less sensitive to winning risk premiums, given the ability to reprice those assets every two to three years. The benefit to our portfolio of floating rate, short duration assets and rising rate and spread environment is fundamentally dependent, however, upon credit selection and active portfolio management. We believe these factors will ultimately be what drives the dispersion in returns across the sector over time. Given our track record through COVID, 11 years investing through SOX and 25 years since our first direct mini investment, we feel well positioned to navigate the uncertainty — uncertain macro environment and take advantage of the opportunity set that it presents.”

“While we recognize that the terms are moving into a more lender-friendly direction, there is no free lunch. On the opposite side of the coin, borrowers of many leveraged credit issuers are feeling pressure from sustained inflation, higher interest rates on the debt obligations in a very tight labor market. Similar to our approach during COVID, we are actively monitoring our portfolio of companies by staying in close communication with management teams, so we’re able to respond quickly when necessary if credit quality issues look likely to arise. Based on the ongoing real-time conversations we’re having with our borrowers, however, we feel very good about the health and positioning of our current portfolio as we continue to be largely invested at the top of the capital structure and software and business services sectors that provide mission critical products and solutions to their customers. And the great thing about software business is, it tend to be 80% to 85% gross margin businesses and have variable cost structures beneath that. And so they — and their revenues are typically known. So when we look at the health of our software portfolio, just to go through, because I think it is helpful, and we try to look at KPIs are that more forward leaning about the health of the business.”

“We had no material amendment activity this quarter. The portfolio is in really, really good shape. It was a very, very benign level of activity on amendments and waivers. And I think that speaks to the portfolio and the quality portfolio, which we’ve built, which mostly is when you think about the nature of our business, I think like 78% to 80% has been of existing portfolio relates to software and business services that have recurring revenue and variable cost structures.”

Despite these rising costs, the overall health of our borrowers’ financial position remains strong. We are heavily invested in businesses that are characterized by having predominantly variable cost structures, strong recurring revenue attributes, high switching costs and low customer concentration. We believe these fundamental characteristics will be key in the ongoing inflationary environment as we expect companies with pricing power and variable cost structures will be better positioned than those with large exposure to commodities, high fixed costs and limited ability to pass through price increases.”

As shown below, TSLX continues to reduce its concentration risk with the top 10 investments now accounting for only 26% of the portfolio. However, as discussed later, its two largest investments accounting for over 6% of the portfolio (BioHaven Pharmaceuticals and Frontline Technologies) were prepaid in October 2022.

 



 

TSLX Dividend Coverage Update

Last month, TSLX increased its base dividend from $0.42 to $0.45 per share for Q4 2022.

“For the second consecutive quarter, our Board has increased our quarterly base dividend regions figured by approximately 7.1% or $0.03 per share to $0.45 per share. This quarter’s net investment income and the rise in our base dividend, was driven by an increase in the core earnings power of our portfolio. We’re now seeing the positive asset sensitivity from higher base rates impacting core earnings. Since we reported last quarter, the forward curve has deepened resulting in core earnings in excess of what we previously anticipated. Over the last five years, the rolling four quarter dividend coverage on our core earnings, core earnings defined as excluding all activity-based income average 102%. At the new quarterly base dividend level of $0.45 per share, we expect our core earnings to exceed this level and highlight the significant influence that all-in yields have had in the core earnings generated ability for our portfolio.”

When calculating supplemental dividends, management takes into account a “NAV constraint test” to preserve its NAV per share. As discussed later, its NAV per share increased by only by $0.09, resulting in no supplemental dividend paid in Q4 2022:

“While the base dividend level in Q3 was well covered through core earnings, no supplemental dividend was declared related to Q3 earnings given the NAV limiter in our distribution framework which serves to retain capital and stabilize net asset value. The revised level of our quarterly base dividend increases the quarterly booked dividend yield to 11% from our prior quarterly annualized book dividend yield of 10.3%. Our supplemental dividend framework remains in place, allowing for the opportunity to increase book dividend yields with future supplemental dividends.”

However, there is a good chance that its NAV per share will increase due to credit spreads, eventually tightening, driving a partial reversal of the recent unrealized depreciation:

“Spread widening and lower implied equity values during this quarter resulted in approximately $0.05 per share of unrealized losses and not as a result of material changes in the underlying credit quality of our investments. We would expect to see a reversal of these unrealized losses related to credit spreads over time as our investments approach their respective maturities.”

For Q3 2022, TSLX reported between its base and best case projections covering its regular dividend by 112% with NII of $0.47 per share, again with historically low amounts of fee and prepayment-related income. However, during the first week of October 2022, its two largest investments (BioHaven Pharmaceuticals and Frontline Technologies) were prepaid, resulting in $0.11 per share of prepayment-related income, which has been taken into account with the update projections:

“Since quarter end, Frontline and Biohaven, our two largest portfolio companies based on fair value as of 9/30 were repaid during the first week of October, driven by previously announced M&A. As of quarter end, our weighted average mark on Biohaven was 110%, reflecting the impact of the anticipated fees embedded in our underlying exposure to this portfolio company that has since been crystallized in the $0.11 per share of activity-based fees, which will flow through investment income in Q4.”

 

Leverage recently increased near the midpoint of its targeted debt-to-equity ratio between 0.90 and 1.25 but declined closer to 1.05 after taking into account the prepayments of BioHaven and Frontline. This is excellent timing as the proceeds will be redeployed “into a more appealing investment environment”:

“Our balance sheet positioning was further enhanced post quarter end from the payoff of our positions in BioHaven and Frontline totaling approximately $146 million. Pro forma for these payoffs, which were the two largest positions in our portfolio at quarter end, we have close to $1 billion of liquidity. The repayment activity we experienced in the first week of Q4 brought our debt-to-equity ratio down to approximately 1.05 times. On top of the activity-based fees earned, these payoffs also increased our capital base by creating incremental investment capacity for new deployment opportunities into a more appealing investment environment.”

Management typically avoids having excessive amounts of excise tax by “cleaning out” the spillover as it “creates a drag on earnings” which is why the company paid a total of $1.95 per share in supplemental/specials during 2021. During 2022 there were lower amounts of supplemental/specials paid partially due to increasing its regular dividend plus its “NAV constraint test” as mentioned earlier. However, there is a good chance that the company will pay higher amounts in 2023 related to increased fee and prepayment-related income, higher portfolio yield, the reversal of previous unrealized losses, and building undistributed taxable income (“UTI”). Previously, there was $0.56 per share of spillover that continues to build and there will likely be a ‘special’ dividend announced at some point in 2023, in addition to supplemental dividends paid over the coming quarters, as shown in the projections.

“Based on the enhanced levels of the dividend coverage, that we anticipate extending through 2023 and an understanding of our anticipated leverage levels, our Board felt comfortable raising the quarterly dividend. As the operating environment continues to evolve, the Board will continue to evaluate further increases on a quarterly basis. This is consistent with our philosophy of establishing a base dividend level that we have a high degree of confidence and meeting each period.”

Most dividend coverage measures for BDCs use net investment income (“NII”) which is basically a measure of earnings. However, some BDCs achieve incremental returns with equity investments that are sold for realized gains often used to pay supplemental/special dividends. So far in 2022, there has been another $16.5 million or $0.21 per share of net realized gains mostly related to the full exit of SMPA/MD America Energy, partial exit of Copper Bidco and most recently from dissolving its non-accrual investment in Mississippi Resources:

“We had one full and one partial investment realization, totaling approximately $16 million in Q3. Our full investment realization of the Mississippi Resources was related to the proceeds available from dissolving the business. We received our final distribution at the end of September, and the remaining debt was repaid, resulting in a small realized gain.”

As shown below, many of its equity positions are still marked above cost including IRGSE Holding Corp., Copper Bidco, Validity, Inc., and ClearCompany,that could result in an additional $0.32 per share of realized gains if sold/exited at September 30, 2022, fair values.

During Q3 2022, there was another meaningful increase in the overall portfolio yield from 10.9% to 12.2% likely responsible for the continued dividend increases.

“Our weighted average yield on debt and income-producing securities at amortized cost was up to 12.2% from 10.9% quarter-over-quarter and is up about 200 basis points from a year ago. The weighted average yield at amortized cost on new investments, including up-sizes this quarter was 12.6% compared to a yield of 10% on investments partially paid down.”

Similar to other BDCs, TSLX management mentioned the “more lender-friendly environment” with “higher overall yields” and better terms including stronger covenants (safer investments) as well as “issuers willing to pay higher fees” taken into account with the best-case projections:

“New issued leveraged loan volumes are down 86% in Q3 relative to the same period last year and high-yield bonds year-to-date reached its lowest level since 2008. In addition to the limited number of deals getting done in the public credit markets, we are also seeing a pullback from banks as they focus on satisfying regulatory-driven capital ratio requirements. Given these dynamics, there has been an increasing number of borrowers and sponsors turning to the direct lending market, including those seeking larger financings. We believe this broadening of the opportunity set is a net positive for our sector, and specifically for our business and our stakeholders, given our ability to be a solutions provider at scale through co-investments with our affiliated funds. With fewer financing options available for borrowers, we’re seeing a shift towards a more lender-friendly environment. Not only are we seeing higher overall yields, driven by higher base rates, spreads have also widened as well. We’re also seeing issuers willing to pay higher fees in order to get deals across the finish line, which allows us to pick our spots and remain selective.”

Management is expecting “to exceed the top end of our target range for full year 2022” implying earnings of over $1.92 per share for 2022, implying over $0.54 per share for Q4 2022 compared to its regular dividend of $0.45 per share.

“At the beginning of this year, we communicated an annualized ROE target of 11% to 11.5% based on our expectations over the intermediate term for our net asset level yields, cost of funds and financial leverage. Year-to-date, we’ve generated an annualized ROE on adjusted net investment income of 11%. Given the strength of our investment pipeline, continued positive impact from higher all-in yields and our expectations for fee-related activity for the remainder of the year including the $0.11 per share of fees that were crystallized in October from the payoff of Biohaven, we believe we are on pace to exceed the top end of our previously stated target range for 2022 NII per share of $1.84 to $1.92. This implies Q4 NII in excess of $0.54 per share and a full year ROE on adjusted net investment income of greater than 11.5%.”

 


 

TSLX Risk Profile Quick Update

During Q3 2022, net asset value (“NAV”) per share increased by 0.6% (from $16.27 to $16.36) due to the $0.08 per share accretive impact of issuing shares to settle the majority of its 2022 convertible notes which matured in August 2022 as discussed in the previous report. Spread widening and lower implied equity values resulted in approximately $0.05 per share of unrealized losses offset by overearning the dividend.

“Growth in our reported net asset value per share from $16.27 to $16.36 was primarily driven by the accretive impact of issuing shares to sell the majority of our 2022 convertible notes, which matured in August. As you may recall from our conference call and the accompanying letter we published last quarter, our valuation framework includes the impact of market spreads movements into the valuation of our portfolio, adjusting for the expected weighted average life and other idiosyncratic factors. Spread widening and lower implied equity values during this quarter resulted in approximately $0.05 per share of unrealized losses, thereby partially offsetting the increase in net asset value we experienced from the combination of accretion within notes conversion and earnings above our base dividend level.”

TSLX’s stock price dipped slightly below its NAV per share during the market pullback in late September 2022, resulting in a small amount of share repurchases:

“During September, our 10b5-1 stock repurchase program was triggered resulting in repurchases of $3 million, which represents approximately 180,000 shares at an average price of $16.62. The existence of this program is consistent with our objective of allocating capital to accretive opportunities for our shareholders, and we will continue to prioritize capital efficiencies throughout this ongoing volatile and uncertain environment. Our Board renewed this program and reset the total size to $50 million. Given the premium on capital availability and the more compelling new investment environment that Bo spoke about earlier, our program trigger will be reset to activate at $0.01 below the most recent reported net asset value per share.”

 

As mentioned earlier, its non-accrual investment in Mississippi Resources was exited/dissolved during Q3 2022, resulting in a small realized gain:

“After the realization of Mississippi Resources during the quarter, we have only one portfolio company on nonaccrual representing less than 0.01% of the portfolio at fair value with no new names added to non-accrual during Q3. The strength and improvement of these metrics quarter-over-quarter illustrates our confidence in the underlying credit quality of our portfolio. Our full investment realization of the Mississippi Resources was related to the proceeds available from dissolving the business. We received our final distribution at the end of September, and the remaining debt was repaid, resulting in a small realized gain.”

There were no new investments added to non-accrual status, which remain 0.0% of the portfolio fair value. As of September 30, 2022, 100.0% of the portfolio at fair value was meeting all payment and covenant requirements.

“We had no material amendment activity this quarter. The portfolio is in really, really good shape. It was a very, very benign level of activity on amendments and waivers. And I think that speaks to the portfolio and the quality portfolio, which we’ve built, which mostly is when you think about the nature of our business, I think like 78% to 80% has been of existing portfolio relates to software and business services that have recurring revenue and variable cost structures. And so it was, again, no material amendments and waivers this quarter.”

 

The amount of investments considered ‘watch list’ remains very low at under 2% of the total portfolio fair value, mostly its first-lien position in American Achievement that remains on accrual status and some of its debt positions in structured credit investments:

As discussed in previous reports, American Achievement is a company that manufactures and supplies yearbooks, class rings and graduation products and was discussed on the previous call:

“American Achievement was a relatively small position. It was a COVID-impacted name. It’s in the yearbook, class rings, caps and gowns business. Obviously they missed the selling season in 2020 and 2021 should be better. Our expectation and hope is that it would rebound to around pre-COVID numbers.”

American Achievement has been renamed Balfour & Co and recently reported good news:

“A nearly 100% fiscal year-over-year improvement in operating performance as well as the construction of its new, state-of-the-art printing facility. The company’s financial improvement was largely a reflection of strong sales and operating improvements across its core graduation products categories. With its financial flexibility and strong operating position, Balfour continues to invest in its platform to expand its products and customer support within existing and emerging categories in the commencement services space. Balfour is also well underway in the construction of its additional, new, and state-of-the-art yearbook printing facility to provide schools an extra edge by offering access to the latest innovations in printing technologies to deliver best-in-class yearbooks to its customers starting in 2023. In addition, Balfour has also arranged a partnership with an established printing company, which is under common ownership and has three printing locations, to provide printing capacity overflow and redundancy whenever it is needed.”

TSLX has around 5% of the portfolio with foreign currency exposure, but these investments are adequately hedged:

“And finally, movement in foreign exchange rates drove unrealized losses on our foreign currency denominated investments, which were offset by unrealized gains on our foreign currency denominated debt outstanding. It’s worth spending a moment on the financial statement presentation of our foreign currency denominated investments as this can cause some confusion. Our philosophy when funding foreign currency investments is to borrow the par amount of that investment in local currency through our multicurrency revolving credit facility. This gives us both an asset and a liability denominated in local currency. Therefore, any movement in the FX rates applying to that investment impacts both the asset side and the liability side of our balance sheet in an equal but offsetting way. It’s important to note that movement in the fair market value of an investment due to changes in foreign currency rates is distinct and separate from a change in the valuation mark caused by credit or widening spreads. To use a specific example, let’s look at the Canadian borrower in our schedule of investments, Acceo Solutions, Inc., where we hold a first lien term loan. The valuation market quarter end is 101.0. At the end of Q2, the valuation mark on Acceo was 101.25, so from a credit perspective, there’s been very limited movement quarter-on-quarter. Over that same period, however, the fair market value as a percentage of cost has fallen from 104.2 to 97.5, representing a significantly larger decrease in value than that represented by the limited decrease in the valuation mark. For Acceo, this divergence was the impact of the strengthening US dollar over the period. Taking into account our natural hedge created by borrowing in local currencies, the value of our Canadian dollar debt expressed in US dollars terms decreased in an equal and offsetting way over the same period. None of these investments are on non-accrual status, and each of the investments was rated one, consistent with that of the overall portfolio.”

As of September 30, 2022, the overall performance of the portfolio continues to be solid, with approximately 98.8% rated 1 or 2 on a performance rating scale of 1 to 5, with 1 being the strongest.

“Moving on to portfolio composition and credit staff, across our core borrowers from whom these metrics are relevant, we continue to have a conservative weighted average attach and detach point on our loans at 1.0x and 4.4x, respectively, and their weighted average interest coverage remained stable at 2.6 times. As of Q3 2022, the weighted average revenue and EBITDA of our core portfolio companies was $149 million and $44 million, respectively.”

“The performance rating of our portfolio continues to be strong, with a weighted average rating of 1.12 on a scale of 1 to 5 with 1 being the strongest, representing a positive change from last quarter’s rating of 1.13.”


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning, we provide we provide quick updates for the sector, including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates discussing Building A BDC Portfolio, suggested pricing and limit orders, comparing expense/return ratios, interest rates, leverage, BDC Notes/Baby Bonds, portfolio mix, and potential impacts on dividend coverage and risk.

This information was previously made available to subscribers of BDC Buzz Premium Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying, including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters, as discussed earlier.

 

ARCC Equity Offering: Strongest Quarter Of Earnings So Far

The following information was previously provided to subscribers of BDC Buzz Premium Reports along with:

  • ARCC target prices/buying points
  • ARCC risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • ARCC dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


BDC Buzz is a higher quality service providing investors with detailed institutional quality research in a timely manner to take advantage of buying/selling opportunities.  The following information was provided to subscribers along with updated target prices and dividend coverage projections.

ARCC’s pricing could dip this morning related to the equity offering as most of the information discussed below was not provided in a “press release” and was only included in the associated SEC filings. If you get a chance, please read the comments from retail investors on the following breaking news from SA:


ARCC Equity & Notes Offering Update

On January 12, 2022, ARCC announced that it had priced a public offering of 10 million shares at $21.40 with the underwriters’ option to purchase up to an additional 1.5 million shares and is expected to close on January 18, 2022. Net proceeds after fees and expenses will be just under ~$250 million depending on the total amount of shares (underwriters option) which is relatively small compared to the estimated net new investments during Q4 2021 of around $1.3 billion and the additional $500 million of unsecured notes discussed next. Also, 11.5 million shares are only 2.5% more than the number of total shares as of November 2021.

  • I have updated the projections for ARCC to take into account the following information.
  • Most of this information was not included in a “press release” and was only available in the associated SEC filings.

NAV per share increased by around 2.1% to 2.6% during Q4 2021 and this offering will be accretive adding another 0.3% firmly putting it over $19.00 per share as of Q1 2022. Investors should be expecting additional dividend increases in 2022 that could be announced as soon as next month when the company reports Q4 2021 results. Included in the SEC filings were the following preliminary estimates for the three months ended December 31, 2021:

  • Core NII between $0.56 and $0.58
  • NAV per share between $18.90 to $19.00 (previously $18.52)

The Company estimates that basic and diluted GAAP earnings per share (“EPS”) will be in the range of $0.77 to $0.86 and basic and diluted Core EPS will be in the range of $0.56 to $0.58, in each case, for the three months ended December 31, 2021 and net asset value per share as of December 31, 2021 will be in the range of $18.90 to $19.00.

Analysts are currently expecting Core EPS of $0.44 to $0.48 which is much lower resulting in an “earnings beat” announcement on February 9, 2022.

As mentioned earlier this week in the BDC Sector Weekly Update, on January 7, 2022, ARCC priced another $500 million of 2.875% unsecured notes due 2027 just below par (99.504%) resulting in a yield-to-maturity of 2.975%. (CUSIP: 04010L BD4).

More importantly was the additional portfolio detail included in the SEC filings especially the $4.8 billion of new funded investments through December 29, 2021, at a weighted average yield of 6.3%. These new investments were partially offset by exiting $3.5 billion at a weighted average yield of 6.8%, a portion of which were non-accrual investments resulting in a realized loss of around $11 million or $0.02 per share.

“From October 1, 2021 through December 29, 2021, we made new investment commitments of approximately $5.6 billion, including $296 million of new investment commitments to IHAM. Of the approximately $5.6 billion of new investment commitments, $4.8 billion were funded. Of these new commitments, 64% were in first lien senior secured loans, 16% were in second lien senior secured loans, 2% were in subordinated certificates of the SDLP, 2% were in senior subordinated loans, 4% were in preferred equity and 12% were in other equity. Of the approximately $5.6 billion of new investment commitments, 83% were floating rate, 12% were non-income producing and 5% were fixed rate. The weighted average yield of debt and other income producing securities funded during the period at amortized cost was 7.2% and the weighted average yield on total investments funded during the period at amortized cost was 6.3%. We may seek to sell all or a portion of these new investment commitments, although there can be no assurance that we will be able to do so.”

“From October 1, 2021 through December 29, 2021, we exited approximately $3.5 billion of investment commitments, including $1.3 billion of loans sold to IHAM or certain vehicles managed by IHAM. Of the total investment commitments exited, 78% were first lien senior secured loans, 15% were second lien senior secured loans, 4% were senior subordinated loans, 2% were subordinated certificates of the SDLP and 1% were other equity. Of the approximately $3.5 billion of exited investment commitments, 98% were floating rate, 1% were non-income producing and 1% were on non-accrual status. The weighted average yield of debt and other income producing securities exited or repaid during the period at amortized cost was 7.0% and the weighted average yield on total investments exited or repaid during the period at amortized cost was 6.8%. Of the approximately $3.5 billion of investment commitments exited from October 1, 2021 through December 29, 2021, we recognized total net realized losses of approximately $11 million, including $3 million of net realized losses from the sale of loans to IHAM or certain vehicles managed by IHAM.”

My takeaway from this information is another strong quarter of originations and repayments (as expected) likely driving large amounts of fee income in Q4 2021. However, the yield on new investments is a bit lower than expected which will partially offset but I firmly believe that ARCC will report closer to its ‘best case’ projections for NII. Also, ARCC continues to lock in lower rate unsecured borrowings to keep appropriate margins and dividend coverage as well as positioning for rising interest rates.


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of BDC Buzz Premium Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

Blackstone Secured Lending Fund (BXSL): BDC Buzz Initiating Coverage

The following information was previously provided to subscribers of BDC Buzz Premium Reports along with:

  • BXSL target prices/buying points
  • BXSL risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • BXSL dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


Blackstone Secured Lending Fund (BXSL) IPO & Lock-Up Expirations

On October 28, 2021, Blackstone Secured Lending Fund (BXSL) closed its initial public offering of 9,180,000 shares at a public offering price of $26.15 per share and on November 4, 2021, the underwriters exercised their option to purchase an additional 1,377,000 shares. However, fewer than 6 million shares have traded since the IPO and were recently averaging around 34,000 shares daily. The company has around $9 billion in assets after taking into account the IPO proceeds making it the 4th largest publicly traded BDC.

“We’re proud to report strong third quarter financial results including rising net investment income and net asset value. This follows BXSL’s initial public offering, which represented the largest BDC IPO in fifteen years and the largest ever upsize in a BDC offering,”

Earlier this week in the “BDC Sector Weekly Update: December 27, 2021” we provided the following update to subscribers of BDC Buzz Premium Reports:

“I typically do not suggest selling BDC stocks unless there are upcoming credit and/or dividend coverage issues. However, BXSL is overpriced at these levels and on January 3, 2022, there is a very good chance that this stock will trade below where it currently is which is $37.64. BXSL trades around 34,000 shares daily which is almost considered “illiquid” and is likely why the price is detached from fundamentals. I am certain that when pre-IPO shareholders are able to sell 10% of their positions next month they will which means that an additional 15.8 million shares will hit the market. Keep in mind that could sell simply for portfolio diversification needs.”

As shown below, the stock has started to decline and I expect to continue especially after my upcoming public article discussing portions of this report. I will likely start a position in BXSL near or below its LT target price.

As always public articles will not include target prices, rankings, or dividend coverage projections as this information is only for subscribers of Premium BDC Reports.

BXSL Stock Price
BXSL Stock Price

As of November 11, 2021, there were 168,946,951 outstanding (including the IPO amount of ~10.6 million). All shareholders owning shares before the IPO are subject to a lock-up period with a staged liquidity schedule over a period of eight months following the IPO. This means that 15.8 million more shares will be on the market as of January 3, 2022, increasing to all 169 million through July 1, 2022.

BXSL is almost “illiquid” at current trading volumes and is likely why the price is detached from fundamentals. I am certain that when pre-IPO shareholders are able to sell 10% of their positions next month they will, simply for diversification needs and/or being overpriced.


ORCC Example

ORCC’s stock price started to decline after the Q4 2019 ex-dividend date and then through the first lock-up expiration. I have included the comparison with the S&P 500 that was headed higher at that time. ORCC was previously trading around $19.00 for a regular dividend yield of around 6.5% or 8.2% including the temporary special dividends (similar to BXSL currently yielding 5.7% or 7.5% with specials). However, the price quickly declined to just under $16.00 driving a more appropriate yield of 7.8% or 9.8% with the temporary specials.


Quick BXSL Investment Summary

BXSL is for lower-risk investors that do not mind lower yields with an investor-friendly fee structure and over 98% of its portfolio invested in first-lien positions of larger companies (relative to smaller BDCs) that would likely outperform in an extended recession environment. Also, BXSL has a relatively stable NAV with no investments on non-accrual status and an excellent balance sheet of lower-cost flexible borrowings that are 71% unsecured.

“Our high-quality portfolio, concentrated in first-lien senior secured loans with no loans on non-accrual, and active deployment in the quarter underscore the benefits of our scale, expertise and market position. We are pleased to bring a low-fee, low-operating expense BDC product to the market and look forward to continuing to deliver for our investors as a public company.”


The following are some high-level positives for BXSL:

  • Solid portfolio of higher credit quality likely among the strongest in the sector
  • Lower fee structure especially over the next two years
  • Total return incentive fee hurdle
  • A solid balance sheet of lower-cost borrowings, currently around 71% unsecured
  • Excellent historical and projected dividend coverage
  • Well-positioned for rising interest rates
  • Special distributions of $0.65 per share in 2022
  • Share repurchase plan of up to $262 million (below NAV ~$26.15)

The following are some high-level negatives for BXSL:

  • Upcoming lock-up expirations on 158 million shares
  • Stock is currently overpriced
  • Management fees will increase in two years
  • Likely not as much improvement in borrowing rates relative to other BDCs
  • Potentially lower portfolio yield, reducing net interest margins
  • Special distributions are likely non-recurring and will directly reduce NAV
  • Younger portfolios typically do not have credit issues until year 2 or 3
  • Limited operating history as a publicly-traded company

In connection with the IPO, the Board declared the following special distributions but please keep in mind that these are temporary and only for 2022 related to the IPO similar to what ORCC paid in 2020 discussed next.


It should be pointed out that the company had undistributed earnings as of September 30, 2021, some of which was due to over-earning the dividend and realized gains which is a good sign. But of course, quite a bit was driven by unrealized gains which are also good but do not necessarily need to be paid out. I am guessing that the $0.65 per share of special dividends in 2022 is directly related to these amounts as it comes to almost $110 million and is likely being used to encourage previous shareholders to hold shares rather than sell.


As of November 26, 2021, the company has the ability to acquire approximately $262 million (representing the net proceeds from the IPO) of common shares at prices below NAV per share in accordance with the guidelines specified in Rule 10b-18 and Rule 10b5-1 or a period of twelve months.

“The company put the share repurchases program in place because it believes that, in the current market conditions, if common shares are trading below the then-current net asset value per share, it is in the best interest of the Company’s shareholders for the Company to reinvest in its portfolio.”

The Adviser and the company entered into a new advisory agreement to include a three-year total return lookback feature on the income-based incentive fee, which provides that following the IPO, the incentive fee on income will be subject to a twelve-quarter lookback quarterly hurdle rate of 1.50% as opposed to a single quarter measurement and will become subject to an incentive fee cap based on the company’s net cumulative return. While under the company’s advisory agreement the management fee and incentive fees paid to the Adviser would have increased following the IPO, the Adviser is waiving the increase in these fees for two years. This means for the first two years following the IPO, the management fee will remain at 0.75% and incentive fees will remain at 15%, then step up to 1.00% and 17.5%, respectively, as shown below:


 


As mentioned earlier, BXSL has a relatively new portfolio and credit issues typically do not show up until later in the second year or early third year. However, I have had a chance to go through the portfolio and there are mostly higher-quality companies. I have put together a ‘watch list’ with only a few that have been marked down slightly including Plantronics (unsecured debt, communications equipment), Tennessee Bidco (insurance), Spitfire Parent (software), and Abaco Energy Technologies (energy equipment and services). However, these investments only account for around 1.1% of the portfolio and are still mostly fully valued (implying no impairment).

During Q3 2021, BXSL issued two unsecured bonds, a $650 million bond maturing in 2028 with an interest rate of 2.85% and a $650 million bond maturing in 2027 with an interest rate of 2.125%. As of September 30, 2021, 71% of all funded debt represents unsecured borrowings.



As of September 30, 2021, 99.9% of its debt investments at fair value were at floating rates. BXSL is one of the best-positioned BDCs for rising interest rates including the first 100 basis points as shown below:


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of BDC Buzz Premium Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

CGBD Update: Currently Yielding 10.8%

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • CGBD target prices/buying points
  • CGBD risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • CGBD dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


The total yield for CGBD includes $0.20/share of supplemental dividends paid annually.


CGBD Dividend Coverage Update

Similar to other BDCs, CGBD converted to a “variable distribution policy” with the objective of “paying out a majority of the excess above the $0.32 and we would anticipate doing the same going forward”.

“Similar to prior quarters, as we look forward to the fourth quarter and into 2022, we remain very confident in our ability to comfortably deliver the $0.32 base dividend plus continue the sizeable supplemental dividends.”

On November 1, 2021, the company announced a base quarterly dividend of $0.32 plus a supplemental dividend of $0.07 for a total of $0.39 per share which was the ‘best case’ projections in the previous report.

“We again generated strong earnings this quarter with net investment income of $0.39 per common share. We’ve declared a total dividend of $0.39, which represents a trailing 12-month dividend yield of 10.6% on our common stock and 9% on our net asset value. In line with our dividend policy investors can expect us to distribute substantially all of the excess income earned over our base $0.32 dividend.”


Similar to other BDCs, CGBD is expecting an active Q4 2021 including new investments partially offset by prepayments that will drive prepayment-related income including accelerated original issue discount (“OID”). As discussed later, First Watch Restaurant Group (FWRG) completed its IPO in October 2021 raising $170 million partially used to prepay its $35 million first-lien loan. There is a good chance that the company will report closer to the ‘best case’ projections.

“While the new deal environment continues to be very robust, we’ve definitely seen a pickup in repayment activity based on just a really robust M&A environment. As we look at this quarter, as we sit here today, we’re probably looking at very robust new deal volume probably being offset by repayments in the book. So we’re seeing, I’d say, in the aggregate, steady in terms of overall net-net deployment for the quarter in terms of not looking at too much portfolio growth leverage remaining in the range where we’ve been.”


Upcoming Share Repurchases

On November 1, 2021, the Board authorized an extension as well as the expansion of its $150 million stock repurchase program at prices below NAV per share through November 5, 2022. During Q3 2021, the company repurchased another 0.5 million shares at an average cost of $13.65 per share for $6.8 million resulting in accretion to NAV per share of $0.02. Since inception, the company has repurchased almost 9 million shares at an average cost of $13.25 per share or $117 million resulting in accretion to NAV per share of $0.48.

“This quarter, we repurchase $6.8 million of our common stock resulting in $0.02 of accretion to net asset value. Recently our Board of Directors reapproved our stock repurchase authorization for $150 million. And at our stock’s current valuation, we will continue to be purchasers of our common shares.”

As of September 30, 2021, there was $32.7 million remaining under the stock repurchase program. Management discussed on the recent call including less share repurchases if the stock price continues higher and I have taken into account with the updated projections:

“We look closely at the level of the discount. And while we’ve been active buyers over the last number of years, except during the March 2020, related 2020 timeframe based on the impact of the pandemic. We anticipate continuing to be steady purchasers. But depending on the discount to NAV, you could see that those numbers rightfully – we think rightly have gone down the last couple of quarters. So we think, based on if we continue to trade in the 80s where we are now, we’ll continue at that steady pace, to the extent that NAV, as we anticipate that discount should decrease, we should get closer to trading at NAV, you could see those level of repurchases decline.”

As mentioned in previous reports, the amount of payment-in-kind (“PIK”) interest income has been increasing and needs to be watched as it now accounts for 5.6% of total income as compared to only 1.3% in Q1 2020.

As of September 30, 2021, CGBD had cash of around $46 million and $261 million available for additional borrowings under its revolving credit facilities. Management is targeting a debt-to-equity ratio between 1.00 and 1.40 including the recently issued preferred equity and is taken into account with the projections.

“Statutory leverage was about 1.3 times, while net financial leverage was about 1.1. Both increased modestly quarter-over-quarter, given the net positive deployment in the investment book. We’re still sitting close to the lower end of our target range of 1.0 to 1.4, giving us flexibility to invest judiciously in the current robust deal environment.”

For Q3 2021, CGBD reported between its base and best-case projections covering its regular and supplemental dividends by 103% mostly due to higher-than-expected portfolio growth and repayments driving accelerated original issue discount (“OID”) partially offset by lower amendment and underwriting fees during the quarter. Also, there was a slight decline in its portfolio yield from 7.73% to 7.69%.

“We had another impressive quarter on the earnings front. Total investment income for the third quarter was $44 million, that’s up from $43 million in the prior quarter. The primary driver was an increase in core interest income on our investment book, partially offset by lower other income. OID accretion from repayments experienced a moderate increase.”


Middle Market Credit Funds Update

In November 2020, CGBD announced a joint venture with Cliffwater to create Middle Market Credit Fund II (“Credit Fund II”) for “enhanced balance sheet flexibility, including increased capital to deploy into an attractive origination environment and additional capacity to repurchase shares.” CGBD sold senior secured debt investments of $250 million to Credit Fund II in exchange for 84.13% of membership interests and cash proceeds of $170 million. During Q3 2021 ORCC recognized almost $7.5 million in income (same as previous quarter) related to the funds compared to $6.5 million in Q4 2020. Management expects the amount of dividend income to remain around $7.5 million and is taken into account with the ‘base case’ projections.

“Moving on to the performance of our two JVs. Total dividend income was again, $7.5 million, in line with the last two quarters. On a combined basis, our dividend yield from the JVs was about 11%. Going forward, we continue to expect stable dividend generation from the two JVs similar to this quarter’s results.”

Previous reports predicted a reduction in the regular quarterly dividend (from $0.37 to $0.32) due to lower income from its Credit Fund I, declines in portfolio yield and interest income primarily due to the decrease in LIBOR and additional loans placed on non-accrual as well as the need to reduce leverage.


CGBD Quick Risk Profile

There have been no new investments added to non-accruals status over the last five quarters which recently increased from 3.3% to 3.5% of the portfolio only due to increased valuations which is typically a good sign showing improvement. If these investments were completely written off it would have an impact of around $1.26 to its net asset value (“NAV”) per share or around 7.5%. However, management discussed these investments on the recent call mentioning “we see a path to both NII expansion and increased recovery above our 9/30 valuations”:

“We don’t manage our non-accrual statistics. We manage our non-accrual assets for maximum value realization. These situations often require the right mix of turnaround experience, incremental capital and patience, always we possess. We’ve used the combination in the past to achieve successful recoveries and we’re following a similar playbook on our current non-accruals, dermatology, direct travel and Celero. Based on our continued focus and investment over a number of years, all else equal, we see a path to both NII expansion and increased recovery above our 9/30 valuations.”


It should be noted that Direct Travel and Product Quest currently have a risk ranking of 4 compared to Derm Growth Partners and SolAero with a lower risk ranking of 5 and have been discussed in previous reports.

Risk Rating 4 – Borrower is operating materially below expectations and the loan’s risk has increased materially since origination. In addition to the borrower being generally out of compliance with debt covenants, loan payments may be past due, but generally not by more than 120 days. It is anticipated that we may not recoup our initial cost basis and may realize a loss of our initial cost basis upon exit.

Risk Rating 5 – Borrower is operating substantially below expectations and the loan’s risk has increased substantially since origination. Most or all of the debt covenants are out of compliance and payments are substantially delinquent. It is anticipated that we will not recoup our initial cost basis and may realize a substantial loss of our initial cost basis upon exit.

Other ‘watch list’ investments remain around 10% of the total portfolio including DermaRite Industries and TCFI Aevex which were marked down in Q3 2021 and need to be watched along with CircusTrix, Emergency Communications Network, PPT Management, Sapphire Convention, SPay, Inc., and Jazz Acquisition. However, its investment in FWR Holding Corporation also known as First Watch Restaurant Group (FWRG) completed its IPO in October 2021 raising $170 million partially used to repay its first-lien loan which was marked up during Q3 2021 as shown below. Most of the following watch list investments are likely included in the internal risk rating 3 investments discussed next.


During Q3 2021, CGBD’s net asset value (“NAV”) increased by another $0.51 or 3.2% mostly due to improving credit fundamentals (including non-accruals impacted by COVID, Derm Growth Partners and Direct Travel), realized gains on equity co-investments, and an increase in value of the Credit Fund as well as $0.02 per share due to accretive share repurchases.

“We ended the quarter with net asset value per share of $16.65, up $0.51 or 3.2% from the $16.14 we reported last quarter. Notably, our NAV now sits above what we reported in the fourth quarter of 2019, the final quarter before the onset of the global health crisis. We took aggressive action to manage our portfolio throughout the pandemic. The performing lower COVID impacted names plus our equity investments in the JVs, increased in value about $14 million compared to 6/30. The largest components were an $8 million increase in the value of our investment in MMCF 1 plus $5 million in gains from our equity co-investment book. Second, the assets that have been underperforming pre-pandemic, some which have COVID exposure. We’re up $5 million, marking the six consecutive quarter of stability or improvement. The final category is the moderate to heavier COVID impacted gains. We continue to see improvement in the underlying financial performance of these borrowers. Collectively, they experienced a net $7 million increase in value. Of note, our investment in First Watch Restaurants, which we marked up during the third quarter, repaid in full during October.”


It is important to point out that the previous tables used the percentage of the total portfolio as compared to the following table which excludes ‘Investment Funds’ at 14% and equity investments at 3% of the portfolio.

CGBD previously had 6 categories of risk ratings and basically combined the previous rating 3 and 4 that accounted for 17% of debt investments as of Q1 2020 into the new rating 3 which is now 19% and needs to be watched. However, the total amount of investments with an internal risk rating between 3 and 5 (implies downgraded) decreased from 25.4% in Q2 2021 to 23.3% in Q3 2021:

“Our internal risk ratings again improved as through the performance of our watch list credits. We expect continued positive fundamental performance going forward and see opportunity in 2022 for improvements in our non-accrual investments. We’ve held our current non-accrual investments for an average of 10 quarters. As we look forward, with several years of hard work behind us, we believe these assets now generally stand on sound fundamental footing.”


On the recent call management was asked about impacts from supply chain disruptions and inflation:

Q. “You gave some commentary in your introduction regarding some supply chain shortages and inflation pressures as being a fairly moderate concern right now in the marketplace, which is understandable. Does that change the specific industries that you guys are focusing on today when you guys are looking to deploy new capital? Or does that just influence the way you guys are due diligence-ing specific companies, making sure that the supply chains are set up well or that they can pass on increasing costs to their end markets.”

A. “The answer is, absolutely on the latter, maybe a little less so on the former, meaning that it really causes us to focus a lot more on near-term earnings trajectory and proving out the price pass-through mechanisms of the borrowers that we have. That, of course, is a really important part of any underwrite and always will be, and then seeing those demonstrated in the current period, as costs rise, to recapture those and profitability. So I think that it really causes us to kind of double down in those places where you might see those things happening. And naturally, in an environment like this, you’re going to skew a little less towards highly labor-intensive business models, highly energy-intensive business models, where you’re seeing the most pressure. But it certainly doesn’t rule out those sectors, if you have confidence in your ability to underwrite and understand that the pricing capture is happening on the other side of cost pickup.”


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

SUNS & SLRC Merger: Opportunity or Risk?

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • BDC target prices/buying points
  • BDC risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • BDC dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


SUNS/SLRC Merger Announcement

This article discusses SLR Senior Investment (SUNS) and SLR Investment (SLRC) which are currently yielding around 8.2% for SUNS (but headed higher) and 8.4% for SLRC (but headed lower). After the markets closed on December 1, 2021, SUNS and SLRC announced that they have entered into an agreement to merge together, with SLRC as the surviving company. Both are managed by SLR Capital Partners and the transaction is expected to close in the “first half of 2022”.

Source: SLR Senior Investment Corp

As shown below this would result in SLRC/SUNS being among the largest publicly traded BDCs:


SLRC & SUNS Historical Yields

One thing that SLRC and SUNS have in common is that they have seriously underperformed the average BDC from a stock price and total return standpoint. I generally do not suggest that my subscribers own these stocks until they have a clear path to dividend coverage without the need for fee waivers. Most BDCs have easily surpassed their pre-pandemic stock prices while paying much higher dividend yields providing excellent total returns to investors especially compared to equity and mortgage REITs as discussed and shown in “BDCs Vs. REITs: Comparing Returns For Higher-Yield Investors“.

However, both SLRC and SUNS have not reached their previous levels as well as paying lower-than-average dividend yields.

BDCs are priced based on expected risk and returns. Investors expect higher returns for higher risk. BDC returns are typically through dividends paid to shareholders. Historically, SLRC has yielded around 1.0% more than SUNS.

As shown below, over the last 12 months the average yield for SLRC is much higher than SUNS but has started to tighten over the last few weeks and especially since the merger announcement. There are a few reasons for this including dividend coverage expectations and changes in risk profile and less shareholder-friendly fee agreement as discussed next. This is discussed at the end to help investors understand the recent and likely upcoming changes to stock prices.


BDC Pricing

Why is the yield spread between SUNS and SLRC tightening?

There are very specific reasons for the prices that BDCs trade driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage).

  • BDCs with higher quality portfolios typically have lower yields.
  • BDCs with lower expenses and higher potential dividend coverage typically have stable to growing dividends and investors pay higher prices driving lower yields.

This is discussed throughout this article.

BDCs yields


SUNS & SLRC Risk Profile Discussion

As mentioned earlier, BDCs with higher quality portfolios typically have lower yields. Interestingly enough this typically applies to the investments within the portfolio as well. This means that safer BDCs generally have lower yield investments – not always but generally.

As shown below, 58% of SUN’s income comes from its lower risk ‘cash flow lending’ portfolio with a weighted average yield of 6.6%. To be clear, a 6.6% yield for a BDC loan is considered bank-like quality.

As shown below, only 21% of SLRC’s income comes from its lower risk ‘cash flow lending’ portfolio with a weighted average yield of 7.9%.


SUNS & SLRC Dividend Coverage Discussion

BDCs with lower operating expenses can pay higher amounts to shareholders without investing in riskier assets. The following tables show the recent dividend coverage for SUNS and SLRC along with the “Operating Cost as a Percentage of Available Income” which measures operating, management, and incentive fees compared to available income.

  • “Available Income” is total income less interest expense from borrowings and is the amount of income that is available to pay operating expenses and shareholder distributions.

However, management is expecting reduced borrowing rates and lower ‘Other G&A’ which I have taken into account with the updated projections along with the previously discussed changes to the fee agreement.

We project the merger should initially generate approximately $1.4 million of annual operating synergies through elimination of certain fixed costs of SUNS and reduction in our debt financing costs through potential interest expense savings.

Source: December 2, 2021, joint conference call

The total ‘Other G&A’ for both SUNS and SLRC over the last 4 quarters was around $12.3 million and should be closer to $11.0 million annually if these companies are merged. However, this is a small amount compared to almost $40 million of fees paid to management over the last 4 quarters with underleveraged portfolios driving no incentive fees for SUNS. It should be noted almost $37 million of the fees were paid by SLRC compared to under $3 million paid by SUNS during the same period. However, the combined company will adopt a fee structure closer to SLRC as discussed later.

Source: SLR Senior Investment Corp

Please note that similar to SUNS, SLRC has $420 million of “cash equivalents” as of September 30, 2021, typically offset by “Payable for investments and cash equivalents purchased” and is not taken into account with the base management fee. However, as of September 30, 2021, there were almost $77 million of additional amounts payable for investments purchased even after taking into account $40 million of additional cash. This has been taken into account with the updated projections and leverage ratios.

Source: SEC Filing

It is important to point out that the transaction will result in higher leverage as well as a more flexible (unsecured) balance sheet for SUNS:

Sources: SLR Senior Investment Corp & BDC Buzz


SUNS & SLRC Fee Agreements

As mentioned earlier, BDCs with lower expenses and higher potential dividend coverage typically have stable to growing dividends and investors pay higher prices driving lower yields.

The base management fee for SUNS is among the lowest in the sector at only 1.00% of gross assets excluding “temporary assets”. However, SLRC’s base management fee is currently 1.75% (1.00% for assets that exceed 200% of net assets).

Management has agreed to reduce the fee to 1.50% for the combined company. Also, the base management for assets that exceed 200% of net assets will be the lower 1.00%.

Source: SLR Senior Investment Corp

Most BDCs have an income incentive fee with a hurdle rate that requires a minimum return on net assets to be at least 7% to 8% (higher is better) annually before paying incentives to the advisor. Once this hurdle is reached, the advisor is entitled to 100% of the income up to a certain point. This is called a ‘catch-up’ provision that catches up the incentives to 20% of pre-incentive fee net investment income and then the advisor is paid 20% after the ‘catch-up’ as shown in the diagram below.

SLRC has a similar incentive fee agreement with a 7.00% hurdle which is not ideal as it results in lower dividend coverage.

However, SUNS investors only pay 50% of income over its 7.00% hurdle up to another hurdle of 11.67% and then 20% after that. This is a good thing for shareholders.

However, this feature will not be included in the new fee agreement:

The incentive fee payable by the combined company will remain consistent with SLRC’s existing fee structure.”

Source: December 2, 2021, joint conference call 

This is very important to management over the coming quarters as they will receive 100% of the cost savings from lower ‘Other G&A’ and reduced borrowing rates up to a certain point.

The following table shows the “pre-incentive fee net investment income” per share before management earns income incentive fees based on “net assets”. SUNS will likely earn around $0.275 per share each quarter before paying management incentive fees covering around 92% which is ‘math’ driven by an annual hurdle rate of 7% on equity. As shown in the previous financial results, there were no incentive fees paid. It is important to note that the calculation is based on the net asset values from the previous quarter and SUNS could have lower earnings per share over the coming quarters due to being underleveraged but management will not earn an incentive fee.

SLRC is paying a higher dividend relative to its NAV per share which will result in lower dividend coverage during periods of lower earnings likely due to being underleveraged as discussed later.


Merger Specifics

The Board intends to declare and pay its regular monthly distributions of $0.10 per month for the first fiscal quarter of 2022, including the March 2022 distribution, which will be declared and paid just prior to the anticipated closing of the transaction. Also, SUNS investors could receive a special dividend if there is any “undistributed taxable income” but I would not expect much if anything as the company will likely not fully cover its dividend over the next two quarters.

Additionally, the SUNS Board of Directors intends to declare a special distribution that represent any previously undistributed taxable income. This distribution will help ensure that SUNS maintains its RIC status and avoids paying excise tax.

Source: December 2, 2021, joint conference call

As shown below, SUNS investors could receive an increase of around 6% to their current distribution depending on the final exchange rate of shares from SUNS to SLRC which is based on net asset value. However, there is a chance for upcoming NAV declines for SUNS due to American Teleconferencing Services as discussed below.

The current exchange ratio is 0.7763 taking into account September 30, 2021, results are shown below:

Sources: SLR Senior Investment Corp & BDC Buzz

As predicted in a public article from October 2019 “Time To Sell SUNS”, SUNS finally placed American Teleconferencing Services (“ATS”) on non-accrual status which currently accounts for $9.6 million or 2.5% of the portfolio. This was the primary reason for the recent NAV per share decline of 0.9% during calendar Q3 2021.

ATS is an investment also held by PFLT, MAIN, and CSWC that operates as a subsidiary of Premiere Global Services (“PGi”), offering conference call and group communication services. On June 4, 2021, S&P announced that PGi was downgraded to CCC-, from CCC+, with a negative outlook, with the rating agency citing “significantly” deteriorating operating performance over the past quarter. Also downgraded was the company’s senior secured debt to CCC-, from CCC+ due to declining operating performance “increases the likelihood that [PGi] will default or undertake a distressed exchange” in the next six months unless the company’s private equity sponsor injects equity. PGi previously defaulted on positions held by CSWC with maturity dates of June 2023 and June 2024 but there are still other tranches maturing this year currently on non-accrual.

SUNS has consistently had aggressive valuations for ATS relative to other BDCs with similar positions especially PFLT and MAIN that also have a first-lien position at L+650 maturing on September 9, 2021. Investors should be prepared for additional NAV declines if PGi is not able to restructure and/or improve performance. Also, management is paid a base management fee on total assets which is directly impacted by the fair value marked on assets which results in lower earnings compared to BDCs with conservative valuations.

ATS was discussed on a previous CSWC call:

Previous CSWC call: “This company has experienced softness in their post-COVID performance and is currently engaged in an active restructuring conversations. We have decided to place this loan on nonaccrual pending more clarity on the loan terms and company performance post restructuring.”


Article Summary & Recommendations

Clearly, SUNS has a more shareholder-friendly fee agreement with a lower-than-average base management fee of 1.00% and incentive fees at only 50% of income over its 7.00% hurdle up to another hurdle of 11.67%. This is partially responsible for its lower “Operating Cost %”. Again, BDCs with lower operating expenses can pay higher amounts to shareholders without investing in riskier assets. SLRC has a higher-yielding portfolio which is likely why management is using the higher expense management fee agreement.

The “dividend coverage LTM” in the previous table shows the average dividend coverage over the last 12 months (four quarters) but please keep in mind that SUNS has much lower leverage with higher portfolio growth potential to improve dividend coverage over the coming quarters. As shown below, SUNS has among the lowest leverage (debt-to-equity net of cash) in the sector:

On December 2, 2021, SUNS and SLRC held a joint conference call to discuss the transaction. One of the analysts asked the following:

Q. “And just another higher-level question with the merger. SUNS, I know they converged recently, but SUNS has traditionally traded at a higher multiple than SLRC, has a better fee structure and so forth. So why didn’t SUNS acquire Solar? Why did you do it this way?”

A. “Well, SUNS is 1/4 of the size, so that makes it very difficult to do that. And in terms of valuation, today, they are — prior to the announcement, they were trading within 1% of each other. They’ve traded within typically 3% to 5% with each other. So they have always traded very tightly. And for the SUNS shareholders, which clearly we had an independent committee on both sides, so this was obviously a critical consideration. They’re stepping into an entity that gives them a 6% greater distribution day 1, a company that’s a higher ROE, and frankly, higher ROE growth potential and expand liquidity, and eventually a lower cost of capital as well.”

Again, SUNS has lower leverage contributing to its smaller portfolio and I’m not sure size is as important as which fee agreement was adopted for the combined company. Clearly, management will be making higher amounts of fees over the coming quarters through the 1.50% management fee with increased leverage on SUNS’s equity capital but also from the 100% ‘catch-up’ provision on the incentive fee. This is a big win for management especially as the reduced ‘Other G&A’ and borrowing rates will first benefit management as they will receive 100% up to a certain point as discussed earlier.

The following table shows exactly why SUNS stock has declined and SLRC stock has increased since the merger announcement:

As shown below, SUNS is mostly retail owned which means they can vote down this proposal or at least call Investor Relations and ask for some of the items listed below.

Here are a few suggestions to make the merger more equitable to SUN’s shareholders:

  • Post-merger fee waivers for full dividend coverage until leverage is closer to mid-target similar to many BDCs after their mergers.
  • Base management fee to 1.00% similar to many lower risk BDCs.
  • Incentive fees of 50% of income over its 7.00% hurdle up to another hurdle of 11.67% and then 20% after that.
  • Include a ‘total return hurdle’ similar to almost EVERY new fee agreement to keep management and shareholder interest aligned.

Please keep in mind that this list is exactly what the other BDCs have provided when asking for shareholder approval especially if it includes an increase in management fees which I think is a first for the sector. Most BDCs are reducing fee structures and adding items for increased shareholder alignment.

Investors expect lower yields (pay a higher multiple) for BDCs with investor-friendly fee agreements which will benefit the company as it can easily access the equity markets as well as IG debt markets for lower rates on unsecured borrowings. Win-win.

One analyst on the call mentioned the following:

I appreciate you taking my questions and good luck on closing this deal, which looks like a good deal all around.”

I actually like this analyst but respectfully disagree from the standpoint of SUNS investors which I am urging them to vote NO.



What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

MAIN Update: Upgraded As Predicted

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • MAIN target prices/buying points
  • MAIN risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • MAIN dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


Quick Quarterly Update (September 30, 2021)

  • Earnings: Easily beat its best-case projections due to another record level of $23 million of dividend income with NII per share of $0.714 and distributable net investment income (“DNII”) of $0.76 per share easily covering its dividends of $0.615.
  • Dividends: As predicted in the best-case projections from the previous report, MAIN increased its regular monthly dividends from $0.210 to $0.215 per share for Q1 2022 which is a 2.4% increase from Q4 2021. Also, the company announced a supplemental dividend of $0.10 per share payable in December 2021.
  • NAV Per Share: An increase of 3.6% mostly came from its Lower Middle Market (“LMM”) and accretive share issuances similar to previous quarters.
  • Credit Quality: Eight investments on non-accrual status accounting for 0.9% (previously 1.2%) of the investment portfolio at fair value and 3.5% at cost.
  • This information will be discussed in the updated MAIN Deep Dive Projections report.

This supplemental cash dividend, which will be payable as set forth in the table below, will be paid out of Main Street’s undistributed taxable income (taxable income in excess of dividends paid) as of September 30, 2021.

 


 

MAIN Q3 2021 Quick Update

For Q3 2021, MAIN easily beat its best-case projections due to another record level of $23 million of dividend income with NII per share of $0.714 and distributable net investment income (“DNII”) of $0.76 per share easily covering its dividends of $0.615. The additional dividend income and NAV per share increase of 3.6% mostly came from its Lower Middle Market (“LMM”) similar to previous quarters. As predicted in the best-case projections from the previous report, MAIN increased its regular monthly dividends from $0.210 to $0.215 per share for Q1 2022 which is a 2.4% increase from Q4 2021. Also, the company announced a supplemental dividend of $0.10 per share payable in December 2021 driven by realized gains discussed in the previous report including NRI Clinical Research and Safety Holdings.

“The third quarter represented another quarter of sequential growth in total investment income and included another record level of dividend income from our portfolio equity investments. In addition, primarily due to the continued favorable performance of our portfolio companies, our net asset value per share increased by 3.6% during the quarter. Net investment income and distributable net investment income for the quarter of $0.71 and $0.76 per share, respectively, are both Main Street quarterly records, and together with the significant net gains realized on several equity investments in the quarter, provided our board of directors the comfort to declare the supplemental dividend to our shareholders of $0.10 per share in December and another increase to our monthly dividends in the first quarter of 2022.”


As predicted, MAIN has been upgraded mostly due to continued improvement in MAIN’s net interest margins as well as continued NAV per share increases and additional realized gains. As mentioned in previous reports, I am expecting dividend coverage to improve over the coming quarters due to:

  • Continued dividend income from portfolio companies.
  • Effective October 30, 2020, MAIN became the sole adviser/manager to HMS and the company will now receive 100% of all management and incentive fees.
  • Portfolio growth (increased interest income).
  • Lower borrowing rates.
  • Lower non-accruals (increased interest income from restructured investments).


As of September 30, 2021, there were eight investments on non-accrual status, which comprised 0.9% (previously 1.2%) of the investment portfolio at fair value and 3.5% at cost. During Q3 2021, MAIN fully exited its investments in NRI Clinical Research, realizing a gain of $8.8 million as well as Safety Holdings, realizing a gain of $4.5 million.

In October, MAIN issued an additional $200 million of the 3.00% Notes at a premium to par of 101.74% resulting in a yield-to-maturity of 2.60%.

“We are also very pleased that we were able issue an additional $200 million of fixed rate, long-term investment grade debt at an effective rate of 2.6% in October, representing our lowest rate ever on an investment grade debt issuance and providing further improvement to our strong capital structure and additional liquidity to fund the continued future growth of our investment portfolio. As we look forward to the remainder of the year and into 2022, we believe we are very well positioned to continue to execute on our diversified strategy and to continue to provide superior results.”



What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

HTGC Q3 2021 Update

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • HTGC target prices/buying points
  • HTGC risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • HTGC dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


This update discusses Hercules Capital (HTGC) which is an internally managed BDC with mostly first-lien debt positions and equity investments primarily in venture capital (“VC”) backed technology companies at the venture growth stage historically providing realized gains and supporting supplemental dividends.


HTGC September 30, 2021, Quick Update

HTGC reported between its best and base case projections for Q3 2021 covering its regular dividend by 104%. There were plenty of variances during the quarter including a higher amount of unscheduled/early prepayments ($319 million) and lower debt expense due to recording the early redemption of its Baby Bond “HCXZ” as a realized loss (below the NII calculation). Please see the previous report for discussion.

“The acceleration of the unamortized debt issuance costs on repayment of the 2025 notes is shown separately as a realized loss in the current quarter.”

HTGC remains a ‘Level 1’ dividend coverage BDC and as mentioned earlier this week increased its regular quarterly dividend from $0.32 to $0.33 per share as well as the expected supplemental of $0.07 per share.

“With our debt investment portfolio at $2.3 billion, at cost, combined with the size of our pipeline and record earnings spillover of nearly $182 million, or $1.57 per share, the Board has made the decision to increase our quarterly base distribution to $0.33 per share and has also declared a supplemental distribution of $0.07 per share for the third quarter.


On the recent call (October 28, 2021) management was asked about additional supplemental dividends in 2022 and responded with “we expect to announce a new supplemental distribution program early next year” and “obviously with the potential for it to be a higher number given the strength of our current spillover”:

Q. “You mentioned on the prepared remarks that you’ll kind of reevaluate that supplemental policy for fiscal 2022. I guess I’m curious with the spillover of about $182 million call it. Where do you think that goes and what would the cadence look like?

A. “It’s a difficult question to answer, because that’s obviously a Board decision and that decision will not get made until early next year. I think we had a very consistent theme with respect to our distributions. With respect to the base quarterly distribution, we generally set that at a level that we feel comfortable can be covered by ordinary net investment income and that gave us comfort in terms of moving from $0.32 to $0.33 for the quarter. And going forward when we sort of look at the supplemental distribution program, we expect to announce a new supplemental distribution program early next year for fiscal year 2022. In terms of the cadence, we would expect it to be similar to 2021 in terms of it being on a quarterly basis. But in terms of what that ultimate number will be, that will be something that we will finalize and discussions with our Board after we finalize the tax dividend numbers at the end of this year. I think we continue as a company to believe that doing that is best accomplished by doing what we did in 2021 making sure that our base quarterly distribution is a number that we feel confident is covered by net investment income and then setting a supplemental distribution program payable on a quarterly basis based on where we end the year. But the policy that we put in place in 2021 in terms of paying out a set amount on a quarterly basis is likely to be what we do in 2022 obviously with the potential for it to be a higher number given the strength of our current spillover.”

During Q3 2021, its net asset value (“NAV”) per share declined by $0.17 or 1.5% partially due to paying $0.07 per share of supplemental dividends as well as unrealized losses during the quarter including some of its equity/warrant positions that will be discussed in the updated HTGC Deep Dive Projections report.

“During the quarter, our NAV decreased to $0.17 – decreased by $0.17 per share to $11.54 per share. This represents a NAV per share a decrease of 1.5% quarter-over-quarter. The main driver for the decrease was the $35.6 million of change in unrealized depreciation offset by $21.1 million of realized gains resulting in a $14.5 million decrease to NAV. The $14.5 million decrease was primarily related to the mark-to-market movement on our publicly traded equity positions.”

There was an additional $21.1 million or $0.18 per share of realized gains during the quarter to support additional supplemental dividends:

“The net realized gain in Q3 of $21.1 million comprised of $25 million of gains from the disposal of equity and warrant positions, offset by $2.2 million of realized loss pertaining to one legacy debt and warrant position that was impaired and had been on non-accrual in previous quarters. In addition, we had the $1.7 million of realized loss relating to debt extinguishments.”

Non-accrual remain low at around 0.3% of the portfolio fair value and 1.0% at cost:



In September 2021, HTGC issued $325 million of 2.625% notes due 2026 used to redeem the aggregate outstanding principal and accrued interest of the 2027 and 2028 Asset-Backed Notes.

“Our most recent offering of 2.625% Notes exemplifies our active balance sheet management as we continue to lower our average cost of debt capital over the coming year. Our strong origination activity throughout 2021 has given us the opportunity to fund growth in both our public portfolio as well as our private funds. Given these factors and the overall continued strength of the VC ecosystem, we believe Hercules is exceptionally well positioned heading into Q4 and allowing us to remain focused on delivering strong total shareholder returns.”

Since the close of Q3 2021 the company has closed new debt and equity commitments of $125 million and funded $50 million with pending commitments of $377 million:






Portfolio Company IPO and M&A Activity in Q3 2021 and YTD Q4 2021

Equity Portfolio

Hercules held equity positions in 71 portfolio companies with a fair value of $204.4 million and a cost basis of $135.6 million as of September 30, 2021. On a fair value basis, 52.9% or $108.6 million is related to existing public equity positions.

Warrant Portfolio

Hercules held warrant positions in 94 portfolio companies with a fair value of $42.9 million and a cost basis of $25.9 million as of September 30, 2021. On a fair value basis, 33.4% or $14.3 million is related to existing public warrant positions.

Portfolio Company IPO and M&A Activity

As of October 25, 2021 year-to-date, Hercules has had 33 portfolio companies complete or announce an IPO or M&A event, which is comprised of: 13 IPO’s, 13 M&A events and seven (7) portfolio companies that have registered for the IPOs, or have entered into definitive agreements to go public via a merger or special purpose acquisition company, or “SPAC.”

IPO Activity in Q3 2021 and YTD Q4 2021

As of October 25, 2021, Hercules held debt, warrant or equity positions in three (3) portfolio companies that have completed their IPOs and seven (7) companies that have registered for their IPOs or have entered into definitive agreements to go public via a merger or SPAC, including:

  • In August 2021, Hercules’ portfolio company Rocket Lab (NASDAQ: RKLB), a developer of launch and space systems, completed its reverse merger initial public offering with Vector Acquisition Corp. (NASDAQ: VACQ), a SPAC. Hercules initially committed $100.0 million in venture debt financing beginning in June 2021.
  • In September 2021, Nerdy (NYSE: NRDY), the parent company of Hercules’ portfolio company Varsity Tutors, a technology developer of an online tutoring platform, completed its reverse merger initial public offering with TPG Pace Tech Opportunities (NYSE: PACE), a SPAC. Hercules initially committed $50.0 million in venture debt financing beginning in August 2019 and currently holds 100,000 shares of common stock as of September 30, 2021.
  • In September 2021, Hercules’ portfolio company VELO3D (NYSE: VLD), a developer of metal laser sintering printing machines intended to offer 3D printing, completed its reverse merger initial public offering with Jaws Spitfire Acquisition Corp. (NYSE: SPFR), a SPAC. Hercules initially committed $12.5 million in venture debt financing beginning in May 2021.

In Registration or SPAC:

  • In October 2021, Hercules’ portfolio company SeatGeek, a global technology ticketing marketplace and live entertainment technology platform, announced it has entered into a definitive agreement for a reverse merger initial public offering with RedBall Acquisition Corp. (NYSE: RBAC), a SPAC with a focus on sports, media and data analytics. Hercules initially committed $60.0 million in venture debt financing in June 2019 and currently holds warrants for 1,379,761 shares of common stock as of September 30, 2021.
  • In September 2021, Hercules’ portfolio company Intuity Medical, a commercial-stage medical technology and digital health company focused on developing comprehensive solutions to improve the health and quality of life of people with diabetes, announced it has filed a registration statement on Form S-1 with the U.S. Securities and Exchange Commission for an initial public offering. Intuity intends to list its common stock on the Nasdaq Global Select Market under the stock symbol “POGO.” Hercules initially committed $30.0 million in venture debt financing beginning in December 2017 and currently hold warrants for 3,076,323 of Preferred Series B-1 stock as of September 30, 2021.
  • In July 2021, Hercules’ portfolio company Gelesis Inc., a biotherapeutics company advancing superabsorbent hydrogels to treat excess weight and metabolic disorders, announced it has entered into a definitive agreement for a reverse merger initial public offering with Capstar Special Purpose Acquisition Corp. (NYSE: CPSR), a SPAC. Upon completion of the merger, the combined company will be listed on the New York Stock Exchange under the ticker symbol “GLS.” Hercules initially committed $3.0 million in venture debt financing in August 2008 and currently holds 227,013 shares of common stock, 243,432 shares of Preferred Series A-1 stock and 191,626 shares of Preferred Series A-2 stock as of September 30, 2021.
  • In July 2021, Hercules’ portfolio company Nextdoor, a provider of a social network that connects neighbors, announced it has entered into a definitive agreement for a reverse merger initial public offering with Khosla Ventures Acquisition Co. II (NASDAQ: KVSB), a SPAC. Upon completion of the merger, the combined company will be listed on the New York Stock Exchange under the ticker symbol “KIND.” Hercules currently holds 328,190 shares of common stock as of September 30, 2021.
  • In July 2021, Hercules’ portfolio company Planet Labs, an earth data and analytics company, announced it has entered into a definitive agreement for a reverse merger initial public offering with dMY Technology Group IV Inc. (NYSE: DMYQ), a SPAC. Upon completion of the merger, the combined company will be listed on the New York Stock Exchange under the ticker symbol “PL.” Hercules initially committed $25.0 million in venture debt financing beginning in June 2019 and currently holds warrants for 357,752 shares of common stock as of September 30, 2021.
  • In May 2021, Hercules’ portfolio company Valo Health LLC, a technology company using human-centric data and artificial intelligence powered computation to transform the drug discovery and development process, announced it has entered into a definitive agreement for a reverse merger initial public offering with Khosla Ventures Acquisition Co. (NASDAQ: KVAC), a SPAC. Upon completion of the merger, the combined company will be listed on the Nasdaq Global Select Market under the ticker symbol “VH.” Hercules initially committed $20.0 million in venture debt financing beginning in June 2020 and currently holds 510,308 shares of Preferred Series B stock and warrants for 102,216 shares of common stock as of September 30, 2021.
  • In March 2021, Hercules’ portfolio company Pineapple Energy, LLC, a U.S. operator and consolidator of residential solar, battery storage and grid services solutions, announced that it entered into a definitive merger agreement with Communications Systems, Inc. (NASDAQ: JCS), and IoT intelligent edge products and services company. Upon closing, CSI will commence doing business as Pineapple Energy, and expects shares of the combined company to continue to trade on the Nasdaq Global Select Market under the new ticker symbol “PEGY.” Hercules initially committed $12.3 million in venture debt financing beginning in December 2010 and currently holds 17,647 shares of Class A Units as of September 30, 2021.

M&A Activity in Q3 2021 and YTD Q4 2021

  • In October 2021, Hercules’ portfolio company Tapjoy, Inc., a mobile performance-based advertising platform that drives deep engagement and monetization opportunities for app developers, announced that they have entered into an agreement to be acquired by ironSource (NYSE: IS), a leading business platform for the App Economy, for approximately $400.0 million in cash. Hercules initially committed $20.0 million in venture debt financing beginning in July 2014 and currently holds warrants for 748,670 shares of Preferred Series D stock as of September 30, 2021.
  • In October 2021, Hercules’ portfolio company OneLogin, Inc., a leader in Unified Access Management, announced that they have been acquired by One Identity, an industry leader in Privileged Access Management, Identity Governance Administration, and Active Directory Management and Security. Terms of the acquisition were not disclosed. Hercules initially committed $40.0 million in venture debt financing beginning in February 2016 and currently holds warrants for 381,620 shares of common stock as of September 30, 2021.
  • In October 2021, Hercules’ portfolio company Clarabridge, a global leader in Customer Experience Management (CEM) for the world’s top brands, was acquired by Qualtrics (NASDAQ: XM), the leader and creator of the Experience Management (XM) category, for $1.125 billion in stock. Hercules initially committed $40.0 million in venture debt financing beginning in March 2017.
  • In September 2021, Hercules’ portfolio company Sapphire Digital, Inc., the healthcare industry’s leading platform for provider selection, patient access, price transparency, and digital consumer navigation, announced that they entered into a definitive agreement to be acquired by Zelis, a leading payments company in healthcare. Terms of the acquisition were not disclosed. Hercules initially committed $15.0 million in venture debt financing beginning in May 2017 and currently holds warrants for 2,812,500 shares of common stock as of September 30, 2021.
  • In September 2021, Hercules’ portfolio company Envisage Technologies, the leader in unified training, compliance, and performance software for public safety, was acquired Vector Solutions, the leading provider of industry-focused software solutions for training, workforce management and risk communications. Hercules initially committed $12.0 million in venture debt financing beginning in March 2020.


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

PSEC Quick Q3 2021 Update

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • PSEC target prices/buying points
  • PSEC risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • PSEC dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


PSEC September 30, 2021, Quick Update

Prospect Capital (PSEC) reported just below its base case projections after taking into account the preferred stock dividend and using diluted common shares. PSEC’s announcement of $0.21 per share of net investment income (“NII”) did not include the preferred stock dividend as well as only using 389 million shares versus the 409 million diluted shares. After taking both of these into account the adjusted NII was $0.193 per share covering its monthly dividends by 107%. I am pointing this out because this discrepancy will continue to grow larger as the company issues additional preferred stock.

There was another decline in CLO residual income as well as a decline in its overall portfolio yield fully offset by structuring, advisory, and amendment fees from First Tower Finance Company and PGX Holdings, Inc. (“PGX”). Dividend income remains lower-than-expected at only $1.3 million especially given 22.4% of its portfolio is now in equity positions that typically pay dividends (for healthy companies).

Leverage remains low with a current debt-to-equity at 0.63 (below the lower end of its target range) after taking into account the convertible Perpetual Preferred stock that continues to increase.

NAV per share increased by 3.2% (from $9.81 to $10.12) due to unrealized appreciation related to the same control/affiliate investments as previous quarters (National Property REIT, InterDent, and First Tower Finance). It should be noted that the continued issuance of common shares below NAV through its DRIP and additional issuances of preferred stock have a dilutive impact on its NAV.


 

For common shareholders, the preferred shares create additional risks as the preferred is cumulative and has to be paid in full before common stock shareholders receive their distributions. The preferred stockholders have the option to convert into common at any time and there is a chance that PSEC could redeem these shares at “any time” converting into common stock based on the most recent 5-day trading price. This could be another way for management to issue additional shares below NAV.


 

It should be noted that four investments (National Property REIT, InterDent, PGX Holdings, and First Tower Finance) have been continually marked up and now account for over $2.6 billion, 41% of the total portfolio or almost 67% of NAV per share (see below). This is very high concentration risk, especially if management is using aggressive valuation measures.

 


The company reaffirmed its monthly dividend of $0.06 per share through January 2022:






What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

GLAD Update: NAV Increase & Upcoming Realized Gains

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • GLAD target prices/buying points
  • GLAD risk profile, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • GLAD dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


GLAD September 30, 2021 Update

Gladstone Capital (GLAD) hit its base case projections covering its dividend due to continued management fee waivers. Its portfolio yield declined again from 10.5% to 10.3% offset by another quarter of higher-than-expected dividend income. Its portfolio companies continued to perform well, generating equity and loan market value appreciation with no assets on non-accrual status.

Leverage (debt-to-equity) remains low partially due to another 8.9% increase of its net asset value (“NAV”) per share mostly related to additional appreciation from its equity positions that now account for over 15% of the portfolio (up from 12% the previous quarter). Some of these investments will likely drive realized gains including Lignetics, Inc., and reinvested partially into higher yield assets which will hopefully be discussed on the upcoming earnings call.


In November 2021, GLAD sold its investment in Lignetics, Inc. resulting in success fee income of $1.6 million and net cash proceeds of approximately $47.2 million, including the repayment of our debt investment at par. As shown below, its equity positions were valued at over $13 million over cost which will likely drive around $0.40 per share of realized gains. Also, this investment accounted for around 8.5% of the portfolio which will need to be reinvested.


In November 2021, the company issued $50 million of its 3.75% notes due 2027 partially used to redeem almost $39 million of 5.375% notes due 2024. As of September 30, 2021, the company has over $100 million of available liquidity under its credit facility for additional portfolio growth. It should be noted that interest income has reached a new quarterly high over $13 million that is mostly recurring potentially supporting a dividend increase in 2022.

Bob Marcotte, President: “We are pleased to report that our portfolio has continued to perform well as reflected in last quarter’s appreciation which lifted our net asset value by 8.9% and our cumulative ROE for the last two years to 16.5% while maintaining our conservative leverage position. We believe these results affirm the resilience and attraction of our lower middle market investment strategy, and while our shareholders should benefit from this NAV appreciation, it also provides support for our continuing to scale the portfolio and grow our net investment income and shareholder distributions.”


In October 2021, GLAD reaffirmed its monthly dividends for calendar Q4 2021:


Subsequent to September 30, 2021, the following significant events occurred and will be taken into account with the updated GLAD Deep Dive Projections report.

  • In October 2021, we invested $26.3 million in Engineering Manufacturing Technologies, LLC through secured first lien debt and equity.
  • In November 2021, our investment in Medical Solutions Holdings, Inc. paid off at par for net proceeds of $6.0 million.
  • In November 2021, our investment in Lignetics, Inc. was sold, which resulted in success fee income of $1.6 million. In connection with the sale, we received net cash proceeds of approximately $47.2 million, including the repayment of our debt investment of $29.0 million at par.
  • In November 2021, our investment in Prophet Brand Strategy paid off at par for net proceeds of $13.1 million. In conjunction with the payoff, we received a prepayment fee of $0.1 million.

In April 2021, the company amended and restated its advisory agreement to maintain the revised hurdle rate included in the calculation of the incentive fee for the period beginning April 1, 2021, through March 31, 2022, which was previously amended for the period beginning April 1, 2020 through March 31, 2021, increasing the hurdle rate from 1.75% per quarter (7% annualized) to 2.00% per quarter (8.00% annualized) and increasing the excess incentive fee hurdle rate from 2.1875% per quarter (8.75% annualized) to 2.4375% per quarter (9.75% annualized).



What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.

Head-To-Head Public Article Preview: ORCC Versus GSBD

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • ORCC and GSBD target prices/buying points
  • ORCC and GSBD risk profiles, potential credit issues, and overall rankings. Please see BDC Risk Profiles for additional details.
  • ORCC and GSBD dividend coverage projections (base, best, worst-case scenarios). Please see BDC Dividend Coverage Levels for additional details.


Young Business Boys Making Money

The Big Boys Continue To Pile Into This Dividend Sector

As mentioned in “The Big Boys Continue To Pile Into This Dividend Sector: ORCC” Business Development Companies (“BDCs”), like REITs almost 20 years ago, want institutional investors and the scale that comes with them. Many of the largest asset managers have been actively building assets in the sector including BlackRock, Goldman Sachs Group, Franklin Templeton, The Blackstone Group, Barings, Apollo, The Carlyle Group, Ares Management, KKR & Co. Inc., Oaktree Capital Management, TPG Capital, Bain Capital, and Blue Owl. However, Ares and Apollo have managed Ares Capital (ARCC) and Apollo Investment (AINV) for quite a while as compared to others. This article discusses Goldman Sachs BDC (GSBD)and Owl Rock Capital (ORCC). There are now 20 publicly traded BDCs with more than $1 billion in assets and I have discussed many of them over the last few months (see list below) and will try to cover the others in upcoming articles.

These 13 asset management companies combined manage more than $16.5 trillion in assets (up from $11 trillion in early 2020), and there will likely be continued positive changes to regulations over the coming quarters driving up multiples for current investors. Please keep in mind that higher multiples mean higher prices (and lower yields) as the BDC sector continues to attract more attention and respect from the investment community especially given how they performed during the pandemic. Most BDCs seem to be in a virtuous circle of improving asset quality supporting a lower cost of capital driving improved earning, NAV, and dividend increases. Many have recently issued very low rate unsecured notes and refinanced their balance sheets including Owl Rock Capital (ORCC) and Goldman Sachs BDC (GSBD) as discussed in this article.


Portfolio Mix and Credit Quality

The following tables show a handful of some of the metrics used to compare BDCs but please keep in mind that this information is oversimplified and needs discussion. For example, not all “first-lien” is the same credit quality. I would feel much safer with second-lien in a higher quality BDC than first-lien in a lower quality one. Plenty of the BDCs that were the worst performers had plenty of first-lien only to have huge declines in book values or net asset values (“NAV”) the following quarters. Medley Capital (MCC) and Fifth Street Capital (FSC) were perfect examples of this.

Also, please note that BDCs such as GSBD, ORCC, and AINV have mostly secured debt positions as compared to equity participation which has been primarily responsible for most of the NAV growth for other BDCs. That is why the average BDC has experienced ANV growth of around 9% over the last four quarters but they also have lower amounts of secured positions. For some examples of BDCs that have been benefitting from equity positions please see the following articles from September 2021:

It is important to point out that BDCs that have been marking up equity positions would likely experience larger NAV declines during a serious market downturn or economic event. Please be careful.

Also, non-accruals are investments that a BDC is currently not accruing income due to credit issues. Some BDCs will exit or restructure these investments just before the quarter-end taking a realized loss but avoiding being listed as a credit issue when it comes to reporting. It’s better to look at historical realized losses which clearly identify historical credit issues as discussed in some of the articles linked above including “FS KKR Capital: Dividend Decrease Coming” which discussed FSK and AINV.

As shown in the previous table, FSK and AINV have had larger NAV declines over the last 5 years but so has GSBD mostly related to legacy investments. These investments have been discussed in previous articles and were considered idiosyncratic especially given the improved credit quality over the last two years. GSBD has 111 portfolio companies and with only 2 put on non-accrual status over the last 7 quarters.

As of September 30, 2021, GSBD’s investments on non-accrual status accounted for 0.1% and 0.7% of the total investment portfolio at fair value and cost, respectively. If its non-accrual were completely written off the impact to NAV would be around $0.04 per share or 0.2%:

Two of ORCC’s smaller first-lien loans to QC Supply were added to non-accrual status during Q2 2021 and marked down again during Q3 2021. Also, CIBT Global, Inc. remains non-accrual and was also marked down as shown in the following table. Please keep in mind that ORCC has 130 portfolio companies so there will always be a certain amount on non-accrual which currently account for 0.4% of the total portfolio fair.

We are carefully monitoring the current headwinds caused by the labor shortages and supply chain disruptions. To date, we have not seen a material impact as many of our companies are services businesses, which have modest exposure to the manufacturing economy. For example, some of our largest sectors are software, insurance, and health care, which are not as exposed to the current economic headwinds. In line with last quarter, our nonaccruals remained low with only two investments on non-accrual status, representing 0.4% of the portfolio based on fair value. One of the lowest levels in the BDC sector and our annualized loss ratio is 14 basis points.”


Expense Ratio & Fee Agreements

As a part of assessing BDCs, it’s important to take into account expense ratios. BDCs with lower operating expenses can pay higher amounts to shareholders without investing in riskier assets.

“Operating Cost as a Percentage of Available Income” is one of the many measures that I use which takes into account operating, management, and incentive fees compared to available income. “Available Income” is total income less interest expense from borrowings and is the amount of income that is available to pay operating expenses and shareholder distributions.

As discussed in “Conservative Portfolio Safely Paying Investors 7.3%“, many BDCs have been temporarily waiving fees or have fee agreements that take into account previous capital losses that are ending this year. GSAM is waiving a portion of its incentive fee for the four quarters of 2021 (Q1 2021 through and including Q4 2021) in an amount sufficient to ensure that GSBD’s net investment income per share is at least $0.48 per share per quarter.

However, GSBD has what I consider to be a more shareholder-friendly fee agreement with a lower-than-average base management fee of 1.00% and a total return hurdle to protect shareholders from additional credit issues. ORCC has a lower yielding portfolio which is why its hurdle rate is only 6.0% (not ideal) and lower-than-average incentive fee rate.

The ‘dividend coverage LTM’ is showing the average dividend coverage over the last 12 months (4 quarters) and is higher for GSBD due to fee waivers and lower for ORCC as the company was previously underleveraged. ORCC continues to increase leverage covering its dividend by 109% in Q3 2021 as discussed later.


GSBD Dividend Coverage Update

Author’s Note: The following information was provided to subscribers along with three quarters of financial projections using base, best, and worst-case assumptions to test the sustainability of the current dividends for GSBD.

For Q3 2021, GSBD reported slightly below its best-case projections mostly due to an increase in accelerated accretion related to repayments and higher fee income partially offset by lower portfolio yield and lower portfolio growth (decline). Leverage (debt-to-equity) remains at its near-term low of 0.91 (net of cash) giving the company adequate growth capital for increased earnings potential. It should be noted that fee waivers continued to decline and were only $1.4 million.


I am expecting improved dividend coverage for GSBD over the coming quarters mostly due to:

  • Portfolio growth due to lower prepayments
  • Reinvesting the proceeds from Hunter Defense Technologies
  • Continued lower cost of borrowings
  • Higher portfolio yield from rotating into higher yield assets

It is important to point out the GSBD remains below its targeted leverage due to $1.5 billion of repayments over the last 4 to 5 quarters which is meaningful given that its total portfolio is only $3.1 billion. However, management is not expecting the same level of repayments:

Elevated repayments continued unabated this quarter. At $672 million repayments equaled 21% of the fair value of investments at the beginning of the quarter and were 2.4 times greater than last quarter which itself was the previous high water mark repayments in the company’s nearly 10-year history. Repayments were diversified across the book with the single large repayment only amounted to less than 10% of the total. This is a somewhat remarkable level of portfolio turnover in a single quarter, there are a few takeaways I would offer for this unusual activity. First, I believe this repayment activity is a reflection of our focus on sectors and companies that continue to grow, perform well, and are therefore increasingly in investor favor. In an environment where M&A activity is high and equity evaluations are rising, it’s not surprising that high quality companies are either being sold or graduating to a lower cost of capital.”

One of the repayments from Q3 2021 was Hunter Defense Technologies which accounted for almost $48 million or 1.5% of the portfolio driving a realized gain of almost $36 million or $0.35 per share. This was a non-income producing equity investment that will be reinvested into debt investments yielding at least 8% which is an additional ~$3.8 million of annual income.

During the quarter, we exited our equity position in Hunter Defense Technologies. Hunter Defense is a provider of shelters and ancillary products used primarily by the U.S. military in mobile troop deployments. The sale of the position generated a realized gain of $36 million. Hunter Defense was a previously non-income producing asset that’s been able to be monetized, recycled back into income producing assets.”

Similar to most BDCs, GSBD has been lowering its borrowing rates as well as constructing a flexible balance sheet including a public offering of $500 million of 2.875%unsecured notes due 2026. In August 2021, the company reduced the interest rate on its credit facility from LIBOR plus 2.00% to LIBOR plus 1.875%/1.75% which will be used to refinance its $155 million of 4.50% convertible notes on April 1, 2022. This will have a meaningful impact on earnings starting in Q2 2022:

There’s also tremendous tailwinds on the liability side of the balance sheet for the company here as well. I’m sure many of the investors in this space are following what’s going on in the financial markets for these assets. There’s typically generally a high correlation between if there’s pressure on asset yields, there’s also an opportunity on the liability side. For example, we’ve got our convertible bond which has a 4.5% coupon coming due early next year, that will be recycled. Our current plan would be to refinance that with our existing capacity under our revolving credit facility, which of course comes with a much lower cost of capital. I think there’ll be ongoing opportunities over the course of next year to do that, as well. So I think those are just a few things that I point to that that give us some optimism that there’s still really good opportunities to perform here.”


ORCC Dividend Coverage Update

Author’s Note: The following information was provided to subscribers along with three quarters of financial projections using base, best, and worst-case assumptions to test the sustainability of the current dividends for ORCC.

For Q3 2021, ORCC beat its best-case projected earnings due to higher-than-expected prepayment-related, dividend, and fee income as well as higher portfolio growth growing total income to the highest level of $269 million.

ORCC was not expected to cover its quarterly dividend but Core NII of $0.337 (excluding excise tax) covered 109% of its dividend of $0.310.


I am expecting improved dividend coverage for ORCC over the coming quarters mostly due to:

  • Increased dividend income from its Senior Loan Fund and Wingspire
  • Maintaining target leverage with new investments offsetting repayments
  • Additional prepayment fees and accelerated OID
  • Higher portfolio yield from rotating into higher yield assets
  • Continued lower cost of borrowings

ORCC continues to increase leverage and is now near the midpoint of its target debt-to-ratio between 0.90 and 1.25 (currently 1.06 excluding $780 million of available cash) giving the company plenty of growth capital.

We experienced a record level of originations this quarter which resulted in a fully ramped $12 billion-plus portfolio. We also had a record level of repayments. Prior to this quarter we had not yet seen the pace of repayments expected for a portfolio of our size but this trend finally materialized in the third quarter. We had more than $2 billion of repayments, which generated healthy fee and amortization income. At the same time, we’re able to seamlessly replace those repaid investments with equally attractive new investments of a similar credit quality and comparable economics, which has allowed us to finish the quarter in an equally strong position and with leverage comfortably in our target range. While this quarter may prove to be on the higher end, we do expect repayments to continue to exceed the levels we have seen in the last couple of years.”

Management is expecting another strong quarter partially due to higher prepayment-related income which has been taken into account with the updated financial projections and was discussed on the recent earnings call:

We had a significant amount of repayments this quarter, which drove a material increase in earnings from accelerated accretion and prepayment fees. While this is not a contractual earnings stream, we do expect repayment-related income to broadly stay around these levels in future quarters, as we expect that our repayments will remain at a more normalized pace, recognizing that the timing of repayments is idiosyncratic in any specific quarter.”

“We expect to see a healthy level, likely lower than this quarter’s record, but higher than previous quarters. Now that the portfolio is fully ramped, we will generally be targeting originations in line with repayments in order to maintain a fully levered, fully invested portfolio, and we have a strong backlog of attractive deals expected to close this quarter.”

The increased dividend income was mostly related to equity investments in Windows Entities and Wingspire Capital Holdings that will likely continue over the coming quarters:

Our total investment income for the quarter, increased to $269 million, up $20 million from the prior quarter. This increase was primarily driven by dividend income, which increased by $8 million. We received our first dividend from Wingspire this quarter, as well as continued dividend income from Windows Entities and our senior loan fund. We expect dividend income from Wingspire and our senior loan fund to continue to increase as our committed capital is deployed.”

“Our investment in Wingspire, an asset-based lender to US-based middle market companies, with roughly $350 million of assets and very strong credit performance. We currently have approximately $195 million invested in Wingspire and see opportunities to invest more capital going forward. We expect Wingspire will be run rating at a high single-digit ROE by the end of this year and can generate a 10-plus percent ROE.”

Also taken into account with the updated projections is additional dividend income from its ORCC Senior Loan Fund (previously Sebago Lake LLC) which now accounts for 1.9% of the total portfolio. Management is expecting this joint venture with Nationwide Life Insurance to eventually provide quarterly dividend income of $7 million:

“The other investment is in our Senior Loan Fund. As you recall, last quarter, we increased our equity commitment in the fund to $325 million and our economic ownership to 87.5%. The fund has already generated an attractive average quarterly ROE over the past three years of approximately 10%, and we will look to increase our capital invested over time.”

From previous call: “And so we’ll just be able to increase over time the amount of money ORCC has working and grow that number, when we get all that working it’s going to take some time should be we $7 million a quarter, which is I think terrific.”


On November 23, 2021, ORCC announced the prepayment of its higher rate of 4.75% notes due 2023. In August 2021, the company issued another $400 million of its 2.875% notes due 2028. As of September 30, 2021, ORCC had around $2.4 billion of liquidity consisting of $780 million of cash and almost $1.6 billion of undrawn debt capacity (including upsizes).


Setting Target Prices

There are very specific reasons for the prices that BDCs trade driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). Also, and this is very important, the price-to-book/NAV is highly dependent on the amount of dividends that a BDC is paying as a percentage of NAV (but also taking into account risk profile and projected dividends).

For example, GSBD is currently paying a regular quarterly dividend of $0.45 per share which is $1.80 annually and 11.3% of its current NAV per share ($1.80/$15.92). This is much higher than most BDCs which are currently averaging around 9.0% of NAV.

ORCC pays a regular quarterly dividend of $0.31 per share which is $1.24 annually and 8.3% of its current NAV per share ($1.24/$14.95).

The last table from “Dividend Increase Coming For PennantPark” shows each BDC roughly categorized into groups of paying below 7.5%, 7.5% to 9.0% (including ORCC), and over 10.0% (including GSBD). If GSBD is able to maintain its regular dividend then the current pricing should be higher driving a yield closer to the average of 9.0% and its price-to-NAV closer to the other BDCs in the top group (paying over 10.0% of NAV).

Again, BDCs with higher quality credit platforms and management typically have higher quality portfolios and investors pay higher prices. This drives higher multiples to NAV and lower yields.

BDCs with lower expenses and higher potential dividend coverage typically have stable to growing dividends and investors pay higher prices. This drives higher multiples to NAV and lower yields.

BDCs yields

 


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk. This week we are providing a general market update with “suggested limit orders” for each BDC due to the expected volatility.

This information was previously made available to subscribers of Premium BDC Reports. BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying including setting target prices using the portfolio detail shown in this article (at a minimum) as well as financial dividend coverage projections over the next three quarters as discussed earlier.