Betting on BDCs

02/13/2015 10:00 am EST

Focus: STOCKS

Adrian Day

Chairman and CEO, Adrian Day Asset Management

Adrian Day has long been a fan of the niche financing sector known as Business Development Companies (or BDCs). Here, the editor of the Global Analyst explains these income-oriented vehicles and highlights a trio of plays in the sector.

Steven Halpern:  Our guest today is Adrian Day, editor of the industry leading international investing service, the Global Analyst.  How are you doing today, Adrian?

Adrian Day:  I’m fine, thank you Steven. How are you?

Steven Halpern:  Very good. Thank you for joining us. Today we’re going to discuss a trio of business development companies, a sector where you believe we’ve seen an unwarranted selloff, but to begin, before we look at any individual companies, could you first explain to our listeners what business development companies are and how they differ from other stocks in the financial sector?

Adrian Day:  Well, sure, yes. Business development companies, or BDCs, have been around since, really, the late 1950s.  Essentially, they’re companies that lend money to small- and medium-sized private companies, private businesses.  

The important key though from the investor’s point of view is they are structured as registered investment advisors, like REITs, so they don’t pay any tax at the corporate level so long as they distribute all the income.  

I mean, there are a few arcane rules, but essentially, as long as they distribute all of their net operating income to shareholders, they pay no taxes at the corporate level.  

Yields on these stocks tend to be quite high.  Now, obviously, there’s a huge range of these companies.  Some are more aggressive than others.  Some concentrate on a particular sector, you know, there’s a technology BDC, there’s an oil and gas BDC, but most of them are fairly broad based, and, you know, reasonably conservative.

Steven Halpern:  Now, you note that selling this sector has been interest driven lately, in large part related to the weak energy markets.  Can you explain that connection?

Adrian Day: Sure.  Well, last year was a bad year for the BDCs.  It was sort of one hit after another for one reason or another.  One company had to cut its dividends in half and that of course shook the sector, but the most recent selloff has been because of the weak energy market.  

A lot of BDCs had made investments in the energy sector, and so, of course, when the oil prices dropped precipitously, all the analysts started looking at, well, how much exposure do they have to energy companies?  It’s been indiscriminate.  I call it indiscriminate selling for two reasons.  

Number one, even companies with very low exposure to the energy sector sell all of those with exposure and the same happens when the company I mentioned cuts dividends.  I mean, even companies have no risk of cutting their dividends.  

The second reason I call it indiscriminate, however, is because you look at different industry sectors and certain companies have been put into the energy box.

But energy can be anything from exploring for oil and gas, producing it, or all the way through to power producers or pipelines, and pipelines, of course, are mostly shipping companies. They’re much less sensitive to the price of oil so long as the volume stays up, so that’s why I call it really quite indiscriminate selling.

Steven Halpern:  Now, one BDC that you particularly like now is Ares Capital (ARCC).  What’s the attraction there?

Adrian Day:  I should mention that Ares, the stock, just had a bit of a pop in the last couple of weeks, as have had most of these, to be honest with you, but Ares, as mentioned, was recommended in the Barron’s Roundtable a couple of weekends ago, so it got a bit of  a pop.  

Ares is probably the largest of the dividend paying BDCs.  It’s about a $5.5 billion market cap.  It’s one of the more conservative BDCs.  

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It tends, in the recent past it has tended towards investing in the higher security, so it will invest in the senior debt, secured senior debt.  Obviously, you get lower yields, lower returns on those debt, but you have much less risk.  

You know, in the low yield environment, a lot of people include companies, investors, individual investors, they start taking on extra risk to try to boost their returns.  

Ares has kind of taken the opposite tact, which is; if you’re not going to get much money anyway, why take the risk of higher risk subordinated debt, mezzanine debt, so they have been going for the first tier. They’ve got a very low default rate because of that.  

Right now, Ares, even though it’s had this pop that I talk about, it is not trading at $17, it was trading under $16 two weeks ago, it’s still yielding 9%.  

It’s still trading only at net asset value, no premium at all, and I should say that, I should emphasize here Steve, that that 9% yield I’m talking about is from their regular quarterly dividends which come entirely—are covered entirely—from the recurring income that they get on the loans that they have lent out.  

Any additional income, such as origination fees, syndication fees, early pay off penalties, et cetera, any special interest is paid out in special dividends that the company has paid.  They’ve had four of them in the last two years, special dividends, but the 9% comes entirely from recurring income.  

For any conservative investor who thinks  9% is an attractive yield, I would go ahead and buy it and I wouldn’t worry too much about the stock price going up or down frankly.

Steven Halpern:  Now, another idea in this sector is Gladstone Capital (GLAD). What do you like about that situation?

Adrian Day:  You know Gladstone is a lot smaller than Ares and that’s what makes it a little less conservative, but the management is extremely conservative, they have taken a very conservative approach to investing the money for many years after the credit crisis. They held onto their cash.  

Again, what I like about Gladstone, apart from the management, is that the stock has fallen significantly, even only in the last couple of weeks it has popped up 50 cents to $7.87.  $7.87, that’s yielding over 10%.  

Again, Gladstone is a little bit less conservative than Ares because of the size. Obviously, if you have a smaller company, you have fewer loans out there.  If something happens to one of your loans, it has a bigger impact than if you’re a more diversified company, but again, for an investor who wants income.  

You know, if you buy a basket of these and something happens to one of them, I think there’s a very attractive portfolio. Gladstone has one of the highest exposures to energy of all the BDCs.  

I should point out that about 25% of their portfolio is exposed to energy, but again, energy for them includes a pipeline and shipping company, which really don’t have a lot of sensitivity to the price.

Steven Halpern:  Now, finally, you point to American Capital (ACAS).  What’s the story here?

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Adrian Day:  Yes, American Capital is a little bit different.  It doesn’t pay a dividend.  They suspended the dividend back in 2008, because, you know, during the crisis it broke some of its covenants on its stead.  

The story with American Capital is they have paid down their debt significantly. They’ve got a very good balance sheet right now.  They bought back a lot of stock in the order of 30% of the market cap—the shares outstanding over the last five years—but the stock, because it doesn’t pay a dividend, it trades at an enormous discount.  

At $14.68, which is what it is today, the stock is trading at almost 30% discount to its net asset value.  The net asset value on these companies, I should say, is normally calculated in the case of ACAP—American Capital—is calculated by an independent third party what the value of these loans are.  American Capital is trading at an almost 30% discount, which is an enormous cushion.  

Now here’s the point.  They have announced a restructuring.  They’re going to break the company into four components.  The bulk of it will be two regular dividend paying BDCs, right?  

Then they’ll have a management company and they’ll put all their bad loans, leverage loans, et cetera, they’ll put into a sort of like a venture capital company, so they’ll have four companies, but the bulk of what you get will be regular dividend paying BDCs.  

As they give us more detail on when this will happen—it will probably happen sometime in the third quarter of this year; it takes a long time to restructure in that way—as we approach that and they give us more details on it, I expect, I fully expect, that discount to narrow.  

The NAV right now is a little over $21. Even if you don’t get the NAV growing, you’ve still got enormous potential on the stock to close that gap and then you’ll wind up with two dividend paying BDCs at the end of it, so again, ACAP I think is a very good buy, but I have to emphasize it doesn’t pay in dividends right now.

Steven Halpern:  Now, before I let you go, I would point out that many are worried about the Fed finally beginning to raise interest rates later this year.  As financial stocks, what impact would rising rates have on the BDC sector?

Adrian Day:  Well, that’s an excellent question, Steven.  Now, personally, I don’t think the Fed is going to raise rates in any meaningful way, but that’s beside the point. The market is concerned.  

It’s certainly a risk and as financial stocks, that makes them weaker, another reason stocks are trading at such low prices, but truth is that for most of the companies, including the two dividend paying ones I mentioned—ACAP and GLAD, the vast majority of their loans have floating interest rates attached to them.

By vast majority, I mean 85% and 92% respectively, so rising interest rates means simply that they’ll get more income on the loans.

But more importantly than that, in an environment of rising rates, spreads tend to widen, so the companies will actually do better in an environment of rising rates, because they can borrow at X and lend it out to two or three times X.  Right now, those margins are very, very constrained.

Steven Halpern:  Well, thank you so much for taking the time today.  Again, our guest is Adrian Day, editor of the Global Analyst.  Thank you for joining us.

Adrian Day:  Thank you.

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