Darren415
This article was first published on April 1st for Systematic Income subscribers and free trials.
Welcome to another installment of our weekly BDC Market Report, in which we discuss the Business Development Company (“BDC”) market activity from the bottom up and highlight individual news items and events – as well as top-down – providing an overview of the broader market.
We also try to add historical context as well as relevant topics that appear to be driving the market or that investors should be aware of. This update covers the period up to the last week of March.
market action
BDCs had another good week, returning 2%. Despite a couple of strong weeks, the sector ended March around 5% lower. The obvious culprits were significantly lower short-term interest rates (a potential headwind for BDC net income) and an increase in probability a credit crunch as banks are likely to pull back on new lending amid a broad-based contraction in deposits for the sector.
Systematic Income
The sector has recouped about half of the loss from early March.
Systematic Income
However, the decline in March was not enough to offset the positive year-to-date return.
Systematic Income
The average BDC rating rose to 93% from under 90% earlier in the month. In our view, this is in the fair value range for the sector and less exciting for new capital.
Systematic Income
market themes
The IPO market is in a slump with only around USD 20 billion in global IPOs by Q1 – 70% down from 2022 and the lowest since 2019. The BDC keeps a low level of “exits” such as IPOs or M&A -Prepayment fees as low as loans often prepaid when the company has an “exit”. This subdued transaction activity is quite unusual in a rising interest rate environment, as a rising interest rate environment typically represents a risky period for markets. This suggests that after markets normalize, we could see a significant increase in BDC net income from prepayments, which could partially offset a decline in net income if short-term interest rates reverse.
Bloomberg
We can clearly see this decline in fee income across the sector, especially for BDCs that typically generate high fee income. For example, the chart below shows ARCC’s earnings breakdown from our service BDC Tool. We can clearly see that the green bars are getting significantly thinner throughout 2022.
Systematic income BDC tool
HTGC is showing a similar pattern of lower fees as we enter 2022. Aside from these two, HRZN and TSLX are also potential beneficiaries of a return on fee income. We currently hold both ARCC and TSLX in our high income portfolio.
Systematic income BDC tool
While a drop in fees isn’t particularly welcome, it wasn’t as noticeable last year as BDCs had a big net income tailwind of around 20% year-over-year. It also suggests that there could be additional net income tailwinds going forward as the IPO market wakes up and transaction activity resumes. This is probably unlikely in the short term, especially if the long-awaited recession does materialize. However, there could be a positive factor on the other side.
attitude and takeaways
Following the asset swoon caused by banks, we have flipped some of our BDC holdings such as GBDC and CGBD back to Buy. So far this has worked as GBDC is up 8% and CGBD is up slightly. Another rally would push the sector into fairly highly valued territory and we would look to downgrade our holdings and possibly switch to longer-dated assets. The main risk for investors is the potential double whammy of a recession and a reversal in Fed hikes, which could result in a decline in net income, NAVs and valuations.
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