Business Development Companies (BDC) are organizations that lend to the "middle-market"; these are small and medium-sized businesses that typically are not publicly traded, so they don't have access to the public debt or equity markets. Historically, these companies have turned to banks. However, due to changes in banking regulations, banks run tighter ships and have less appetite for these types of loans. Following the Great Financial Crisis, bank regulations have become stricter, making it very unattractive for them to hold illiquid loans. BDCs provide permanent capital and don't have to worry about depositors withdrawing funds. As a result, they can invest in debt with the intent and the ability to hold until maturity. This makes them a powerful institution class as the economy faces a recession.
Most high-quality BDCs maintain a diversified portfolio of senior secured loans backed by the borrower's mission-critical assets. These loans are largely floating rates, providing strong tailwinds as we saw the fastest pace of rate hikes in decades.
Most investors think BDCs make good investments only in an environment of rising interest rates. They couldn’t be more wrong. BDCs were federally institutionalized to help recover the economy from recessions by supporting middle-market companies with vital capital. As we look at rate cuts, we see that high-quality BDCs have ample room to expand their asset base through increased lending activity. Let us now review my top picks in this vital sector.
Pick 1: ARCC – Yield 9.2%
Ares Capital Corporation (ARCC) reported a very strong second quarter with core EPS coming in at $0.61 and NII at $0.58/share, both higher year over year and sequentially. The blue-chip BDC’s NAV increased to $19.61, up 5.5% YoY, and it made $1.77 billion in new investments, more than what we have seen recently. A larger investment portfolio produces more cash, and ARCC’s new originations compare to $45 million in Q1 and $996 million in FY 2023.
During Q2, ~4% of ARCC’s portfolio was in its two highest-risk categories, the same as Q1 and down from 7% a year ago. Higher interest rates have stressed borrowers, but the headwinds are front-loaded. With rates projected to go lower, we expect borrower strength to improve and defaults to shrink.
ARCC ended Q2 with 1.01x debt to equity net of cash, maintaining adequate room to leverage up. We have seen this BDC willing to take leverage up to 1.15x-1.20x in the past. Currently, ARCC trades at a 6% premium to NAV; based on history, it trades as high as a 15% premium to NAV around $22.55.
We expect ARCC’s book value to continue growing as debt markets become more stable with rate cuts. This will be positive for valuations, and ARCC common shares will continue trading at a modest premium to NAV.
Pick 2: CSWC – Yield 9.7%
Capital Southwest Corp (CSWC) gifted us with yet another dividend increase this quarter. The BDC now pays $0.58/quarter in regular dividends, while continuing its $0.06 supplemental dividend. With Q2 NII arriving at $0.69/share, CSWC continues to significantly exceed the total dividend payment.
CSWC is a strong pick for a recessionary environment. We note that this BDC paid large special dividends during the zero-interest environment, and continues to make supplemental dividends at these 20-year high rates.
Within CSWC’s portfolio, there were three upgrades and three downgrades last quarter. The BDC only has two loans in level 4, its lowest rating which suggests a high probability of loss. CSWC has ten loans at level 3 (below expectations), and 139 loans at level 2 or 1.
CSWC is operating at a low level of leverage at only 0.75x debt/equity, with room to expand based on historic trends of 0.8x to 0.9x. As such, we expect CSWC to continue strong execution to join the ranks of MAIN, a premium blue-chip BDC.
Conclusion
There is a reason BDCs maintain two dividend classes, regular and supplemental. Those regular dividends are what management expects to be sustainable over the long term, while supplemental ones are the bonus from unusual tailwinds. The regular dividends can grow to the extent that the BDC is able to continue growing its portfolio. When M&A activity picks up in the future, we can expect a return of the lumpier "special" dividends among BDCs that get significant gains on their equity portfolios.
Well-managed BDCs are operating at low levels of leverage relative to their history to the extent that management is comfortable with leveraging up to grow their asset base. These opportunities will be strong with rate cuts, allowing these BDCs to generate larger cash flows amidst normalizing (and reducing) defaults. Having a larger portfolio is a tailwind to NII, positioning shareholders for sustainable dividends.
A diversified portfolio of asset classes is essential to tackle the known and unknown challenges presented by the economy. At High Dividend Opportunities, we maintain modest exposure to high-quality BDCs and are growing our income from their prudent strategy and robust execution.
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