Big name business development companies (BDCs) such as Prospect Capital () and Main Street Capital () continue to be vulnerable equities, in our view, particularly as credit conditions deteriorate. Ongoing pressure in the energy and metals and mining markets has increased the wariness of investors and their propensity to tolerate weak credits (and those tied to them), and several factors loom that may significantly increase the already-high level of business-model risk associated with BDCs. Investing in these relatively obscure publicly-traded “venture capital” entities is not for the faint of heart.
The market may bear witness to a surge in defaults within the high-yield arena in coming years, and a prolonged weakness in commodity prices may seal that fate. Mostly overleveraged upstream players have been the source of the investor anxiety, but the metals and mining industry is also home to a large number of equities that may not survive from coal miners to steel makers and beyond. The recent collapse in crude oil prices and other commodities is not making things easy, and the onset of a contractionary monetary cycle will only make matters worse, in our opinion. As a percentage of their entire portfolio, PennantPark (PNNT), Main Street and Apollo (AINV) have anywhere between 13%-17% tied to the energy markets.
The median high-yield default rate since 1996 has been ~3%, but according to Fitch Ratings, the trailing twelve month default rate is already higher than those levels, suggesting that the credit market cycle is already far past its prime. Looking ahead to 2016, Fitch is expecting the US high-yield default rate to climb to 4.5%, which may very well mark the threshold at which the pace of credit health and the incidence of defaults accelerate. Moody’s average expected default frequency metric has already risen over 5%, well above that 4.5% threshold. As we wrote earlier this year:
…what has us very concerned is that in the two prior instances since January 1996 when the average expected default frequency metric surpassed 4.5% (1998 and 2008), as it has, the actual high-yield default rate at the eventual depths of the credit cycle turned out to be far worse, ~11% in 2002 and ~15% in 2010. As in the two past instances, high-yield default rates may very well surge in the coming months, and a double-digit rate can’t possibly be ruled out, even as Moody’s says “doom does not necessarily impend.” Surging high-yield default trends tend to occur around recessions, at least in the US.
The expectation for rising default rates is primarily driven by significant pressure on the energy and metals and mining sectors; the two areas, for example, have accounted for ~70% of defaults in 2015. Fitch Ratings expects the 2016 default rate in the high-yield energy sector to be greater than 10%, but this is assuming that the average price of a barrel of crude oil will be $50 for the year, a number that can be viewed as optimistic when considering recent comments from OPEC and the current level of commercial supplies in the US. In the event the price of crude oil hovers in the mid-$30s (today’s levels) and below, we would expect default rates across high-yield energy participants in 2016/2017 to be significantly higher than a 10% incidence rate.
When excluding the energy and metals and mining industries, Fitch expects the remainder of the high-yield market default rate to be 1.5% in 2016, well below the credit rating firm’s non-recessionary average of 2.1%. The expected 4.5% high-yield default rate would be the fourth highest of any year since 2000, however. Though many BDCs aren’t completely levered to energy, it may not matter. Even a few missteps in the space could be enough to derail the resilience of their income profiles, and the contagion impact that may be felt from lost jobs in weakened local energy-dependent economies is difficult to overlook. Remember: subprime loans were only a small slice of total loans, but that small slice was enough to bring the global financial system to its knees during the Credit Crisis of late last decade.
Another cause for concern for investors in BDCs is the coming credit tightening cycle, if only that it will make yields on alternative less-risky assets increasingly more desirable. Though the timing remains uncertain, interest rate hikes are inevitable in our view, and once the Fed begins raising rates, we believe that it will continue to do so. We doubt Janet Yellen will pursue a “one and done” strategy, predoinantly because it may reflect poorly on her conviction in initiating a tightening policy at all (and the Fed may lose credibility as a result). More directly, a higher federal funds rate will also drive the cost of capital for BDCs higher, making it more and more difficult to generate sufficient returns. Higher rates will pressure the underlying valuations of BDCs, but not unlike that of most other equities (a higher discount rate would be applied to their future expected free cash flow streams).
As generally conservative, value-focused investors, perhaps the biggest reason we’re not fans of BDCs is that most hold a significant amount of leverage on the books and are required to distribute at least 90% of taxable income as dividends, leaving little room to handle cash shortfalls. Several BDC’s have cut their dividends, and with so many other companies in our coverage universe with substantial net cash positions and fantastic free cash flow profiles, why take on the added risk? We’re staying on the sidelines.
Continue reading a primer on BDCs here >>
A list of BDCs: American Capital (), Apollo Investment (), Ares Capital (), Blackrock Kelso Capital (BKCC), CorEnergy (CORR), Equus (EQS), Fidus (FDUS), Fifth Street Finance (FSC), Full Circle (FULL), Gladstone Capital (GLAD), Golub (GBDC), Hercules Technology (HTGC), Horizon Technology (HRZN), KCAP Financial (KCAP), KKR Financial (KFN), Main Street (), MCG Capital (MCGC), Medley Capital (MCC), Monroe Capital (MRCC), MVC Capital (MVC), New Mountain (NMFC), NGP Capital Resources (NGPC), Oxford Lane (OXLC), Pennant Park (PNNT), Prospect Capital (), Solar Capital (SLRC), Stellus Capital (SCM), TCP Capital (TCPC), THL Credit (TCRD), TICC Capital (TICC), Triangle Capital (), Whitehorse Finance (WHF).