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BDCs and Reflexivity Theory


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Topic: BDCs
Apr. 2 2015, 3:21 PM ET - by VF member NAL (1006 gold star (click for information on feedback))

BDCs and Reflexivity Theory --

George Soros has written and lectured extensively about the theory of reflexivity. In this post I will make the case that this theory is both relevant and important to thinking about investing in Business Development Companies (BDCs).


Introducing Reflexivity Theory


Reflexivity theory applied to the stock market describes how the underlying value of a business can be influenced by the prices of its securities. An example we see all the time, possibly without even realizing it: a company with a strong currency (in the form of a rich stock price) uses it to buy a competitor in an accretive deal. Would the same deal have been done if the currency of the acquirer was weaker? Does the accretive deal lead participants to then "justify" a rich stock price for the acquirer?


Soros describes how thinking participants can try to understand the world (the "Understanding Function"), as well as change the situation (the "Participating Function" or "Manipulative Function"). These participants interfere with each other. One example he gives that I like, is to consider this statement: "It is raining outside." For the Understanding Function this is clear cut: depending on the weather, the statement is either true or false. But then Soros asks us to consider this other statement: "This is a revolutionary moment." I immediately picture a leader addressing a crowd. Does it become a revolutionary moment, because the statement is made?


Reflexivity theory applied to the stock market tells us to be aware of the influence stock prices can have on the actual underlying business value.



Introducing Business Development Companies (BDCs)


ValueForum members are well aware of what BDCs are and how they are structured, but I will give a little background as it relates to my general argument. Congress created BDCs in 1980 to encourage the flow of public equity capital into private businesses here in this country. BDCs are typically taxed as Regulated Investment Companies so long as they distribute 90% of taxable income to shareholders. A further tax can be avoided by bringing that number up to 98%. So for the most part, as a generalization, BDCs pay out everything they earn in the form of shareholder dividends. In this way they are "pass through" entities much like Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs).


As it relates to reflexivity theory, this payout ratio introduces an interesting dynamic: If by its very structure a BDC is paying out everything it earns, how does it grow? How about adding debt capital? In other words, raise new cash for growth by borrowing money from a bank willing to issue a credit facility, or by issuing debt securities. BDCs can presently do this, but only up to the point where they reach a debt to equity ratio of 1:1; that's their legal limit. Unless that limit gets changed in the future, that means BDCs must constantly raise new equity capital if they want to grow. This could mean issuing new shares under a dividend reinvestment plan. It could also mean conducting a public offering of additional shares of common stock. Or, the BDC could choose not to grow and simply "recycle" capital into new investments.


Because BDCs must distribute their taxable income instead of reinvesting it, portfolio growth must come from retained capital gains or raising new equity and debt capital.



Growing Net Asset Value Per Share Is Difficult


The types of investments made by BDCs are anywhere up and down the balance sheet of private U.S. businesses, so they can invest in equity with capital gains potential, and they can invest in debt by originating a loan to a company (or buying a debt security originated by someone else). Those debt investments may be junior or senior to other outstanding debt obligations, can be to companies of different sizes, different stages of maturity as businesses, and operating in different industries. Different BDCs have different specialties, but generally speaking most tend to put their focus on income-producing investments.


Suppose you have a BDC with a portfolio completely made up of loans to small private companies. In terms of the principal, the best that hypothetical BDC can hope for is for all of those loans to be repaid at par. But there is considerable credit risk to this area of lending, so some percentage of loans can be expected to default and some of those defaults will result in some loss of principal, especially during a period of economic recession. Facing a credit loss, this hypothetical BDC cannot retain a portion of taxable income to offset those losses without losing its tax status as a RIC. Therefore, such a BDC may see net asset value per share decline over time as it experiences credit problems in the portfolio. Some BDCs choose to invest a portion of their portfolios into equity investments, with the idea that such investments will grow in value and generate capital gains to offset credit losses.


Dozens upon dozens of BDCs exist today, but few have a ten year history. In the table below, I have selected eight BDCs with business models fairly typical to the industry, that have at least ten years of earnings statements. Using sec.gov, I looked up the NAV/share at 12/31/2004, and then I looked up the NAV/share ten years later on 12/31/2014, in the 10Q and 10K filings. I will note here that beginning with their tax year ended September 30, 2011, ACAS changed its tax status from a RIC, to a C-corporation. The company has not paid a dividend since the financial crisis, so all recent earnings have been available to re-build per-share NAV. I will also note that a BDC called Allied Capital existed in 2004, but was subsequently acquired by Ares Capital. Finally, I will note that OHAI formerly traded under the ticker symbol NGPC and was called NGP Capital Resources back in 2004.
 
        NAV/share   NAV/share     10Yr NAV/sh 
BDC     12/31/2004  12/31/2014      Change 
---------------------------------------------- 
ACAS      21.11      20.50      -0.61 (- 2.9%) 
MCGC      12.22       4.69      -7.53 (-61.6%) 
GLAD      13.58       9.31      -4.27 (-31.4%) 
TICC      13.71       8.64      -5.07 (-37.0%) 
AINV      14.32       8.43      -5.89 (-41.1%) 
PSEC      13.74      10.35      -3.39 (-24.7%) 
OHAI      14.03       7.48      -6.55 (-46.7%) 
ARCC      14.43      16.82      +2.39 (+16.6%) 



Each of these companies have paid dividends during the start and end date, so the percentage change to per-share NAV does not represent total return. Instead, what this table is meant to illustrate, is how difficult it has been over the past ten years for a BDC to operate as a pass-through vehicle while at the same time turning out per-share NAV growth. The financial crisis made the feat of growing per-share NAV even more difficult. The best result of these eight BDCs is over at ARCC where per-share NAV at 12/31/2014 is 16.6% higher than it was on 12/31/2004.


Growth of per-share NAV over the past ten years was not an easy task for BDCs.



Reflexivity In Action: FSFR


Fifth Street Senior Floating Rate Corporation (FSFR) reported 15.13/share of NAV at June 30, 2014 and 6,666,768 shares outstanding at that date. Over the three months that followed, for the quarter ended September 30, 2014, FSFR would earn .26 per weighted average basic and diluted share and would pay a dividend of .30/share. But NAV/share at September 30th was not 15.09/share (15.13 + .26 - .30). Instead, FSFR reported this number:


12.65/share


How is this possible? Reading this 12.65/share number, one might conclude that I simply have my facts wrong and the company must have posted a loss of 2.18/share that quarter so that after the loss and after the dividend paid, the NAV/share would reach 12.65 (15.13 starting NAV - 2.18 loss - .30 dividend = 12.65). But I have my facts right, and these facts can be verified on page 42 of the following SEC filing: http://www.sec.gov/Archives/edgar/data/1577791/000157779114000053/fsfr10-kended09302014.htm


Here is the explanation. In between 6/30 and 9/30, the company issued new shares of common stock in a public offering. The proceeds per new share sold to the public amounted to 12.14/share before offering expenses. Add those proceeds to the total dollar amount of pre-existing NAV and you get your new numerator in the NAV/share equation. Then add up the new shares issued in the offering with the pre-existing shares and you get your new denominator. So the dramatic change in per-share net asset value was driven not by a quarterly loss but rather by actions taken by the company that changed the numerator and denominator of the per-share NAV calculation.


To put the outcome in this case into perspective, in order to re-claim the pre-offering NAV/share of 15.13, FSFR would need to increase it by 19.6% from its newly lowered level. But for the past decade, the best NAV/share increase we saw in my earlier example was ARCC with an increase of 16.6%. And ARCC was an outlier in that comparison. Per-share net asset value at FSFR was damaged so much in one day, that to recover would require a 3% better result than what it took ARCC a decade to accomplish.


Consider the "Understanding Function" with those market participants trying to understand FSFR when they looked over its original IPO prospectus. Among the key metrics widely used to value BDCs is NAV/share and share price relative to NAV/share. A typical analysis of future NAV/share for FSFR at the date of its original IPO might have included an assessment of the likelihood and expected severity of credit losses based on track record and other factors, and whether or not FSFR would be making any equity investments that could potentially generate future offsetting gains.


Even with the best possible understanding of the portfolio of assets at FSFR, that understanding would have been deprived of the variable of the future impact of the "Manipulative Function." This example at FSFR is one where a "decade large" amount of per-share value was lost because the stock price was low relative to NAV/share, in combination with management's willingness at that time to issue new shares at that low price. This is an example of reflexivity theory in action, where the stock price directly impacted the underlying value from one point in time to another. That value destruction took place because of where the stock was trading and then because management let that prevailing market price become a determinant of the outcome. FSFR was not required to issue that number of shares at that price, doing so was a choice.



Reflexivity In Action: ACAS


Before the financial crisis, American Capital (ACAS) enjoyed a long history of dividend growth and steady access to the debt and equity capital markets. When the financial crisis hit, the company breached financial covenants and both the company's own stock price and securities prices comparable to the types of investments owned in the portfolio had a dramatic impact on the company. In its 10K filings for 2008 and 2009, Ernst & Young LLP concluded that substantial doubt existed at the time about its ability to continue as a going concern:


From its 2008 10K: ...a significant portion of the depreciation that we have reported to date is not the result of credit impairment of our underlying assets, but rather of an unprecedented widening of investment spreads caused by distressed selling in trading markets for assets deemed to be comparable to our assets, declines in purchase multiples of middle market acquisition transactions during 2008 and application of market yield analysis to assets that were acquired with the intent of holding them to settlement or maturity as opposed to trading them. However, as a result of such unrealized depreciation, we are currently in breach of certain financial covenants under our revolving credit facilities and unsecured debt borrowing arrangements...


From its 2009 10K: ...our independent registered public accounting firm concluded in its report dated March 1, 2010 regarding those consolidated financial statements, that there is substantial doubt about our ability to continue as a going concern as a result of not being in compliance with certain covenants under our Unsecured Debt Obligations and receiving event of default notices from the holders of such obligations and being below the 200% asset coverage ratio under the 1940 Act, which impacts our ability to issue new debt. Our consolidated financial statements do not include any adjustments to reflect the possible future effects on the recovery and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.


In February of 2010, ACAS shareholders approved a proposal authorizing the Company to sell shares of its common stock at prices below net asset value, limited to a maximum of 58.3 million shares (an amount equal to 20% of shares outstanding at the time). The 10K for 2009 was filed in March of 2010. In that filing, the company had reported NAV/share of $8.29 at 12/31/2009. The following month, the company secured a $295 million strategic investment from Paulson & Co. Inc., for 58.3 million shares at $5.06 per share. By the end of June, the company had completed a debt restructuring and the "going concern" clause was removed.


This case is a good example of how stock price can become increasingly important to underlying per-share business value when additional capital is needed. I calculate that the 2010 share issuance substantially below net asset value caused a reduction in per-share net asset value to pre-existing shareholders of approximately 6.5%. Had the per-share price in that offering instead been $10 but the same number of shares sold, I calculate that per-share net asset value at the time would have increased by 3.4%.


In "part two" of the ACAS case study, once the company had regained its footing but the stock price remained below per-share net asset value, it began to repurchase and retire shares of stock. By purchasing shares at prices below the per-share net asset value, the remaining net assets divided by the lower share count resulted in more per-share net assets available to the shares that remained.


Between the third quarter of 2011 through the first quarter of 2014, American Capital made open market purchases of 101.6 million shares at an average price of $11.74 per share. These purchases were $1.88 per share accretive to net asset value, or expressed another way, by March 31, 2014, I calculate that per-share net asset value was approximately 10.9% higher than it would have been absent the share repurchases. Had the company been able to retire shares at a lower price, the repurchases would have been more accretive; had the company retired shares at prices above net asset value it would instead have been dilutive. Management's reaction to stock prices above or below underlying value and the ability to issue or repurchase shares exemplifies the "Participating Function" or "Manipulative Function" described by Soros.



Reflexivity In Action: MAIN


In its 10K filings, Main Street Capital (MAIN) includes notes to its consolidated financial statements. One of these notes details the "Accretive effect of public stock offerings (issuing shares above NAV per share)" while another details the same effect for issuance of shares under the dividend reinvestment plan (DRIP plan).


Adding together the accretive effect of issuance of stock in offerings and the DRIP plan, MAIN's NAV increased by $1.19 per share in 2014. To better think about this number, consider for context that MAIN began the year 2014 with NAV/share of $19.89, and reported net investment income of $2.20 per share for the year. If we compare the $1.19 number to the net investment income, we can see that it is about 54% of the size of net investment income. And if we express the $1.19 number as a percentage of starting NAV, we can see that it works out to just about 6% of starting NAV. Because the stock price of MAIN resulted in accretion when shares were issued, the underlying business value increased meaningfully.


Thinking about this further and moving from MAIN specifically to a broad generalization, suppose you have a company that can generate a 10% return on equity. If that company has $10/share of equity, a 10% return produces earnings of $1/share. If that same company can simultaneously cause shareholder equity to rise by 6% over the course of a year, it will end the year with $10.60/share of equity and if it can again generate a 10% return on equity, earnings the following year would be $1.06/share, a six percent earnings increase year over year. If that same company pays out most of its earnings as dividends, we would also expect a dividend increase.


A company that can consistently grow its earnings and dividend will usually command a higher valuation versus a company with the same earnings level and no growth. Going back to the example of the previous paragraph, if in your left hand you hold a share of stock in a company with $10/share of net asset value that will earn $1.00 this year and $1.00 the following year, and then in your right hand you hold a share of stock in a company with $10/share of net asset value that will earn $1.00 this year and $1.06 the following year, if I offered to sell you either certificate at the same $10 price, which hand would you choose?


If you chose the right hand, that should also imply you would be willing to pay a higher price for the right hand, than you would pay for the left hand. In other words, the right hand should command a higher valuation. If you were to demand a 10% return for the risk for each hand, part of your expected return from the right hand will come from growth. Therefore, you might require less of the expected return to come from earnings yield or dividend yield. Applying a lower earnings yield or dividend yield translates into a higher stock price.


Here we have an example of what George Soros would call a "Feedback Loop." The Understanding Function argues that a stock should trade at a higher valuation. That higher valuation enables the Manipulative Function to create value simply because of the higher valuation of the stock. The extra value creation then reinforces the fact that the stock should trade at a high valuation.



Elements Impacting Price/NAV Valuation


By this point I hope to have successfully argued, with supporting historical examples, that the stock price of a BDC relative to its underlying net asset value can alternatively result in situations where value can be destroyed, as well as situations where value can be created.


A next natural question to discuss would be: how can we understand what elements, what features of a BDC, are likely to cause it to trade at a high or a low valuation relative to underlying net asset value? Profitability as measured by earnings and return on equity is a common yardstick that typically tends to draw the most investor attention. I want to cover some of the things investors may not have put as much time into thinking about.


One important element to consider is how easy or difficult it would be to "replicate" the BDC. To begin a thought experiment, consider a hypothetical very basic closed end fund (CEF). Our hypothetical CEF has just raised a fixed amount of capital in an offering. Our hypothetical CEF then appoints and pays (handsomely) one person to manage the portfolio and invest it into stocks chosen from within the S&P 500. Our hypothetical CEF then applies leverage using a basic margin account. Our hypothetical CEF will pay a dividend at the end of the year on an annual basis.


Any one of us here on ValueForum could replicate the hypothetical closed end fund I have just described, so long as we know the stocks it owns and in what amounts. S&P 500 stocks are highly liquid, margin accounts are easy to obtain, and so we could just go out and buy a portfolio exactly matching that of the closed end fund. Therefore, logic would dictate that it would be ridiculous if shares of that closed end fund were to trade at, say, a 50% premium to their underlying net asset value. If that situation were to occur, a short seller could easily step in and go short shares of the closed end fund, go long a portfolio that exactly replicates it, and reverse the trade when the unjustified premium disappears.


The above thought experiment should highlight some of the areas beyond strict profitability considerations, that we can think about when looking at a BDC. What does it own and how difficult would it be to replicate ownership of that portfolio? If it uses leverage, how difficult would it be to replicate that leverage? How much does it cost to operate the BDC, especially in relation to the size of the portfolio? What kinds of employees (and with what capabilities) does the BDC employ? Does the BDC pay a dividend and at what frequency?


Working through this list backwards, there is strong evidence to support the notion that a non-dividend-paying BDC or low-dividend-paying BDC will tend to trade at a discount to its NAV. Three examples I will cite are:


(1) Capital Southwest (CSWC) has historically invested its portfolio in equity investments with the goal of long-term capital gains, as opposed to debt investments that would support a high regular dividend. As a result, shares traditionally traded at a large discount to NAV. On December 2, 2014, the company announced a spin-off plan and change in focus at the remaining BDC from equity investing to lending, which over time would support a regular dividend more in line with other BDCs. From that date to 3/31/2015, shares gained 19.1%, to trade at a share price roughly in line with per-share NAV. The recent move toward NAV from a historical discount, is explained by the expectation of the upcoming spin-off and associated prospect of a high level of future regular dividends.


(2) MVC Capital (MVC) was formerly the Internet-focused closed end fund called MeVC Draper Fisher Jurvetson Fund, a fund which generated large losses and was taken over by activists. Michael Tokarz, a former KKR partner, was appointed to take over management of the fund. In order to utilize the losses generated by the former strategy, the new strategy focused on equity investments. While MVC has paid a small quarterly dividend, the present rate only works out to about 3.4% against the current per-share net asset value. At 3/31/2015, shares traded at prices representing approximately a 40% discount to previously reported per-share net asset value. On its recent strategy call, the company said it will shift its portfolio from equity investments to yielding investments, and said its advisers believe a transition to a market-rate dividend will help close the discount.


(3) American Capital (ACAS) switched its tax status to that of a taxable BDC, in order to make use of losses incurred during the financial crisis. As a result, the company has not paid a dividend since 2009. At 3/31/2015, shares of ACAS traded at prices representing approximately a 28% discount to previously reported per-share net asset value. The company has announced a plan to spin off new business development companies to shareholders, with the remaining company continuing its asset management business line, including management of the new BDCs being spun out.


If a non-dividend-paying BDC or a low-dividend-paying BDC tends to trade at prices below NAV, that suggests the existence of a high regular dividend is an important element in achieving a strong valuation.


Employees and capabilities are an important consideration. Thinking back to the hypothetical very basic CEF with the one handsomely paid portfolio manager choosing S&P 500 stocks, the investment capabilities of that hypothetical fund are clearly quite limited. It would be difficult to provide any type of significant managerial assistance to a company in the portfolio. The idea of our hypothetical portfolio manager buying AAPL and then calling Tim Cook to provide managerial assistance seems like a stretch of the imagination. But for BDCs this is actually an important consideration, because BDC legislation mandates that BDCs must make "significant" managerial assistance available to their portfolio companies. This is arguably open to some interpretation. And when we look at the franchise differences between different BDCs, it is clear to see how the capabilities of some BDCs are much stronger in this area versus the capabilities of other BDCs.


One of the case study BDCs discussed earlier, MAIN, had 38 employees as of 12/31/2014, all located in their Houston, Texas office. Those employees include investment and portfolio management professionals, operations professionals and administrative staff. In its 10K, MAIN states that managerial assistance may mean "significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company."


Another of the case study BDCs discussed earlier, ACAS, had 366 employees as of 12/31/2014, with offices in Bethesda, New York, Chicago, Boston, Annapolis, London, Paris and Singapore. Those employees are spread out over different groups, including an "Operations Team" with significant turnaround and bankruptcy experience, capable of providing intensive operational and managerial assistance to portfolio companies when they require such assistance. The Operations Team includes seven former CEOs and presidents, three lean champions, seven financial VPs and associates and three supply chain and outsourcing specialists.


And finally, the first case study BDC discussed earlier, FSFR, does not have any employees.


Moving on, let's talk about costs to operate the BDC. What's that? "Wait" you say? Why doesn't FSFR have any employees, you ask? FSFR's day-to-day investment operations are managed by Fifth Street Management as their investment adviser, under an investment advisory agreement that spells out the fees that will be paid for these services. FSFR is an example of an "externally managed" BDC. As with other externally managed BDCs, FSFR's 10K filings contain a discussion of conflicts of interest. Fifth Street Management is, in fact, a publicly traded company itself, under ticker symbol FSAM. The manager earns a sufficient profit from its role as adviser to FSAM and other funds under management, that those profits (and their perceived future growth potential) collectively support the existence of a separate public company.


For externally managed BDCs the cost structure is spelled out in the management agreement, and for the typical externally managed BDC there is a fixed "base fee" as a defined percentage of total assets, and usually an "incentive fee" entitling the manager to 20% of the return as long as a hurdle is cleared. A typical base fee may be between 1.5% and 2% of total assets. Internally managed BDCs by comparison may be more or less expensive to operate, based upon various factors including the scale of the operation, its capabilities, and the number of employees necessary to support those capabilities. Looking at the year ended 12/31/2014 for MAIN for example, total operating expenses excluding interest expense, worked out to approximately 1.4% against the average total assets.


It should be clear in this comparison that MAIN is operating more efficiently than the typical externally managed BDC. Another important factor to consider is that an internally managed BDC like MAIN may be able to achieve economy of scale benefits, spreading out the operating costs over a larger asset base, compared to an externally managed BDC with a management contract spelling out a fixed based fee no matter how large the asset base.


Employees, capabilities, and cost to operate the BDC are important elements in determining valuation.


The way a BDC uses leverage can be another differentiating factor compared to our hypothetical very basic CEF discussed earlier. A margin account is very easy to obtain. How about a license from the Small Business Administration (SBA) to operate a Small Business Investment Company (SBIC)? That is decidedly more difficult to obtain. You or I would face quite a challenge to get one <g>! Even some BDCs have had difficulty obtaining or holding onto an SBIC license. One BDC, MCG Capital (MCGC), had been operating an SBIC and then, following a period of corporate restructuring, filed an application for a second license. In 2013, the SBA, apparently concerned about how MCGC stacked up against other specialty finance companies, allowed MCGC to withdraw its application. In September 2014, MCGC surrendered the one SBIC license it did have.


Obtaining an SBIC license (or two) opens the door to issuance of SBA-guaranteed debentures. The interest rate on SBA-guaranteed debentures is generally lower than interest rates on other comparable debt sources. Such debentures are also long-term (ten years), do not require principal payments prior to maturity, and the interest rate is fixed. MAIN holds two SBIC licenses, and in its 10K filing for 2014 indicated an annual weighted average interest rate on its SBA-guaranteed debentures of approximately 4.2%. A further benefit of SBIC debentures is their exclusion for purposes of the 1:1 debt:equity limit (also referred to as the 200% asset coverage requirement).


BDCs can also access other forms of debt capital that are difficult for you or me to replicate. Another example is issuance of unsecured debt obligations commonly referred to as "baby bonds" that trade publicly, similar to preferred stock. BDCs can even seek a credit rating from a ratings agency like Standard and Poors, Moody's, or Fitch. If a BDC can utilize leverage on attractive terms, a higher return on equity can be achieved versus use of no leverage at all.


The way a BDC uses the right side of its balance sheet can be an important element in determining valuation.


The final element I will discuss is the difficulty of replicating the portfolio, or more broadly, replicating sources of income. Going back to the hypothetical very basic CEF example, replicating ownership of a portfolio of S&P 500 stocks is an easy task: we could just enter an order to buy the same stocks. When BDCs make equity investments, they are investments in private companies. That is already more difficult to replicate; even if we wanted to, it may actually be impossible to buy equity of a given private company if we can find no willing sellers. We could buy shares of a similar company, if we can find one, but if the investment thesis is more of a special situation, buying a similar company could lead to a very different investment outcome.


But as mentioned earlier, most BDCs tend to put their focus on debt investments. Is the BDC originating the debt investments it makes? Is the BDC earning fees for doing so? Is the BDC in control of how each investment is structured? If so, these are things that would be difficult to replicate. Buying very liquid debt securities originated by someone else would be much easier. Some BDCs may earn syndication fees by underwriting a large investment and then syndicating a portion of it to other investors. HMS Income Fund has co-invested in some investments originated by Main Street Capital. MAIN then earns an asset management fee for services provided to HMS. Replicating a contract to provide asset management services to HMS Income Fund or a similar fund would be exceedingly difficult, requiring among other things proven years of expertise and success.


The contents of the portfolio itself are obviously quite important, including what specific companies the BDC has invested in, the nature of those investments including underwriting quality and risk/reward characteristics, the size of the companies, the industries those companies operate in, even the year the investment was made relative to the credit cycle or economic cycle can be important.


What a BDC owns and the ways it earns income are important elements in determining valuation.



Finding BDCs That Can Benefit From Reflexivity


If a BDC can create value by buying back shares substantially below net asset value, or by issuing new shares substantially above net asset value, then identifying those BDCs which have the potential to benefit from this dynamic is a simple matter of sorting the universe of BDCs by price/NAV and then determining whether the BDCs at the greatest discount have the desire and ability to buy back stock, and determining whether the BDCs at the greatest premium have the desire and ability to grow by issuing new shares of stock.


As we saw earlier in the example cases, the reverse is also true, where BDCs trading at a discount to NAV can destroy value by issuing new shares of stock, and in theory BDCs trading at a premium to NAV can destroy value by repurchasing stock. However, a BDC repurchasing shares of stock at prices above NAV is practically unheard of, although I can cite one such case: FS Investment Corporation (FSIC) is a BDC which started its life as a "non-traded" BDC -- shares were not listed on a stock exchange, leaving its original owners with limited liquidity. Shortly after listing on the New York Stock Exchange, FSIC conducted a tender offer (something fairly common when a non-traded vehicle decides to list). On June 4, 2014, FSIC accepted for purchase 23,255,813 shares of common stock at a purchase price of $10.75 per share, for an aggregate cost of approximately $250 million. According to its 10Q filing for the quarter ended March 31, net asset value had been $10.28/share. Therefore, the tender offer price represented a repurchase of shares at an approximate 4.6% premium to pre-existing per-share net asset value.


Therefore, since value may be both created and destroyed depending on the Participating Function, it is incumbent upon investors in BDCs to gain an understanding of the participants and what motivates them -- this includes the investors, the analysts, the credit rating agencies, and of course the management at the BDC. One particularly destructive motivation to be aware of among externally managed BDCs, is the incentive for an asset manager to increase its funds under management. Such an incentive may cause management to choose to conduct an offering of new shares, even when doing so would be below the pre-existing per-share net asset value. Analysts will often cite investor concern over capital issuance conflicts as a valuation-limiting factor. If investors have these concerns, and if analysts repeat these concerns and use them to justify lower valuations, then I argue that externally managed BDCs are already inherently disadvantaged when it comes to valuation potential. This is especially true given the fee structure and lack of economy of scale benefits. In other words, I contend that being externally managed automatically puts a BDC at a disadvantage when it comes to being able to benefit from reflexivity.


That being the case, if our goal is to identify BDCs that can benefit from reflexivity, job one should be determining whether or not a BDC is internally managed. As it happens, there are relatively few BDCs that maintain their own employees. A negative to this small number is relative lack of choice, but a positive to this small number is the ability to more quickly identify the BDCs that have the best possibility of trading at a high valuation. I will list all of the internally managed BDCs that I am aware of below, with short notes about each.


Capital Southwest (CSWC)
All of CSWC's employees currently operate out of their Dallas office. At the moment I would argue that CSWC falls into the category of "special situation" because their spin-off plan is underway and will radically change the company's business direction. The company plans to file an initial form 10 sometime in the second quarter, for the spin off of an industrial growth company in a tax-free spin-off. The remaining CSWC will be an internally managed BDC with a new focus on lending to middle market companies in the Southwest as well as elsewhere in the country. CSWC's net asset value per share at 12/31/2014 was $47.17.


Medallion Financial (TAXI)
As of December 31, 2014 TAXI employed 159 people including a 50-person staff at its Medallion Bank subsidiary, an FDIC-insured depository institution. TAXI has historically held a leading position in Taxi Medallion Lending, with medallion loans comprising a full 59% of the net portfolio at 12/31/2014. Because of its high concentration in this one area, the long-term impact of services like Uber and Lyft on the dynamics of the taxi cab industry are an important question investors in the company appear to be focusing on. At 12/31/2014 TAXI had per-share net asset value of $11.16.


MCG Capital (MCGC)
Interestingly enough, when the company came public in 2001, one of its high-profile shareholders was none other than George Soros. Originally a division of Signet Bank (which became First Union, which became Wachovia), MCGC originally had a special focus on the communications, information services, media, and technology sectors. A number of business model transformation attempts took place over the years that followed, without lasting success. According to the ValueForum CAGR calculator, an investment into MCGC on 11/30/2001 through 3/31/2015 returned a total of just 6.35% if dividends were collected in cash. However, the same calculator shows that if dividends were reinvested, total return was a negative 15.75% -- with shares above $16 in 2001 and around $4 today, it is logical that reinvesting along the way into new shares that are now worth so little today would have a big impact on total return. I think this highlights how BDC investors should always want per-share value to grow over time and should be wary when a BDC pays a dividend with a return of capital component which causes unnecessary reduction of per-share value. I had mentioned earlier how MCGC surrendered its SBIC license; in February of this year the company announced it is exploring strategic alternatives including a possible sale of the company. At 12/31/2014 MCGC had per-share net asset value of $4.69.


American Capital (ACAS)
Also more of a "special situation," ACAS as touched upon earlier became so stressed during the financial crisis that their survival was in question. Once they had regained their footing, with the stock price remaining depressed relative to NAV, ACAS began repurchasing shares of stock. A billion plus buyback dollars later, ACAS decided to embark on a plan to spin off two BDCs to shareholders, leaving the remaining company continuing in the asset management business line. At 12/31/2014, ACAS had per-share net asset value of $20.50.


KCAP Financial (KCAP)
Originally called Kohlberg Capital, KCAP owns an asset manager with a focus on CLO funds. In addition to owning the asset manager, KCAP also invests in the subordinated securities of these CLO funds. Balancing these higher-risk-higher-return investments are a portfolio of senior secured loans, as well as mezzanine loans. KCAP recently completed a restatement of prior period financials after it was discovered that material errors existed. These errors caused a reclassification of certain amounts of income, as return of capital. For the year ended 12/31/2014, KCAP reported taxable distributable income of .78/share, yet dividends paid in 2014 amounted to 1.00/share. In other words, KCAP over-distributed to where a portion of its dividend represents a return of capital. Years of this phenomenon have contributed to a steady decline in per-share net asset value, which at 12/31/2014 was $6.94/share.


Triangle Capital (TCAP)
At 12/31/2014, TCAP has 25 employees and indicated they expect to expand their management team and administrative staff in the future in proportion to portfolio growth. Triangle operates two SBIC subsidiaries. TCAP's investment focus tends to be mezzanine financing with equity components, and companies targeted tend to be the "lower" portion of the middle market, meaning companies typically having revenues of between $20 and $200 million, and EBITDA of between $5 and $35 million. As of 12/31/2014, TCAP had net asset value per share of $16.11.


Main Street Capital (MAIN)
Like Triangle, MAIN operates two SBIC subsidiaries and invests in "lower" middle market companies. But where Triangle has a mezzanine focus, MAIN tends to target the first lien debt position, while also taking an equity stake in portfolio companies. In addition to a "lower" middle market portfolio, MAIN also invests in larger middle market companies as well. MAIN pays its dividend in monthly installments, with semi-annual bonus dividends. As of 12/31/2014, MAIN had net asset value per share of $20.85.


Hercules Technology Growth Capital (HTGC)
Hercules provides what is known as "venture debt" to technology companies, to complement a venture capital investment made by a venture capitalist. Whereas the venture capitalist invests in the equity of a given company, Hercules provides a loan and often is in the senior secured position while also typically receiving warrants. Target companies may need a future equity round as part of the long-term business plan, so when they accept a loan from HTGC it can allow that company more time until that next equity round is needed. A high profile example of a recent portfolio company to come public is Box Inc. (BOX). As of 12/32/2014, HTGC had 65 employees, and per-share net asset value was $10.18.


Rand Capital (RAND)
With four employees at 12/31/2014, Rand makes venture capital investments in early or expansion stage companies, typically in New York and its surrounding states. The company is based in Buffalo. At 12/31/2014, RAND reported per-share net asset value of $5.11.


Harris & Harris (TINY)
With twelve full time employees at 12/31/2014, TINY makes venture capital investments in companies it believes will be transformative, using disruptive science. A prior business description indicates the company targeted venture capital investments exclusively in "tiny technology" (nanotechnology), hence the symbol TINY. At 12/31/2014, TINY reported per-share net asset value of $3.51.


Newtek Business Services (NEWT)
A recent "BDC conversion," Newtek operates an SBA 7(a) lender that originates, sells and services loans to qualifying small businesses. At 12/31/2014, NEWT reported per-share net asset value of $16.31.



Conclusions


Reflexivity theory applied to the stock market tells us to be aware of the influence stock prices can have on the actual underlying business value. Because BDCs must distribute their taxable income instead of reinvesting it, portfolio growth must come from retained capital gains or raising new equity and debt capital. BDCs tend to therefore be serial equity issuers over time, generally speaking. A BDC can build per-share value by issuing new shares at prices substantially above NAV. A BDC with a price per share below NAV and willing to shrink in size, can build per-share value by repurchasing shares at prices below NAV and retiring them.


Growth of per-share NAV over the past ten years was not an easy task for the BDCs that have been around that long, so BDCs with the capability to grow per-share NAV over the long term are stand-outs. Important determinants of valuation potential for a BDC include the ability to earn and pay a large and growing dividend, the nature of what a BDC owns and the ways it earns income, the employees and capabilities the BDC maintains, and cost to operate the BDC including whether the BDC is internally or externally managed.


My own conclusion is that internally managed BDCs with strong track records and capable management teams aligned with shareholders, will use the reflexive relationship in the right way and will create the most value over the long haul. Dilutive and accretive effects can easily get lost from consideration when looking at traditional metrics like earnings per share and dividend yield. Therefore my own favorite way to compare the business-level performance of BDCs over different periods is to take starting NAV, ending NAV, and dividends paid over the comparison period, to reveal how much value has been created by the BDC for its shareholders during that period. As we saw in the case study examples, it does not take long for accretive or dilutive effects to show up in the numbers, often one calendar quarter is enough. A longer period such as the past two years, may be sufficient time for value-creators to reveal themselves. Any comparison period would be arbitrary and one could perform this exercise going back further in time (albeit with fewer BDCs to compare the further back the start date). Choosing 12/31/2012 as the start date already discards many of the newly public BDCs from the comparison, including Alcentra Capital (ABDC) which only came public in May of 2014, and FSFR, one of my examples mentioned earlier, which only came public in July of 2013. Note that FSIC existed in 2012 as a public non-traded BDC and from its 10K filings I was able to obtain per-share NAV at 12/31/2012 and 12/31/2014, as well as the per-share dividends paid over the past two years. Therefore, even though it has only been publicly traded on an exchange for roughly half the comparison period, I have included it anyway.


The first column after ticker symbol is NAV per share at 12/31/2012, followed by per-share NAV two years later at 12/31/2014. I then compute the 2-year change in per-share NAV. For dividends paid during the two year period, I use the output from the VF CAGR calculator. I next add together the dividends and the change in per-share NAV, which totals up the value the BDC was able to create for its shareholders. This is of course different from the total return an investor would have achieved over the same period, because starting and ending stock price will differ from starting and ending per-share NAV. What I think this exercise does a good job of measuring, is the total value creation delivered at the business level, encompassing income, gains, losses, dilution, accretion, and dividends.

 
        NAV     NAV     2yr             NAV     Value Created  
	12/31   12/31   NAV             Chg     As % of   
        2012    2014	Chg	Divs	+Divs	2012 NAV  
--------------------------------------------------------------  
MAIN	18.59	20.85	+2.26	5.23	 7.49	+40.3%  
TCAP	15.30	16.11	+0.81	4.72	 5.53	+36.1%  
SVVC    22.90   24.49   +1.59   6.18     7.77   +33.9% 
BKCC	 9.31	10.49	+1.18	1.93	 3.11	+33.4%  
RAND	 3.90	 5.11	+1.21	0.00	 1.21	+31.0%  
TAXI	 9.99	11.16	+1.17	1.84	 3.01	+30.1%  
HTGC	 9.75	10.18	+0.43	2.35	 2.78	+28.5%  
ARCC	16.04	16.82	+0.78	3.14	 3.92	+24.4%  
GBDC	14.66	15.55	+0.89	2.56	 3.45	+23.5%  
AINV	 8.14	 8.43	+0.29	1.60	 1.89	+23.2%  
TCPC	14.71	15.01	+0.30	3.07	 3.37	+22.9%  
FDUS	15.32	15.16	-0.16	3.66	 3.50	+22.8%  
PNNT	10.38	10.43	+0.05	2.24	 2.29	+22.1%  
NMFC	14.06	13.83	-0.23	3.10	 2.87	+20.4%  
PSEC	10.81	10.35	-0.46	2.65	 2.19	+20.3%  
TCRD	13.20	13.08	-0.12	2.79	 2.67	+20.2%  
GLAD	 9.17	 9.31	+0.14	1.68	 1.82	+19.8%  
FSIC     9.97    9.83   -0.14   1.91     1.77   +17.8% 
SAR	21.75	22.74	+0.99	2.83	 3.82	+17.6%  
WHF	15.30	15.04	-0.26	2.84	 2.58	+16.9%  
CSWC	41.34	47.17	+5.83	1.09	 6.92	+16.7%  
PFLT	13.99	14.16	+0.17	2.13	 2.30	+16.4%  
SCM	14.45	13.94	-0.51	2.78	 2.27	+15.7%  
MCC	12.69	11.74	-0.95	2.94	 1.99	+15.7%  
GAIN	 8.65	 8.55	-0.10	1.45	 1.35	+15.6%  
MRCC	14.54	14.05	-0.49	2.72	 2.23	+15.3%  
ACAS	17.84	20.50	+2.66	0.00	 2.66	+14.9%  
KCAP	 7.85	 6.94	-0.91	2.06	 1.15	+14.6%  
FSC	 9.88	 9.17	-0.71	2.14	 1.43	+14.5%  
OFS	14.80	14.24	-0.56	2.55	 1.99	+13.4%  
GSVC    13.07   14.80   +1.73   0.00     1.73   +13.2% 
HRZN	15.15	14.36	-0.79	2.76	 1.97	+13.0%  
SLRC	22.70	22.05	-0.65	3.60	 2.95	+13.0%  
SUNS	18.33	17.65	-0.68	2.82	 2.14	+11.7%  
TICC	 9.90	 8.64	-1.26	2.32	 1.06	+10.7%  
MCGC	 5.18	 4.69	-0.49	0.75	 0.26	 +5.0%  
MVC	16.14	15.86	-0.28	1.08	 0.80	 +5.0%  
OHAI	 9.57	 7.48	-2.09	1.28	-0.81	 -8.5%  
FULL	 8.03	 5.48	-2.55	1.73	-0.82	-10.2%  
TINY	 4.13	 3.51	-0.62	0.00	-0.62	-15.0%  




The list of BDCs included in the above comparison includes 40 companies, 25% of which are internally managed. But interestingly, of the top ten value creators of the past two years, 50% of those are internally managed, including #1 and #2. But as mentioned earlier, value creation at the business level may differ from investment performance at the stock level. The stock prices at the beginning and end dates will not match the corresponding per-share net asset values at those dates. So below, using the VF CAGR calculator as my source, I present the annualized returns with dividends reinvested for the two year period ended 12/31/2014, as well as the 5-year, 7-year, and 10-year periods ended 12/31/2014 for those BDCs that have been trading publicly for that long. Note that FSIC is omitted here because it was not exchange traded at any of the start dates.
 
        2-year    5-year     7-year      10-year 
------------------------------------------------- 
MAIN    +6.44%    +22.50%    +22.04% 
TCAP    -2.58%    +21.76%    +19.32% 
SVVC   +18.82%     
BKCC    +0.04%    +10.72%     +3.22% 
RAND   +32.21%     +0.55%     +1.84%    +10.11% 
TAXI    -1.21%    +11.83%     +8.05%     +7.76% 
HTGC   +25.21%    +16.77%    +13.93% 
ARCC    +3.49%    +14.73%    +14.17%     +9.55% 
GBDC   +13.97%      
AINV    +3.77%     +5.58%     +0.80%     +4.28% 
TCPC   +17.09% 
FDUS    +4.80%  
PNNT    +2.96%    +12.09%    +11.50% 
NMFC   +11.23% 
PSEC    -1.28%     +4.41%     +5.77%     +7.38% 
TCRD    -1.77%  
GLAD   +10.31%    +11.06%     -0.17%     -1.22% 
SAR     +6.04%     +5.98%    -15.96% 
WHF     -2.56%      
CSWC   +25.50%    +19.74%     +7.94%    +10.10% 
PFLT   +12.25%    
SCM     -6.50%     
MCC    -11.23%     
GAIN   +10.50%    +18.75%     +5.42%  
MRCC    +8.93% 
ACAS   +10.25%    +43.01%     -5.85%     -1.71% 
KCAP    -3.01%    +21.27%     +5.76% 
FSC     -2.33%     +4.88% 
OFS     +2.50%    
GSVC    +1.18% 
HRZN    +6.81% 
SLRC    -5.66% 
SUNS    -2.93% 
TICC    -2.64%    +16.61%    +10.39%     +4.80% 
MCGC    -0.80%     +7.65%     -7.03%     -5.86% 
MVC     -6.06%     +0.36%     -2.94%     +4.80% 
OHAI   -11.06%     -2.02%     -7.33%     -3.16% 
FULL   -12.36% 
TINY    -5.45%     -8.38%    -14.43%    -15.75% 



Stock price paid is clearly very important to the investment result. An investment into MAIN or TCAP, the top two value creators of the 2-year period, hardly stands out in the first column as a strong investment return. But MAIN's stock price at 12/31/2012 of $30.51/share represented a 64% premium to NAV on that date, while at the end date MAIN's stock price represented a 40% premium to NAV -- quite a difference in valuation. TCAP's stock price at 12/31/2012 of $25.49/share represented a 67% premium to NAV, while at the end date TCAP's stock price represented a 26% premium. In another example, ACAS ended 12/31/2014 with NAV/share of $20.50 but a stock price of $14.61, whereas ten years earlier on 12/31/2004 NAV/share was $21.11 but the stock price was $33.35 -- while the two NAV/share numbers are 2.9% apart, the two stock price numbers are miles apart. Changes in premium or discount to NAV over time can have a large impact on the investment return.


This post has already been philosophical in nature, and so when considering the question of "when to buy," here is something to think about beyond the usual questions investors in BDCs might consider (such as where we are in the economic and credit cycles, company-specific issues and outlook, or event-driven buying like waiting for a next follow-on offering of common stock which usually provides an opportunity to purchase shares at a discount to recent prices). Consider the price paid relative to NAV in relation to the value creation potential. A BDC that has the potential to create more value as a percentage of starting NAV, should arguably deserve a premium price compared to a second BDC that has the potential to create less value as a percentage of its own starting NAV. And in a positive "Feedback Loop" the BDC that arguably deserves a premium price can actually use that premium to create value, thereby reinforcing that it deserves a premium price.


I hope this post provokes thought about the impact of reflexivity theory in the context of BDCs. It took me extra time to put together compared to a "normal" post for me, and I have posted it as a public post to share my work with a wider audience than the usual readers of the BDCs topic here and my usual readership levels in general. It was fun to write even if few end up ultimately reading it, but I understand that public visitors can give a positive recommendation to increase my recommendation count for the post -- so to anyone out there reading this who is not a member, if this post was helpful to you, you too can give me a recommendation click <g>!

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BDCs and Reflexivity Theory