Financial ratios rarely tell all. A high return on equity is often the product of too much debt. Similarly, an inflated dividend payout ratio might owe to a goodwill writedown in a single year, which reduces the denominator: income. All the same, though, these two ratios are very revealing over long periods of time.
When it comes to business development companies, I think one ratio supersedes all others: the historical ratio between the price of new stock issued to the public and the net asset value of the stock at the time shares are sold.
The higher the ratio of price to net asset value, the bigger the benefit for existing shareholders. The reasons should be clear:
- Shares sold at a premium result in tax-free increases in net asset value per share.
- The increase in net asset value per share means more money is put to work per share, which should result in bigger dividends.
- BDCs only have so many good investment opportunities. As the pool of investments grows and the credit cycle continues on, marginally worse investments make their way into the portfolio. Capital raised at a premium to book value defrays some of this "hidden" expense of growth.
Conversely, shares that are sold at a discount to net asset value destroy shareholder wealth for exactly the opposite of the reasons above.
Who's really getting rich?
Many BDCs have grown simply for growth's sake, putting more assets to work while failing to generate per-share dividend increases for their investors.
I went back through some of the leading BDCs' SEC filings to compare asset growth to dividend growth over the last two years. The table below shows the two-year change in investments at cost and dividends paid.
Growth in total investments at cost is a good proxy for the growth in the manager's pay. Dividends are a good proxy for what shareholders are getting paid. This chart, though imperfect like any analysis of a single financial ratio, offers a glimpse into which companies are growing for growth's sake. In some cases, it also shows the disparity between how much external managers benefit from this growth and how much shareholders are getting out of it.
You'll notice from the chart above that externally managed firms had the fastest-growing balance sheets, yet the fastest-growing dividends came from internally managed companies.
Why the discrepancy? There are two main reasons:
- Economies of scale for internally managed companies flow to the shareholders, while at externally managed firms the benefits flow mostly to the asset manager.
- Internally managed companies tend to issue stock at much greater premiums to net asset value than externally managed companies.
While I admit there is some noise in selecting a short two-year period and using dividends as a proxy for income, I'm confident you could run the numbers over any time frame and use virtually any measure of profit, and the internally managed companies would still come out on top. Ultimately, underwriting quality also plays an important part, as the best underwriters generate the best returns at cost relative to their investments.
Couple above-average underwriting with premium-priced secondary offerings, and the internally managed companies have a clear history of driving better results for shareholders with relatively slow balance-sheet growth.