The last year hasn't been friendly to companies in the business development company industry. In the last year, the industry as measured by the market cap-weighted Market Vectors BDC Income ETF (NYSEMKT:BIZD) has lost 8% of its value, including dividends.
Among the carnage are two BDCs, Apollo Investment (NASDAQ:AINV) and Main Street Capital (NYSE:MAIN), both of which are heavily weighted toward oil investments, yet have two very different trailing return profiles. Apollo is down by roughly 10.4%, dividends reinvested, while Main Street Capital shares have gained about 9.6% under the same conditions.
Which is the better buy?
Comparing these two BDCs is interesting because they trade at vastly different valuations. Apollo Investment currently trades at a 16% discount to book value, making it one of the cheaper BDCs on the market. Main Street Capital is one of the most expensive, trading at an 40% premium to book value.
In some way, it's easy to call the comparison over and simply take the cheapest assets with Apollo. Its current yield of 11.3% is also vastly superior to Main Street Capital's 8.5% yield including expected special dividends.
And while I find the discount with Apollo Investment compelling from the standpoint of having a margin of safety -- a discount to net asset value affords some protection against additional losses -- there's more than meets the eye for long-term investors.
On the basis of historical underwriting quality, there is almost no comparison between Apollo and Main Street Capital. Looking at the companies' respective net realized gains or losses at the end of each fiscal year, it's notable that Main Street has generated realized gains in excess of losses in all but two of the comparable periods, whereas Apollo has generated losses in excess of gains in all but two periods.
I generally put a big emphasis on realized gains or losses because it shows how the BDC performed on assets it sold to a third party. Unrealized gains or losses simply reflect the optimistic or pessimistic view of the management team with respect to how it values its assets.
Put simply, realized gains or losses are the product of a real transaction in which the assets are valued by a real sale. There is often a very big difference between what someone thinks an asset is worth and what someone else will pay for it.
Apollo Investment has a history of making big bets, many of which haven't paid off. During the financial crisis, it lost hundreds of millions of dollars in a single transaction in which it acquired a large hotel chain. That misstep, among others, has fueled over $1.1 billion in cumulative capital losses over its corporate history.
The company currently faces challenges in its energy-heavy investment portfolio. Losses in the 2015 fiscal year were mostly the result of losses from its oil and gas investments and energy, which made up 15.5% of the portfolio at fair value as of March 31. I expect some further losses here.
To be fair, Main Street Capital has its own challenges in the oil and gas industry, with 9.8% of its portfolio at fair value currently invested in oil and gas and related companies. However, it's notable that its winners in other sectors have papered over the impact to net asset value. Some of its biggest winners are legacy assets purchased before and during the financial crisis -- equity stakes that reward the company with routine dividend income.
Thinking for the long haul
Given the choice between Main Street and Apollo Investment for an income portfolio, I'd have to take Main Street Capital, despite the fact that it is relatively much more expensive. Main Street's valuation based on net asset value is 66% higher than Apollo's.
But the reasons for preferring Main Street Capital are plenty. Historical underwriting history heavily favors Main Street Capital. In addition, it has carved out a niche in financing smaller private businesses with government-subsidized debt -- companies with annual revenue of $10 million to $150 million. It's become a large fish in a small pond, where Apollo Investment is a relatively small fish in a very big pond. Main Street was the SBIC lender of the year in 2011 for lending to smaller, private businesses.
Main Street Capital has a much "cleaner" income statement. Noncash, payment-in-kind interest and accretion of discounts made up a combined 6% of total investment income for Main Street vs. roughly 10% for Apollo, after adjusting for the recent sale of a portfolio company. Since dividends are paid in cash, one would prefer that a BDC's reported income come in as cash.
I think it makes sense to pay up for quality. And I find comfort in the fact that, as a percentage of each company's market cap, Main Street Capital insiders own significantly more of their company than Apollo's insiders do. When you eat your own cooking, you tend to be a better chef.