What's Working in High-Yield BDCs?

BDCs have been pummeled as junk bond spreads widen and investors turn a wary eye toward credit risk. A majority of the industry now suffer from depressed share prices, with only a handful of companies trading above book value.

You could write volumes about what's hurting many BDCs -- bad corporate governance, high fees, energy exposure, etc. -- but I thought it might be interesting to take a look under the hood of BDCs that are breaking from the general industry trends. What's so special about this handful of BDCs that trade at a premium to book value?

Source: Company investor relations. Calculations by author.

What's working? Let's go company by company
For years, their lower middle market exposure and low expenses have made Main Street and Triangle Capital some of the highest-priced BDCs on the block. Both have generally kept expenses at less than 20% of total investment income in an industry where it's common to see expenses consume 35% to 40%. Low expenses have helped them sail through small credit issues in recent quarters. Investors take comfort in the fact that their management teams also own a significant portion of shares outstanding, aligning the interests of managers and shareholders.

TPG Specialty Lending's very conservative dividend policy is certainly doing it favors with investors. It has more than earned its distribution from net investment income, and the case could be made that it's past due for a special dividend. Last quarter, its weighted-average borrowing costs were 2.5% compared to weighted average yields of 10.3% on its investment portfolio -- a fat interest margin in a low-rate environment. The company, like others on this list, has an automatic share repurchase plan to buy back stock when shares trade under net asset value. Alas, it's never been used, as it has consistently traded at a premium.

Golub Capital BDC might not be a household name; the external manager is the largest player in middle market finance, specifically middle market lending. The company's emphasis on credit (it rarely makes equity investments) makes it a preferred lender. Its clients don't have to worry about taking a deal to Golub; it's not interested in competing for buyouts, it just wants to finance them. The company's low management fee (1.375% of assets annually) and its preference for lower-risk loans have certainly helped it hold up against a troubling tide of worries about the credit risk inside BDC portfolios.

Finally, Goldman Sachs BDC is one of the newest on the block. In a sign of the problems plaguing BDCs, it went public with a shareholder-friendly fee structure and a buyback plan in place on the day of its 2015 IPO. At one time, investors were so enamored with the opportunity to invest with Goldman Sachs Asset Management that it traded at a 25% premium to book value -- an exceedingly high valuation for an externally managed BDC. Importantly, Goldman Sachs BDC has some attractive sources of deal flow; executives highlighted the opportunity to invest in the private companies owned by clients of Goldman Sachs Asset Management. These borrowers, the company suggested, will borrow less aggressively (reducing risk), and be less sensitive to lending terms (rates, covenants, etc.).

Boiling it down, it's pretty simple. These five BDCs have managers who have proven prudent in issuing new shares, formulated conservative dividend policies, avoid opaque investments like CLOs and controlled finance companies, and have reasonable expense structures. In sum, compared to their peers, these BDCs are simply more shareholder friendly, a fact that shows in their above-average valuations.