If there's one thing investors should have learned in 2015, it's that fantastically low default rates are probably gone for good. Between oil companies fighting lower and lower prices and overlevered companies simply finding themselves with too much debt and not enough earnings, higher defaults are sticking around for a while.
For business development companies such as Main Street Capital (NYSE:MAIN) and Triangle Capital (NYSE:TCAP), which specialize in making higher-risk loans to small, unrated companies, this development means greater capital losses and potentially lower earnings.
Main Street and Triangle Capital aren't banks. Their balance sheets don't carry allowances for losses -- i.e., stores of value set aside to cushion the blow. Instead, each and every loss flows right to the bottom line when it's incurred, which can make BDCs' earnings more volatile than those of traditional financial companies.
Although they don't and can't make provisions for losses, Main Street and Triangle Capital are required to mark their loans to fair value each quarter. For their part, they seem to do a pretty good job of it, writing down debt and equity investments in their portfolio companies when there is a heightened risk that their capital won't be coming back.
Thanks to these ever-changing portfolio marks, we can get an excellent top-down look at how each company values its portfolio companies and how much of their portfolios are in "troubled" territory.
Top-down portfolio check-up
A debt investment is generally considered distressed when it trades at 80% of par value. There's no firm definition of distressed equity, but I like the 80% figure as a threshold for "troubled companies," because, as I think you'd agree, if a BDC is marking any investment at 80% of what it originally paid for it, then that investment probably isn't going according to plan. BDCs have a tendency to write investments down more slowly than they write them up.
I went through Main Street's and Triangle's recent filings and calculated how they mark their assets as a percentage of cost by portfolio company. It turns out there's a pretty big difference, especially when it comes to the percentage of assets held at 80% or less of cost.
This chart shows that more of Main Street Capital's portfolio value comes from investments in companies held at less than cost (30%, versus 24% for Triangle). However, much more of Triangle's portfolio value comes from companies held at 80% or less of cost. Roughly 6% of Triangle's portfolio companies are marked at a 20% or greater discount to cost, compared with about 3% for Main Street Capital.
From a casual observation, we could reasonably conclude that Triangle's net asset value is probably a little shakier than Main Street's, given the difference in how much of its portfolio comes from assets that have already been marked down significantly.
If you think very conservatively and assume that all portfolio companies held at 80% or less are going to zero, you would need to take Triangle Capital's NAV per share down to $13.77 per share (a loss of $1.71 per share) and Main Street Capital's NAV down to $20.72 (a $1.07 loss). That's probably a conservative estimate over the next couple of years, as not all will go to zero, and one would expect some offsetting gains from the handful of winners.
Any analysis like this is inherently imperfect, but I think it's a good demonstration of the kind of thinking investors should be applying to their favorite BDCs. After all, credit losses are a fact of life, and the trend suggests the future will be a little rockier than the glory years following the Great Recession.
Jordan Wathen has no position in any stocks mentioned, though he thinks Main Street Capital and Triangle Capital are better than your average BDC. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.