Assessing the Rise from the Grave of the BDCs

I have some particularly interesting investments for you to consider for your portfolio. Nowhere else are you going to find such an eclectic selection of both debt and equity securities. Would you be interested in senior secured debt of safety footwear manufacturer Shoes for Crews? Or how about some common shares of specialty trailer manufacturer Universal Trailer Corp. (see picture above)? No wait, even better. I have some senior subordinated debt from private school operator Instituto de Banca y Comercio, Inc. that I know you are going to love. How can you invest in these fabulous companies? Well, according to a recent 10-Q filing, if you buy shares of publicly traded Ares Capital (ARCC) you can become a part owner of these securities as well as a plethora of equally obscure ones.

Now, I don’t mean to disparage these companies. For all I know they are wonderful businesses run by masterful capital allocators who put the interests of their shareholders first and foremost. The problem is that there is just no way for me to assess the quality of these companies or the value of the securities owned by Business Development Companies (BDCs) like Ares Capital. This is the crux of the problem for the BDCs: very little transparency. When people talk about balance sheets that are equivalent to black boxes, they are often referring to those of the (former) investment banks such as Goldman Sachs (GS) that contain millions (if not billions) of dollars of hard to value Level 2 and 3 assets. However, as I began to peruse the balance sheets of the publicly traded BDCs it quickly became abundantly clear that the black box description was particularly fitting for these companies as well.

According to Wikipedia:

A Business Development Company or BDC is a form of publicly traded private equity vehicle in the United States. Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940.Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90% of their income, which may be taxable to its investors.

In more benign times in the credit markets these vehicles were relatively attractive investments. They paid substantial dividends, gave investors enamored with the private equity model exposure to small and mid-sized companies, and often weren’t quite as levered as some other investment vehicles. Unfortunately, the recent dislocation in the credit markets as well as the growing concern about the value of private equity debt that was financed during the boom has absolutely decimated the BDC space. Specifically, the average decline from the 52 week high of the 10 BDCs I reviewed is 59.4%. This is after an astounding rise in the past few months that has brought these stocks, on average, up 220.7% above their 52 week lows. Accordingly, with such a large move off of the bottom I thought it would be interesting to check in on the BDC space to see if the share appreciation was warranted or if the BDCs’ business model had been made unsustainable by the events of the past couple of years.

This first chart illustrates the magnitude of the volatility in share prices for these BDCs over the last year. During the worst period of the bear market in March of this year many of these companies traded as if they were going out of business, with a number of them trading under $1. While it is seductive to look at a possible return to those 52 week highs and see potential 10 baggers, it is important to remember that those prices were reflections of a global economy and credit markets that were very different than they are today. Therefore, the most pressing question for interested investors is what is the new baseline for these companies going to look like? Assuming that we do not go back to the boom years of cheap credit and completely mispriced risk any time soon, how do you value the BDCs in a “new normal” environment?

6/18/2009
Ticker	Stock Price	52 Week High	% <>	52 Week Low	% > 52 Week Low
AINV	$6.44	$20.29	68.26%	$1.99	223.62%
ACAS	$3.27	$32.41	89.91%	$0.58	463.79%
ALD	$3.10	$19.99	84.49%	$0.58	434.48%
ARCC	$8.05	$13.00	38.08%	$3.12	158.01%
GAIN	$4.10	$9.04	54.65%	$2.26	81.42%
GLAD	$7.33	$19.14	61.70%	$4.72	55.30%
KCAP	$5.79	$13.41	56.82%	$1.24	366.94%
PCAP	$1.58	$10.43	84.85%	$0.88	79.55%
PNNT	$7.45	$8.64	13.77%	$2.09	256.46%
TICC	$4.15	$7.10	41.55%	$2.21	87.78%
Averages			59.41%		220.73%

This next chart compares the current valuation of these companies to their averages over the last few years. It should be noted that some historical valuation data is a bit limited because many of these companies became publicly traded only in the last 3 to 5 years (not surprising given the boom in private equity from 2005 to early 2008). In general these stocks trade on multiples to NAV. In the case of these BDCs, NAV is equivalent to book value per shares and tangible book value per share as none of these companies have any goodwill or intangible assets.

			2005-2008		Annualized
Ticker	NAV/Share	P/NAV	Average P/NAV	Recent Dividend	Dividend Yield
AINV	$9.82	0.66x	1.14x	$0.26	16.15%
ACAS	$12.32	0.27x	1.31x	$0.00	0.00%
ALD	$7.67	0.40x	1.42x	$0.00	0.00%
ARCC	$11.20	0.72x	1.05x	$0.35	17.39%
GAIN	$9.73	0.42x	0.88x	$0.12	11.71%
GLAD	$12.10	0.61x	1.46x	$0.21	11.46%
KCAP	$11.53	0.50x	0.88x	$0.24	16.58%
PCAP	$8.13	0.19x	1.45x	$0.00	0.00%
PNNT	$12.00	0.62x	0.70x	$0.24	12.89%
TICC	$7.46	0.56x	0.96x	$0.15	14.46%
Group Averages		0.49x	1.12x		10.06%

* Average P/NAV for AINV was calculated using fiscal year end price divided by fiscal year end book value

* Average P/NAV only includes 3 years of data for GAIN, 2 years for KCAP and 2 years for PNNT

*Sources: Cap IQ, Yahoo Finance, and my calculations

When you compare the average multiples prior to 2009 to the current multiples the wholesale contraction in multiples that the market is willing to pay for these companies becomes readily apparent. The concern that I have and that I believe is shared by many investors is that NAV is a moving target and it impossible to verify or reliably calculate. With so many illiquid private investments on the balance sheet, the BDCs have a tremendous amount of discretion in terms of valuing these securities. In his book “Fooling Some of the People All of the Time” about the alleged fraud at Allied Capital (ALD), hedge fund manager David Einhorn goes into great detail regarding the potential for valuation shenanigans and the problems that even very astute investors and regulators have in terms of spotting misevaluations. Accordingly, an investment in one of these companies is tantamount to a blind leap of faith that the management teams are trustworthy, conservative in their valuations and can manage a portfolio of obscure securities under very severe economic circumstances.

To highlight the problem in assessing the merit of valuation, I think it makes sense to go through an example. One of Einhorn’s major criticisms of ALD is that the company took way too long to write down the value of obviously distressed securities. In the book he discusses a number of occasions in which ALD wrote down the equity investment a company to $0 but still carried the debt at 100 cents on the dollar. While scenarios do arise all the time in which equity holders are wiped out but the assets on the balance sheet are sufficient to cover the senior debt, liquidations are often very uncertain and conservative managers should feel compelled to reflect that in the form of write down. What investors have to be leery of is a company that waits until a piece of debt either stops paying interest or becomes impaired before writing down the value of the asset even though there is ample evidence that the underlying business is struggling.

I found a great example of this difficulty in assessing the value of impaired securities in the recent 10-Q’s of ALD and ARCC. Both companies own the subordinated debt and some common shares of clothing company Wear Me Apparel LLC. Each company indicates in its filings that the debt security is non-income producing, a circumstance that indicates a write down is necessary.

Wear Me Apparel LLC
ALD
Security	Maturity	Cost	Current Value	% Write down
Senior Subordinated Debt	2013/14	$138,559	$46,932	66.13%
Common Shares	N/A	$39,635	$0	100.00%
ARCC
Security	Maturity	Cost	Current Value	% Write down
Senior Subordinated Debt	2013	$24,110	$12,055	50.00%
Common Shares	N/A	$10,000	$0	100.00%

The interesting to note about this chart is that even though both companies have written down their common shares to $0, ALD has chosen to write down the debt by 66% while ARCC has only written it down by 50%. Which company’s valuation is more accurate? The answer to that is impossible to know but even small differences can be meaningful when applied to a portfolio with hundreds of companies. This discrepancy in valuation is one reason why the market is pricing the BDCs well below NAV and illustrates why investors who are interested in buying these stocks should price in a significant margin of safety.

Accordingly, the logical question to ask is whether the current depressed valuations reflect the stress on the portfolios from the recession, the inherent difficulty of valuing the underlying securities and the lack of funding available for balance sheet growth as a result of the shut down in credit markets for private equity? Unfortunately, I don’t have a good answer to that question. But, as a result of all of the uncertainty that surrounds the companies’ balance sheets and funding model, it is just too risky a space for me to allocate my capital. There is no question that the dividend yields are attractive and investors who can identify the companies most likely to survive the cycle are essentially getting paid to wait for the economy to turn around and the credit markets to become less constrained. However, as the economy worsens a lot of the BDCs will be forced to write down their portfolios even further and potentially breach debt covenants that require minimum leverage ratios.

I personally don’t want to wake up one morning an see an 8-K from a company in my portfolio that indicates that as a result of a breach of a covenant on $2.3B in borrowing agreements the company’s auditor now doubts that the company in question can remain a going concern. This is what happened to ACAS. Despite that the stock has run up from a 52 week low of $.58 all the way to $3.27, an amazing 463% appreciation. This is the type of thing that makes me skeptical of the current valuations, no matter how depressed they are. Accordingly, I am content waiting on the sidelines to see if the best in class of these companies (likely AINV) trade down to prices that provide an irresistible margin of safety or optionality. As a result I may never have the pleasure of being a part owner of the stock appreciation rights of ALD’s portfolio company Oahu Waste Services, but at least I won’t be up at night worrying about what the effect of the recession in Hawaii is going to be on my portfolio.

(Picture courtesy of http://www.universaltrailer.com/)