yes-modern
There is currently a growing debate about the sustainability of BDC earnings as we move into a lower interest rate environment. The idea is that higher interest rates allow BDCs to pocket larger income streams through their typical floating rate. Fixed-rate investments tied to SOFR dynamics. The lower the SOFR component, the lower the total return BDCs can earn from their portfolio.
Now, as many of my followers have probably heard (read) this from me several times, the aspect of lower interest rates being a big negative is not so black and white. There are several counterarguments. For example, the debt side of BDCs generally moves in sync with SOFR, which lowers the cost basis. Lower interest rates also support better portfolio investment quality, as underlying companies are less pressured by aggressive funding rates. Additionally, a more accommodative interest rate environment is very likely to boost M&A activity. on the rise, which should allow BDCs to return to positive net investment activity (i.e., grow their portfolios).
In addition to interest rate risk, we are seeing an increase in defaults and higher amounts of unrealized negative losses in the BDC sector. One of the main reasons for this dynamic is once again related to the interest rate aspect, where higher funding costs create immense pressure on corporate cash flow profiles and lead to a subdued transaction market, which has a direct impact on valuations as well as the ability of BDCs to monetize their equity stakes.
Overall, I would say that the current environment for BDCs is not that supportive, so it should come as no surprise that there is not a large presence of premium valuations in this space.
However, there are several BDCs that are trading at a discount that is not justified relative to their underlying fundamentals.
Below are two examples that I believe offer a clear opportunity for investors to enter and benefit not only from decent dividend income, but also from potential convergence of multiples.
Pick #1: CION Investment Corporation (NYSE:CION)
CION is a BDC that focuses on companies that generate annual EBITDA between $20 million and $75 million and that operate in sectors that are inherently defensive and stable. Since the strategy is based on small-cap companies, CION’s size is not that large either, with a current NAV of $861 million, which is almost exactly in line with the sector’s median NAV figure.
CION is currently trading at a 24% discount to its net asset value, which is very high and one of the highest in the industry. In my view, having such a large discount in this case is not justified in the context of the underlying fundamentals.
Looking at how CION’s portfolio is structured, we’ll notice that the majority of the exposure is in the tier-one segment, which is the highest/safest tier in the capital structure at which BDCs provide financing. As of Q2 2024, CION had nearly 85% of its portfolio placed in these securities, which is not the highest tier one could find in the BDC space, but certainly a tier that wouldn’t require a large discount (if at all).
Furthermore, the portfolio is very well diversified across 107 investment companies, of which 99% are at risk level 3, indicating performance, which is perfectly in line with the expectations or projections that were assumed when the investment underwriting process was carried out. As evidence of this, we can take the fact that currently the total non-accrual base stands at 1.36% of the portfolio's actual value, which is once again below the sector average and indicates solid quality. Part of the reason behind the solid quality levels is the strict underwriting policy applied by CION – for example, the weighted average net debt to EBITDA stands at 4.6x and the weighted average interest coverage at 2.01x for CION's investment companies.
That said, the key driver of the current discount is clearly the exposure to non-cash income, which consumes a fairly large portion of CION's net income generation. That is, it is the PIK component (consuming 16% of total income) that drives the presence of a discount to NAV.
However, what is happening here is that over 60% of PIK investments are in companies that currently have risk ratings of 1 or 2 and 98% have a risk rating of 3 or higher. In other words, this is not the usual case, where PIK occurs as a result of poor asset quality. Instead, the focus on PIK is a deliberate strategy by CION, which has still allowed the BDC to maintain low defaults and a high-quality asset base. Commentary from Gregg Bresner, President and Chief Investment Officer, on the Q2 2024 earnings call describes how CION approaches the PIK strategy:
We continue to strategically focus on blue-chip investing at the top of the capital structure and prefer to use guaranteed performance-enhancing provisions such as PIK features, call protection, total compensation provisions and MOICs to gradually improve returns at the top of the capital structure rather than digging deeper into capital structures to make equity and mezzanine co-investments.
Given the above, I simply do not see a justified basis for applying such a steep discount.
Pick #2: Crescent Capital (NASDAQ:CCAP)
CCAP is a BDC similar to CION, as it handles a market of around $650 million and also focuses on providing loan financing to small and medium-sized businesses, which are not at the VC stage but are already cash-flowing businesses.
The discount is not as large as in the case of CION, but it is relatively noticeable, i.e. 10% below the net asset value. In my opinion, the fundamentals are once again strong enough to completely neutralize the discount or at least reduce it to a less substantial level.
In terms of portfolio, CCAP holds on average 0.5% of its total exposure in a single investment and, although CCAP's market capitalisation is not that large, the concentration in the 10 largest investments represents only about 15% of the total portfolio value. Around 89% of investments are deployed in blue-chip instruments, which already in this case sends a message that attention is being paid to higher-quality stocks.
Unlike CION, the PIK component in the case of CCAP comprises a very small proportion of the asset base, i.e. less than 4% of total investment income. This is even lower than the usual or typical exposure in the BDC space.
On the earnings side, the recent net investment income figure reported in Q2 2024 was sufficient to cover the dividend and leave excess capital on the books for CCAP to de-risk the balance sheet or use this liquidity to fund new investments without relying too heavily on external debt. For example, given the base dividend of $0.42 per share, dividend coverage for Q2 2024 came in at 140%, which is one of the highest coverage metrics in the entire BDC sector (although there is a discount to NAV).
The quality is also there, as the weighted average risk rating for CCAP investments stands at 2.1, meaning that most investments are performing at or above the projections that were made once the loans were funded. The fact that the non-accrual base remains low at 0.9% of the portfolio's actual value is clear evidence of the portfolio's strong quality.
The only negative I see is that CCAP has faced and, to a large extent, continues to face headwinds on the transaction activity front, which has prevented Management from growing the portfolio to offset the systematic spread compressions that are relevant to almost all BDCs. Should subdued M&A activity continue to persist for many quarters into the future, CCAP would eventually run into the problem of reducing dividend coverage to a level that would introduce unnecessary risk of a potential dividend cut.
However, Q2 2024 data already revealed some encouraging activity, as CCAP managed to invest $119 million in new assets, which was large enough to offset $73 million of organic redemption. Moreover, since the difficulties in attracting significant transaction volumes are structural and affect almost all BDCs, it should not be a reason for the market to inject a higher risk premium into CCAP’s multiple or value it below the BDC. industry average P/NAV of 0.96x.
The final result
The current challenges in the BDC segment make it difficult to justify a significant premium to NAV. At the same time, as earnings and dividends remain strong and fears that lower interest rates will lead to value destruction are overblown, having significant discounts to NAV would be a mistake and out of sync with reality.
In this article, I look at two specific BDC picks, which are trading at a significant discount to their NAVs, and when we look at the fundamentals, we recognize that much of this is unjustified.