BDC Weekly Review: PSEC gets bad press

Welcome to another installment of our weekly BDC Market Review, where we discuss market activity in the business development company (“BDC”) sector both from the bottom up – highlighting individual news and events – and from the top down – providing an overview of the wider market.

We also try to add historical context as well as relevant themes that seem to be driving the market or that investors should be paying attention to. This update covers the period up to the third week of August.

Market action

BDCs offered a total return of 2% per week. The sector has started to break out of the early August retreat, although there is still work to be done. BDC earnings lag, so individual share price determinants, as PSEC recently discovered, are more idiosyncratic. BCSF was the best performer during week and is up about 6% from our initial allocation at the end of the previous week.

BDC valuations continue to trade around their historical average. We took advantage of the recent decline in valuation to supplement our BDC allocation, which was reduced earlier in light of what we believed to be high valuations.

Market Themes

There was a negative Bloomberg article about Prospect Capital (PSEC). Not a ton that was new, but still had an impact considering how unusual it is for a major news outlet to do a negative piece. The warning signs have been there for a long time. The company has tended to finance itself by selling odd preferred shares to retail investors, holds a large portion of its portfolio in an affiliated REIT, has many CLO Equity positions, has not performed very well, has a large from the portfolio. high level of net realized losses, its management fee is the highest in the sector, etc. One of these can be overlooked, but not when all the factors are together.

The article focused on a few things. First, PSEC generates far less cash than it distributes (this despite its low yield and a dividend that hasn’t changed over the years (vs. big increases in the sector since 2022). The most recent shortfall was of about $200 million.About a third of its revenue was generated as PIK – about 2-3x the average BDC.

The article claims that, to finance the dividends, the company resorted to issuing large amounts of preference shares. There is no straight line here as the company could have chosen to sell the assets to fund the dividends. However, the downside to this is that total assets and therefore fees would decrease. Issuing preferreds incurs common shareholders higher financing costs than they would otherwise have to pay (if the company had financed itself with secured and unsecured debt), but it is a big win for management because it keeps total assets relatively high. It is also a positive for holders of unsecured debt as it keeps leverage low.

Something else the article focused on is that REITs don’t generate free cash – the cash that PSEC pays out comes from capital infusions and debt from PSEC itself. However, the circular movement of capital allows PSEC to claim REIT payments as cash income. Net net the situation at the company is likely to get worse before it gets better. We have never had common in our income portfolios.

Market Commentary

Blackstone Secured Lending (BXSL) reported very good results. Net investment income is rising, likely due to increased leverage. NAV increased over 1% due to retained earnings, unrealized appreciation and an increase in NAV shares in issue. BXSL outperformed ARCC during the quarter, but is lagging year-to-date. It continues to trade at a premium to ARCC.

Update tools

Nuveen Churchill Direct Lending (NCDL) has been added to the BDC Tool. The company has a portfolio of approximately $2 billion with an above-average 91% first-lien allocation. The portfolio yield is on the lower side at 11.4% and reflects decent borrower leverage of 4.8x and interest coverage of 2.2x. Interest expense is high at 7.7% as it is 100% floating. It will also decline relatively quickly as the Fed tapers, but will remain on the upside in the sector. The management fee is 0.75% and will increase to 1% after Q1-25 with an incentive fee of 15%, which is among the best in the sector. Shares are trading at a yield of 12.9% and a 6% discount to book.

We’ve also added two new valuation-adjusted NPV total return columns (1Y and last quarter). This metric combines both total NAV return and current valuation for a holistic view that allows investors to easily compare BDCs against each other based on these two key metrics. The total valuation-adjusted NPV return is the total NPV return per unit of valuation (ie, the total NPV/valuation return).

Position and takeaways

This week we topped up our allocation to Bain Capital Specialty Finance (BCSF) after an initial allocation last week. We continue to have a Buy rating on the name. We have also added a position in NCDL. Along with a number of other BDCs that have IPOed this year, it’s under the radar and offers an attractive entry point.