BDC Weekly Review: Good And Bad Reasons For Rating Upgrades

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company (“BDC”) sector from both the bottom-up – highlighting individual news and events – as well as the top-down – providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the fourth week of August.

Market Action

BDCs were down marginally on the week despite the broader income market holding up well. Month-to-date the sector is down around 3%.

The sector has given up some of the strong June and July gains.

BDCs bounced off their longer-term valuation average of 102% and moved below 100%.

Market Themes

Trinity Capital (TRIN) caught a bid this week with the catalyst being an upgrade from one of the analysts covering the stock. The reasons for the upgrade appear to be an offering accretive to the NAV (i.e. done at a price above the NAV) which opens up balance sheet capacity.

These are fairly odd reasons to switch to Buy. It’s one thing to like as stock because its price falls sharply as a result of the offering. The NAV accretion from the issuance is de minimis and would be priced in regardless as it’s well known.

Additional balance sheet capacity is presumably another way of saying that TRIN leverage was very high and raising additional equity means it doesn’t have to finance lending with debt. That’s all fine however that would be dilutive for net income as the new equity would generate less income than if it were paired with additional debt.

Let’s zoom out a bit and check on the things that actually matter. TRIN has underperformed the sector over the past year.

It also generated some pretty sizable realized losses which creates some concerns about its underwriting process.

Add to that a valuation well above the sector average and we don’t have a very good Buy case.

In our view the key things investors ought to keep an eye on are portfolio quality, consistency and trajectory of total NAV returns and valuation. Everything else is second-order.

Market Commentary

MidCap Financial (MFIC) put up good Q3 numbers. Total NAV return was 2.7% or a touch below the 2.9% median level. Over the past year the company delivered a return 1% above the average and 0.4% above the median level.

Net income came in a bit lower than in Q1 and not much above the Q4 level which is a bit disappointing even as other BDC net income levels pushed significantly higher. This net income stall also means the company has not been able to deliver significant dividend hikes over the past year in contrast to the rest of the sector.

Recall that MFIC is the new rebranding of AINV which was an Apollo BDC and will now be run by MidCap Financial. AINV struggled so the hope is that MFIC will breathe a new life into the company.

So far it’s done ok however the legacy portfolio which has delivered subpar longer-term returns has not gone anywhere.

It’s not very quick or easy to turn over the portfolio to clean out any legacy issues. And now there is a smaller margin of safety to do it – MFIC trades at an 87% valuation. Compare that to CGBD and OBDC both of which are at a similar valuation but have a significantly better performance over the past year and none of the legacy MFIC issues.

Stance and Takeaways

This week we upgraded FDUS to Buy. Over the last year or so the company has tended to trade well above the sector average valuation. This week however it nearly converged with the sector, making it more attractive.

The company has consistently outperformed the sector over different time periods all the while its portfolio quality has remained stable.

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