BDC Weekly Review: Pluralsight Highlights Diversification Benefits

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 first week of August.

Market Action

The first week of August marked a tough week not only for BDCs but for the broader income market. However, it appears to have hit BDCs the worst. This is not surprising as BDCs do have a high-beta profile. A number of bad NAV prints have also not helped matters.

Underperformers this week included HTGC and OCSL, both of which disappointed on the NAV side in Q2 results.

The BDC index fell back to about where it was at the start of the year.

Valuations are back to the lowest level year-to-date.

Market Themes

The recent Pluralsight fiasco in private credit highlights the diversification factor in BDC portfolios. The loan, which we discussed elsewhere a few times, is present in most of the larger BDCs – in various amounts, ranging from less than 1% of NAV to over 5%. Loans have asymmetric risk/reward so when one goes wrong as it has in this case, the impact on the NAV is going to be proportional to the position size. The rightmost column shows the impact so far (actual and estimated at a 48.5% mark) of around 0.35% for ARCC and over 2% for TCPC.

It appears that the impact hasn’t been priced in as OCSL has fallen sharply on the impact disclosure. Of course, the stock could have fallen for other reasons (there was an additional 1% of downside impact on the NAV above and beyond the Pluralsight loan) but it seems that the disclosure of this position, something which was known beforehand, was the key driver of the stock price fall.

Obviously, diversification can cut both ways. Under-diversification can lead to a big drop in the NAV on any one problematic position while over-diversification may mean that the portfolio is stuffed full of lower-conviction holdings. Overall, we do put a big focus on diversification, particularly for BDCs that see a lot of deals and have the capacity to be highly selective.

This is why we track the number of portfolio companies in each portfolio. It won’t tell us the size of the largest position but it does give us a sense of how well diversified a given portfolio is likely to be.

Market Commentary

A number of BDCs have reported their Q2 earnings this week.

FDUS had another great quarter with a total NAV return of 3.9%. The company’s interest expense looks to be the lowest in the sector due to having almost no floating-rate borrowings and fixed-rate bonds that were issued prior to the rate back-up, all of which gives it a big net income tailwind. The portfolio is holding up well with a low level of non-accruals and steady net realized gains. It also highlights that allocating to BDCs with a lower middle-market focus helps to avoid “hot” club deals like Pluralsight. Per unit of valuation, the stock has delivered one of the strongest results over the last 3 years. FDUS remains Buy-rated in the High Income Portfolio.

BDC HRZN delivered pretty poor numbers – not quite dumpster fire TPVG level but not far off. The NAV fell more than 5%, driving a -2.1% total NAV return for the quarter. It remains an amazing feature of the BDC market that such consistently poor performance continues to attract premium valuations. HRZN has delivered a return 23% worse (in absolute terms i.e. -5.2% for HRZN and +17.9% for FDUS) than FDUS over the past year in total NAV terms and yet investors are willing to pay a premium of 24% more than FDUS.

And it’s not like it has been a surprise – HRZN has underperformed in 5 of the last 6 quarters (3 of those quarters with a negative return) and yet investors are not losing hope. Non-accruals remain astronomical – at 18% at-cost, an unheard of number, and 8% on fair-value. Clearly, investors believe that this is just a stumble, however the reality of BDC portfolios, as HRZN has clearly demonstrated, is that underwriting problems do not disappear. They become embedded in portfolios and deliver negative surprises over a period of time.

Stance And Takeaways

Things are getting pretty exciting in the BDC sector for two reasons. One, valuations have come back to the historic average, which is great to see. We have complained about excessive valuations in the BDC sector for a while now. After dialing down BDC exposure across our Income Portfolios, a number of assets stocks in the sector are beginning to look much more attractive. And two, performance divergence is beginning to make itself felt with lower-quality BDCs clearly struggling under the weight of the shifting macro cycle. All of this should open up attractive investment opportunities for the remainder of the year.