The collapse in the Business Development Company stocks in recent weeks offers an opportunity for investors with many yields in the double-digits, and discounts to Net Asset Value up to 50%.We recommend a basket approach to owning BDCs, owning both more conservative, and lower-yielding, as well as the more distressed with yields in the high teens.The stocks tend to be very volatile since the companies tend to be small and mostly retail-owned, and one should always be alert to opportunities to buy a particular stock at a depressed price.Right now, however, the entire sector is depressed, offering buying opportunities across the board.

Overall sentiment towards Business Development Companies has turned very negative, and most stocks in the sector are down significantly.There is concern about energy companies in the portfolios of many BDCs. Amid general market weakness, there is concern about the impact of higher interest rates, and extreme weakness in the high-yield credit market, with particular concern about the Collateralized Loan Obligation market (many BDCs own CLOs). All this has led to fears of a repeat of 2008-2009, a period that saw many BDCs rack up loan defaults forcing them to slash their dividends.

BDC fears are overblown

These fears are misplaced or greatly exaggerated.In particular, the effect of higher interest rates on Business Development Companies is misunderstood.There are three main ways in which rising rates could affect these companies: by affecting the economy and therefore small businesses; by hurting the rate spread on company’s loans; and by affecting dividend-paying stocks.

• The quarter-point hike, and “gradual” outlook for future increases, is not sufficient—in itself—to derail the economy and therefore significantly hurt small business leading to greater defaults.
• Most BDC loans are at floating interest rates, for some companies over 90% of loans, meaning that as the level of rates rises, so too will the interest rate due on those loans. This will hold even in a scenario where benchmark rates increase, but many market rates do not.However, most company debt is at fixed rates.Thus the spread could widen in a period of rising rates.
• The stocks still sport among the best yields around—partly because the stocks were generally weak last year—and with the ability for dividends to grow over time, higher rates should not be too much competition for the stocks.

More important than rising rates per se is the level of bank lending.Since the credit crisis, bank lending to small businesses has fallen significantly—up to 50% at the leading banks.BDCs were able to fill the gap, meaning they were able to lend to better quality companies, companies that would normally borrow from banks, and at higher rates than normal.If higher rates were to spur banks to lend more—and it would require an easing of some of the regulation that was imposed following the credit crisis—that would be more of a concern.

As for the energy exposure, this varies significantly across companies.Main Street Capital, Apollo Investment, Gladstone Capital, and Pennant Park have the highest exposure, ranging from 17% down to 10% of the total portfolio.Moreover the “energy” industry sector includes a variety of companies, including solar and oil-price neutral service industries.They are all affected by the declines in volume from lower exploration activity, but can be less sensitive to the oil price than E&P companies.

Illiquidity in the high-yield market, leading one high-profile open-end fund to suspend redemptions, has led to negative sentiment across the board.But it shouldn’t affect BDCs, which are long-term holders of the loans they make, and rarely in situations where they have to sell loans, and never to meet shareholder redemptions.

Energy perception is hurting Gladstone

Against this background of negative sentiment towards the sector, Gladstone Capital (Nasdaq:GLAD) now at $5.01 has been particularly hurt, largely, it would seem, on concerns about its energy exposure.Gladstone has about 15% of its portfolio in this sector, comprised of loans to three companies. 

Gladstone’s three loans are to companies offering measurement and field meter services to the industry; another selling oil-well chemicals to prevent corrosion and bacteria growth; and a third, the largest fracturing materials logistics company in the U.S. There is not enough information available about these private companies to determine exactly how much as risk they involve, but we can say that, although a reduction in exploration and production activity will definitely see a reduction in demand for these companies’ services, all three have “ample liquidity” to continue to service their debt (according to Gladstone), and all three are receiving support from their main equity sponsors and are looking for attractive acquisition opportunities in the current depressed sector.None of this sounds like companies teetering on the edge of bankruptcy. 

Worst case not that bad

But even if all three companies were completely written off—a highly unlikely scenario—it would still leave Gladstone with a decent balance sheet and the stock still inexpensive. For example, right now, following some loan sales and early payoffs as well as a $20 million equity raise at the end of October, Gladstone has asset coverage of 2.8x.A write-off of all three energy companies would leave Gladstone with asset coverage comfortably above 2x.

Similarly, a complete write-off would see the NAV decline, but the stock would still be trading, at today’s price, at an NAV discount of well over 20%.Remember, this is in an extreme situation that I do not think is at all likely.

Other than the 15% exposure to energy, Gladstone has a well-diversified investment portfolio of over 40 companies, in 20 different industry categories, and headquartered in 20 different states.

Gladstone targets the smaller middle-market of privately held U.S. companies, with loans typically from $8 million to as high as $20 million.Loans are generally made together with private equity sponsors or owner operators, typically to finance buyouts, acquisitions, or to provide financing for a company to pursue organic growth opportunities. Up to 10% of the portfolio can be equity, usually sweeteners to loans.

Balance sheet has improved

As mentioned, the balance sheet has improved in recent months with repayments and the equity issue.That issue was conducted below NAV, something I am generally not inclined to favorably; in Gladstone’s case, it was a defensive move since Gladstone’s preferred stock includes a covenant that the asset coverage not fall below 2x.It was very close to that at the end of the third quarter.Proceeds from the portfolio activity and stock issuance were used to reduce the outstanding borrowing on its revolver, cutting the outstanding amount from $127 million to about $52 million, and moving the asset coverage up to a comfortable 2.8x.

DECLINE IN BOOK VALUE OVER THE YEARS

More investments ahead?

Ultimately, one would like to see proceeds from stock issuances be put to work in more loans to businesses, which carry higher returns than the cost of debt. Given the trends at Gladstone Capital (and sister company Gladstone Investment) over the past 12-18 months, one would expect the company to begin to step up loan activity.GLAD had a strong period of originations in the quarter ending September 30^th, with over $40 million loaned.

Gladstone has had weak non-accrual numbers, but, following valuation write-downs, as well as recent sales of some poorly performing loans, only one company, representing 1.6% of assets at fair value, is non-earning.The company has become more aggressive in dealing with under-performing loans, including selling them.

Cheap, cheap, cheap

The stock today is trading at only 56% of NAV, and yielding nearly 17%. That yield is covered by net investment income, although the management company has waived some of its fee to ensure the dividend is covered.The company has talked about increasing the dividend once the management fee is normalized, possibly this year. The extreme sell-off and these extreme valuation metrics indicate the stock is well oversold, more than discounting the worst outlook. Insiders have been buying in recent months.Now, though a NAV reduction, as well as even a dividend cut, are possible, the stock valuation more than discounts for this, and Gladstone Capital is a buy at today’s level.

I am not suggesting that Gladstone Capital is the best of the BDCs nor that it should be the only one you purchase.Rather, you should buy a basket, including the more conservative ones such as Golub (GBDC) and Goldman Sachs BDC Inc (GSBD), which are each trading around book, but given the declines in stock price yield from just under 8% to almost 10%.; the largest, such as Ares (ARCC), trading at a price-to-NAV ratio of 0.8 and yield over 11%; more aggressive companies, such as Prospect (PSEC), trading at 0.6 x book, with a yield approaching 17%; and some smaller ones such as Gladstone above and Monroe (MRCC) yielding 11.7%.