The BDC industry is experiencing growing pains.
Shares of most BDCs are trading below net asset value. Several BDCs are under attack by activist investors for stock underperformance, and these very public, acerbic battles are casting a pall over the entire sector. The recent market sell-off also punished BDCs as investors fled the credit-focused asset class.
Looking ahead, 2016 is likely to be a year of more shareholder activism for BDCs, market players say, a trend that could ultimately lift BDC share prices in 2016.
“We believe the BDC group could see stock prices increase 5% in 2016. When combined with an average dividend yield of 10%, we expect BDC total returns of 15%. In addition, the growth in shareholder activism could be a further catalyst for the group, particularly for some of the more discounted stocks,” said Troy Ward, an equity analyst at Keefe, Bruyette & Woods, in a Dec. 7 research note.
What won’t likely be a theme next year is raising capital through equity offerings.
“In a period where few BDCs have access to equity capital at accretive levels, earnings growth will be a function of recycling capital and taking optimum advantage of debt capital,” said Merrill Ross, an equity analyst at Wunderlich Securities. “We are looking for earnings growth of approximately 6.7% in 2016.”
Sector dramas unfold
Rifts within the BDC sector will likely widen next year, with battle lines drawn over management fees, the willingness of boards to buy back stock, and whether investors perceive management to be aligned with shareholder interests.
“Activism is going to be a big issue,” said Golub Capital CEO David Golub. Shares in Golub Capital BDC were trading at $16.70 at midday on Dec. 18, a premium to NAV of $15.80 per share as of Sept. 30.
“We are in the midst of what I would characterize as a crisis of confidence in the BDC industry. Investors are skeptical because of self-serving behavior by many BDC managers, often at the expense of their shareholders,” Golub said. The comment was in response to a question on the prospects for the BDC modernization bill, the passing of which Golub believes could be marred by poor timing.
“I hope the industry comes out of this period of activism by becoming a better neighborhood—an industry that’s more focused on shareholder value, that’s more focused on doing things that are fair and good for everybody and not just good for managers. That would be good for the industry.”
For now, all eyes are on dramas involving activist investors, including Fifth Street Finance and Fifth Street Asset Management, which are targets of a class action lawsuit. The suit alleges that the firms fraudulently inflated the assets and investment income of Fifth Street Finance to increase revenue at Fifth Street Asset Management. The firms deny the allegations and are fighting them in court.
Fifth Street Finance has agreed to meet with RiverNorth Capital Management, which is currently the largest stockholder in Fifth Street Finance, with a 6% stake.
American Capital has also been the target of an activist investor since the company unveiled plans to spin off BDC assets. Last month, Elliott Management, which owns an 8.4% stake in the company, urged shareholders to vote against the plan, saying a split would further entrench an ineffective management team that has been overpaid for poor performance and placed valuable assets at risk.
American Capital followed with the launch of a strategic review aimed at maximizing shareholder value, run by an independent board committee and advised by Goldman Sachs and Credit Suisse. Results of the review, which could include a sale of all or part of the company, will be announced by Jan. 31.
American Capital also started a share-buyback program of up to $1 billion of common stock as long as shares are trading 85% below net asset value as of Sept. 30, which was $20.44 per share. Shares were trading at $14.00 at midday on Dec. 18.
In another saga, the board of KCAP Financial, an internally managed BDC, received a letter in October from funds managed by DG Capital Management, its third largest stockholder with a 3.1% stake. DG Capital told the board that selling the business to another BDC would likely reap the best yield to shareholders, who have endured a sustained period of underperformance.
A three-way battle over TICC Capital has intensified in recent months. TICC Capital is urging shareholders to allow Benefit Street Partners, the credit investment arm of Providence Equity Partners, to acquire TICC Management, which manages the investment activities of TICC Capital. NexPoint Advisors, an affiliate of Highland Capital Management, has also submitted a proposal to cut fees and invest in TICC Capital.
The third party, TPG Specialty Lending, has unveiled a stock-for-stock bid for TICC Capital Corp., saying the offer is superior to the competing proposals from either Benefit Street Partners or NexPoint.
The move thrust Josh Easterly, TPG Specialty Lending’s co-CEO, into a prominent role in the drama that could result in such drastic measures as the management company losing its ability to manage a BDC, an outcome that few expected at this time last year.
“Those familiar with our history and investment philosophy understand that it is not in our nature to be public market equity activists,” Easterly said during an earnings call on Nov. 4.
“We have reluctantly assumed this role with respect to TICC as our industry is going through an inflection point,” he said. “We believe that our ecosystem can only thrive in a culture that fosters real value creation for shareholders.”
One possible outcome for the industry longer term is lower management fees. Medley Capital, which has been named as a potential target of activist shareholders, this month unveiled plans to expand a share repurchase program to $50 million after buying back 1.4 million of shares in the most recent quarter, and cut its base management fee on gross assets exceeding $1 billion to 1.5%, from 1.75%, and incentive fees to 17.5%, from 20%.
Medley Capital was part of a trend last year that saw shares of its management company listed in an IPO, following in the footsteps of Ares Management and Fifth Street Asset Management. Medley Management, whose shares trade on NYSE as MDLY, derives most of its revenue from fees for managing BDCs Medley Capital and Sierra Income Corp.
Brian Chase, the CFO of Garrison Capital, said an important factor moving forward is whether a BDC manager also manages other funds, outside of their BDC, that invest in privately originated debt investments. Having access to this institutional capital will be key to staying relevant in the market, particularly in an environment where raising fresh equity is challenging.
Some upsets are possible in the near term due to activist investors’ attention on the BDC sector.
“The BDC space is going through its awkward teenage years. I expect that in due course the sector as a whole will mature and institutionalize, which should further open up access to more capital and solidify their role in the financial system,” said Chase. — Abby Latour
Follow Abby on Twitter @abbynyhk for middle-market deals, leveraged M&A, BDCs, distressed debt, private equity, and more.