07-09-2014, 12:11 PM
There is another data point that I use when evaluating BDCs. Since BDCs must distribute 90% of their income to maintain their tax status, they cannot use retained earnings to finance most of their investments. They must periodically go to the capital markets for additional investment capital, either new shares or new debt.
If a BDC issues new shares at a price below net asset value, this is expensive capital. If a BDC must pay comparatively high interest for its new debt, this is expensive capital.
The technical term for the total cost of a company's capital is weighted average cost of capital or WACC.
Obviously, you want your BDC to have a low WACC. Low WACC lets it invest in less risky loans, typically senior debt, the debt at the top of the capital structure. This debt pays less interest than subordinate debt because it has the least default risk. This creates a virtuous circle. Low WACC lets you invest in low risk debt and still maintain a profitable spread between your cost of capital and your investment income. If your WACC is high then you must invest in riskier debt to maintain a similar spread, and it is more difficult to cover your dividend with investment income because you are more likely to make investments that go bad and must be written off.
PSEC is a good example of a BDC with comparatively high WACC, and HTGC the opposite. As long as economic conditions are favorable, PSEC should be able to maintain its dividend. However, the next recession could put a lot of strain on PSEC.
Take a look at the price-to-NAV ratio of PSEC and compare to HTGC or MAIN. As of this writing, P/NAV for PSEC is 1.02:1, HTGC is 1.57:1, MAIN is 1.78:1. The markets are valuing HTGC and MAIN much higher than PSEC, and I think with good reason.
I am willing to accept the lower yield of HTGC in preference to PSEC just so I can SWAN. If I want to increase my portfolio yield from BDCs I can allocate a small percentage of my BDC positions to BDCL. I think a lot of HTGC and a small amount of BDCL is less risky than all PSEC and can generate equivalent income to PSEC. This is what I have done.
If a BDC issues new shares at a price below net asset value, this is expensive capital. If a BDC must pay comparatively high interest for its new debt, this is expensive capital.
The technical term for the total cost of a company's capital is weighted average cost of capital or WACC.
Obviously, you want your BDC to have a low WACC. Low WACC lets it invest in less risky loans, typically senior debt, the debt at the top of the capital structure. This debt pays less interest than subordinate debt because it has the least default risk. This creates a virtuous circle. Low WACC lets you invest in low risk debt and still maintain a profitable spread between your cost of capital and your investment income. If your WACC is high then you must invest in riskier debt to maintain a similar spread, and it is more difficult to cover your dividend with investment income because you are more likely to make investments that go bad and must be written off.
PSEC is a good example of a BDC with comparatively high WACC, and HTGC the opposite. As long as economic conditions are favorable, PSEC should be able to maintain its dividend. However, the next recession could put a lot of strain on PSEC.
Take a look at the price-to-NAV ratio of PSEC and compare to HTGC or MAIN. As of this writing, P/NAV for PSEC is 1.02:1, HTGC is 1.57:1, MAIN is 1.78:1. The markets are valuing HTGC and MAIN much higher than PSEC, and I think with good reason.
I am willing to accept the lower yield of HTGC in preference to PSEC just so I can SWAN. If I want to increase my portfolio yield from BDCs I can allocate a small percentage of my BDC positions to BDCL. I think a lot of HTGC and a small amount of BDCL is less risky than all PSEC and can generate equivalent income to PSEC. This is what I have done.