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Dividend Cut by Golub Capital BDC Highlights the Industry's Concerns

Business development companies, or BDCs, have always been a popular investment option for income investors. With their high yields and unique exposure to smaller companies, they provide venture capital-like opportunities to non-accredited retail investors. However, the COVID-19 crisis could significantly impact their returns moving forward.

Let’s take a look at the BDC market up until the COVID-19 crisis, how the virus has impacted the markets since, and where it may be headed over the coming quarters.

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BDCs Were Strong Performers

BDCs typically invest in small- and medium-sized companies, as well as larger distressed companies. With a structure similar to closed-end investment funds, or CEFs, they leverage public equity to help small- to medium-sized firms grow and help distressed companies on their road to financial recovery.

BDCs must invest 70% of their assets in private or public U.S. firms with market values of less than US$250 million and provide managerial assistance to its portfolio companies. Since they are regulated investment companies, or RICs, they must distribute at least 90% of their profits to shareholders, resulting in above-average dividend yields.

There have been two recent developments that impacted BDCs in the recent past:

Passage of the Small Business Credit Availability Act (SBCAA) in 2018: This increased the leverage cap for BDCs from a one-to-one debt-to-equity ratio to a two-to-one debt-to-equity ratio and reduced reporting requirements and communication restrictions that apply to normal public companies. These dynamics led many BDCs to significantly leverage their balance sheet.

Interest Rate Cuts: Federal Reserve interest rate cuts due to the U.S.-China trade war lowered interest rates for commercial loans and increased competition for BDCs and other asset-based lenders. That said, the realized returns on portfolio investments helped offset interest rate effects when the economy was strong and mergers and acquisition activity was strong.

How COVID-19 is Affecting BDCs

Many BDCs lend to highly indebted corporations that are owned by private equity firms. Under the existing rules, companies owned by private equity firms aren’t eligible for most federal relief efforts, such as the Payroll Protection Program (PPP). These dynamics could hurt their ability to repay the money that they owe BDCs in a timely manner.

At the same time, BDCs offering lines of credit to their portfolio companies are seeing a significant drawdown in those lines as their portfolio companies shore up liquidity. The large volume of cash leaving BDC coffers could reduce their own cash reserves and harm their ability to maintain lofty distribution payments and dividend yields over time.

These dynamics have led investors to significantly discount BDC shares in anticipation of further problems. As of March 27, 2020, BDCs have traded with an average 39.1% discount to their net asset value, or NAV, compared to a mere 6.6% discount just one month earlier. These trends appear to be worsening over time as the COVID-19 crisis continues.

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What Golub's Dividend Cut Means

Golub Capital BDC (GBDC) recently declared a $0.29 per share quarterly dividend, which represents a 12.1% cut from its prior dividend of $0.33 per share. While the forward yield remains attractive at well over 9%, the high yield comes largely from the significant drop in the company’s share price over the past couple of months due to the COVID-19 outbreak.

GBDC chart

The good news is that Golub is “actively looking” at the bond market and other potential ways to improve its balance sheet, according to CEO David Golub in a recent earnings call. BDCs have sold about $2 billion in investment-grade bonds by late February, which is sharply higher than the $3 billion worth of notes that was sold throughout all of last year.

The entire industry is facing similar headwinds, including Ares Capital (ARCC) and Goldman Sachs BDC (GSBD). In fact, the VanEck Vectors BDC Income ETF (BIZD) fell from highs of around $17.00 per share to lows of nearly $7.50 per share following the COVID-19 outbreak. The ETF’s yield remains around 15% but that doesn’t account for expected distribution cuts.

BIZD chart

The Bottom Line

The COVID-19 crisis, low interest rates, deteriorating credit quality and low deal volume are all factors that could depress BDC yields for the foreseeable future. While some BDCs have income from prior years that wasn’t distributed, several weaker BDCs might have to consider cutting their distributions and dividend yields to preserve liquidity.

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