BDC Weekly Review: Performance Divergence But No Serious Weakness

Summary: We take a look at the action in business development companies through the fourth week of May and highlight some of the key themes we are watching. The BDC sector pulled back 2% this week, but remains up 2.5% month-to-date; valuations are about 5% below historic averages. Despite headlines of credit stress, BDC portfolios' interest income continues to offset markdowns and non-accruals, supporting solid total NAV returns. Performance divergence is increasing; avoiding serial underperformers and focusing on stable BDCs remains key to outperforming the sector. We re-initiated a position in Carlyle Secured Lending as its valuation became attractive again, after previously exiting on a diminished margin of safety.

Market Action: BDCs fell around 2% on the week as the previous equity rally stalled. Month-to-date, the sector is still up around 2.5%. Systematic Income BDCs have given back some of their recent rally and remain about half-way below their pre-Liberation Day level. The average valuation in our coverage is around 5% below its longer-term historic level.

Market Themes: Headlines point to a build-up of stress in the direct lending market. Oaktree Specialty Lending marked down its holding in Mosaic Companies by 76%, Golub Capital BDC highlighted two restructurings during the quarter, and Ares Capital marked down a vet hospital operator to 65 cents on the dollar. The IMF has warned that almost half of direct lending borrowers had negative free operating cashflow - up from about a quarter at the end of 2021. The average NAV return (excluding dividends) was a drop of 1.6%, with the median NAV drop at -0.8%. This is the worst result since 2022, but it's not particularly unusual. Including dividends, the average total NAV return in our coverage for the quarter was 1.4% with the median 2%. This indicates that any credit stress is being more than compensated by the interest generated by the BDC portfolios. Rather than outright weakness, what we are seeing is performance divergence, and avoiding losers remains the way to outperform in the sector and generate very attractive returns. Poor performers have exhibited poor performance in the past, likely due to problems with the underwriting process/deal pool, which are not trivial to improve or resolve. This is why we tend to lean towards BDCs with stable performance.

Market Commentary: Capital Southwest delivered a strong quarterly result of a 4.7% total NAV return. Non-accruals fell to 1.7% but remain above the median in our coverage. Carlyle Secured Lending had a decent quarter with a 1.7% total NAV return. NII fell to $0.41 and should stabilize around that level. Non-accruals are a bit below the average level. CGBD has been performing on par with the sector over the last couple of years, but its valuation has fallen to well below average level. We first initiated a position in CGBD in 2021 when the stock was trading at a huge discount to the average valuation, and then exited the position in 2023 and 2024 when the margin of safety dwindled too very little. We recently added a position in the stock once again when its valuation reached an attractive level.

BDC Weekly Review: Performance Divergence But No Serious Weakness

The BDC sector experienced a 2% weekly decline but remained up 2.5% month-to-date, with valuations 5% below historic averages. Credit stress in direct lending markets was highlighted, but interest income offset markdowns and non-accruals, supporting solid total NAV returns. Performance divergence increased, emphasizing the importance of focusing on stable BDCs. Carlyle Secured Lending was re-initiated after a previous exit due to attractive valuation.