BDC Weekly Review: Management Fees Are Moving Lower

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company (“BDC”) sector from both the bottom-up – highlighting individual news and events – as well as the top-down – providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the first week of February.

Market Action

All but one BDC in our coverage were down this week for an average return of around -2.5%. OCSL led the way with an 8% drop due to disappointing earnings. Month-to-date, the sector is down around 1% so far.

Current sector valuation is right on top of its longer-term average.

Trailing-twelve month BDC dividend yields remain elevated by historical standards and are around 2.5% above the recent lows at the start of 2022. This should support the sector even if the Fed starts taking the policy rate lower.

Market Themes

WhiteHorse Finance (WHF) said in December that its base management fee rate was decreased to 1.75%, from 2.00%, and is effective January 1, 2024. Although its base management fee was staggered with a lower fee for assets financed with leverage, the 2% headline figure was still at the very top end of the sector.

WHF is not the only BDC dropping its fee. Recall that GBDC recently dropped its management fee to 1% which is at the lower end of the sector. More recent BDC IPOs have also been at the lower end of the sector. For example, Blackstone Secured Lending (BXSL) kicked off a couple of years ago with a rock-bottom management fee of 0.75% which then rose to 1% – a still low figure in the sector.

Other more recent IPOs have also been on the low side of the sector which tends to be closer to 1.5%. For example, Nuveen Churchill Direct Lending (NCDL) recently launched with a management fee reduced from its previous 1.25% to 0.75% which will step up to 1% after five quarters.

In one sense these recent reductions are odd since BDC net income levels are unusually high. They are flattered by three factors: 1) very high short-term rates, 2) relatively wide spreads, particularly for the loans that went into the portfolio since 2022 and 3) relatively low leverage cost due to having refinanced much of their unsecured borrowing in the low rate post-COVID period.

That said, the direction of travel for management fees is certainly in the right direction. BDCs are becoming less exotic investment companies and private credit is becoming a core sector for individual investors. This, along with significant competition among private credit managers, makes it difficult for BDCs to sustain management fees closer to 2%, particularly as they also earn sizable incentive fees.

An obvious consequence of lower management fees is that they allow BDCs to generate a higher level of net income, all else equal. A less obvious consequence is that the impact of lower management fees is magnified when BDC net income falls, something we expect when the Fed gets going with its series of rate cuts. This should allow lower-fee BDCs like BXSL, GBDC, GSBD and BBDC to outperform in valuation terms relative to higher-fee BDCs as their net income would hold up somewhat better, all else equal.

Market Commentary

We are now entering the Q4 earnings reporting period.

Capital Southwest (CSWC) reported good numbers. The NAV rose by 1.9% – entirely from accretive equity issuance ($66.5m of proceeds were raised at a weighted-average 33% premium to NAV). Net income rose by 5%, in part from a rise in dividends.

A couple of things to keep an eye on are the non-accruals which rose for the third quarter in a row and remain above the sector average, a jump in PIK and a steady drip of net realized losses which sum up to 6.2% over the last 6 quarters.

Something else to keep in mind is that without its accretive issuance, CSWC is an average performer. And the only reason accretive issuance generates excess NAV gains is because of its high premium. A long position in the stock only makes sense if investors think the high premium is here to stay because, if it doesn’t, a significant source of NAV strength from accretive issuance will disappear.

Oaktree Specialty Lending Corp (OCSL) had a challenging quarter. The NAV fell by 2.5% and net income fell by 8%. The key factor here are the additional 4 loans that went on non-accrual. Non-accruals at cost rose to 5.9% from 2.4% with the fair-value number at 4.2%. This is quite a bit above average.

Stance And Takeaways

This week we added to our Golub Capital BDC (GBDC) position. Its recent cuts in both the management fee and incentive fees will boost its net income by 20%, all else equal.

We don’t expect the full 20% boost because its upcoming merger with GBDC III will raise its cost of leverage as GBDC 3 is financed entirely with floating-rate debt. GBDC has also recently refinanced its upcoming 2024 maturity with a higher-coupon bond. That said, the latter is a trend in the broader BDC sector.

We last downsized our allocation to GBDC in November (red line) when it traded at a valuation slightly above the sector average and we have added it at a valuation below the sector average. This is actually even more attractive than it looks because it includes the incentive fee reduction which was announced in early January.

We continue to carry a minimal allocation to OCSL which we reduced earlier in the year. Our last rotation was into a floating-rate bank preferred (USB.PR.A) which has held in very well and outperformed OCSL. OCSL fell around 8% on its earnings release and is currently trading around the sector average valuation. We would require a significant discount to the sector to add the stock back. Any recovery relative to the sector would likely lead to a zeroing out of the position given its string of middling performance.