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Flat is Good Enough

(Guest Commentary by Rick Konrad – December 16, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick discusses the increasingly attractiveness of bonds—and why he is interested in a closed-end fund that invests in emerging market debt.  Rick also discusses the role of BDCs (business development corporations) in bringing public capital to private companies, and why he likes a certain BDC—even if the economy remains flat.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Beer and Power but No Rare Earth” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


The holiday season is a time for sentimentality and cheer. Investor sentiment has improved as we can see from Henry's oft quoted ISEE stats and from anecdotal reference as we speak to potential investors. The ISE Sentiment index hit a 52-week high a little less than a week ago. In my recent travels, there seemed to be less unease about stock market participation and a lot less focus on yield.

The big story has been the bond market, which has been devastated in recent weeks. The dollar surged thanks to the higher yields. Gold and silver got slapped down. If interest rates are rising because the economy is strengthening, it just doesn't seem to feel that way at the moment.

Though many investors are feeling the ravage that has occurred in muni bonds as we have recently warned, mutual-fund investors are not just fleeing munis any more. For the first time in two years, they're also shedding corporates and Treasurys.

The Investment Company Institute reported a little while ago that $1.66 billion flowed out of bond funds in the week ending Dec. 8, driven mainly by a $1.26 billion outflow from muni funds. Forsaken munis have suffered outflows for five straight weeks now, the longest stretch in two years. It appears that investors are heading for the exits on all fronts except international equities as we can see from the following table (excerpted from the Wall Street Journal). Another interesting observation from yesterday was that both the S&P 500 and the yield on the 10-year U.S. Treasury both closed at six-month highs. While investors usually focus on one year highs, simultaneous new six-month highs in both the S&P 500 and the 10-year U.S. Treasury are relatively rare.

It seems that mutual fund investors are making the ultimate sector rotation into cash. We agree with Henry that while over the short term equity markets may be overbought, we remain optimistic over the longer term. In my opinion, the economic recovery remains intact but painfully slow and protracted.

After staying away from bonds for most of the last two quarters, we have started to nibble at a few closed end funds which are trading at substantial discounts.

For example, AllianceBernstein Global High Income Fund (AWF) is currently trading at a 10% discount to net asset value. The discount has averaged about 7.6% for the last three years for this lightly leveraged fund (about 12% leverage). With a broadly diversified portfolio of emerging markets debt (some 680 holdings) and a fine track record, this closed end fund should be a relatively solid shelter for fixed income money. The yield is about 8.9% based on its current monthly distribution. Not for the faint of heart, the credit averages BB.

I have also augmented my purchase of business development corporations, known as BDC's.

BDC Basics:

  • BDC regulation was created in 1980 by Congress to encourage the flow of public equity capital to private businesses in the United States. BDCs, like all mutual funds and closed-end funds, are regulated by the Investment Company Act of 1940. However, BDCs are unique because they focus on investing in private companies, rather than publicly traded companies.

  • In many ways, BDCs are similar to closed-end funds but rather than invest in portfolios of publicly traded securities, BDCs invest in small- and mid-size companies. Investment in these businesses is primarily fixed income in its nature and can include secured and unsecured debt, mezzanine debt, convertible securities, and preferred stock. Often, BDCs may obtain warrants or equity as a “sweetener” in order to enhance the returns from an investment. Generally, this is a fairly minor component of their assets though there are some BDCs which are very equity oriented.

  • Regulation requires BDCs to diversify their portfolios and cannot concentrate their positions in very few companies. BDCs bear some resemblance to REITs in that regulation requires them to distribute a minimum of 90% of their "investment company taxable income," as defined in the Internal Revenue Code, Consequently, these securities are often fairly high yielding securities. The dividend income does not qualify for the 15% tax rate treatment. BDCs are required to make available significant managerial assistance to their portfolio companies, consequently, BDCs frequently have advisory boards of experienced retired senior executives to provide guidance, management counsel, and due diligence in assessing and monitoring their proposed and actual investments.

  • BDCs can be managed internally, by investment managers on the BDC's payroll, or externally, through an agreement with an outside advisor. A growing number of BDCs are managed externally, and average dividend yields on externally managed BDCs have been somewhat higher over the last five years than those that are internally managed.

  • BDCs are also required to limit their leverage. Debt cannot exceed equity. REITs on the other hand do not have this limitation.

  • BDCs like any other publicly traded security, must file with the SEC regular quarterly and annual reports. In addition, BDCs generally provide detailed financial reporting, in contrast to many private equity funds. These reports generally include financial results, their business strategy, the companies in their investment portfolios, acquisition and sale activity, and information on any non-performing assets.

  • Hence, by investing in a BDC, shareholders enjoy the liquidity of a publicly traded stock, while participating in the private equity industry on a “pooled basis,” which diversifies the risk of any one investment across the whole portfolio.

We have selected Golub Capital BDC (GBDC) for a number of reasons:

  • Reputation and Experience of Management- Golub Capital, the external manager to the BDC, is recognized as a leader in mezzanine financing to smaller “middle-market” companies and has over $4 billion in capital. The firm has very well-established deal origination channels from a wide variety of sources. Our sources within the private equity industry have spoken highly of Golub's due diligence, credit underwriting, investment structuring, and execution. From 2004 through 2009, Golub Capital invested in more than 240 middle-market companies and, as of December 31, 2009, it held debt investments in more than 170 middle-market companies. Since its inception, Golub Capital has completed at least one debt financing with over 110 sponsors and multiple debt financings with over 40 sponsors.

  • Deal Structures Have Become More Conservative in the Current Environment- As a result of the credit crisis, many lenders are requiring less senior and total leverage, more equity and much “tighter” loan covenants than was customary in the years leading up to the credit crisis. Lower debt multiples on purchase prices suggest that the cash flow of borrowing companies should enable them to service their debt more easily, creating a greater margin of safety or buffer against a downturn. According to industry sources, average total debt multiples of middle-market leveraged buy-out loans are at their lowest levels in the 13 years such data have been tracked. The debt-to-EBITDA multiples of GBDC's portfolio has declined from 3.34 times at the time of origination to 3.01 times as of December 31, 2009.

  • Valuation Procedures- Golub has a very well defined valuation procedure for its investments. In addition to Golub Capital's opinion, valuations will be conducted quarterly for 25% of the loan portfolio by third party independent valuation firms so that every loan will be independently valued at least annually. In preparation for its initial offering, Golub hired three independent valuation firms to perform an initial valuation of its portfolio.

  • Incentive Fees- GBDC's pays a base management fee of 1.375% to Golub Capital for its management. This fee ranks at the low end of management fees in the industry which generally are 2.0%. The incentive fees for GBDC are similar to most other BDCs with incentives that are calculated relative to achieving returns above a benchmark return, which for GBDC is a higher hurdle. There is no incentive fee paid unless shareholders achieve an 8% annualized return, In order for the Golub advisor to earn a full incentive fee, shareholders must receive a 13.3% annualized return.

  • Diverse Funding Sources- GBDC has a number of funding sources including cash that was raised in its public offering, excess cash from a securitization that it completed last quarter, and potentially, some additional financing from a “Small Business Investment Company” or SBIC facility that the company will be transferring from Golub Capital (subject to regulatory approval by the fourth quarter). The SBIC will allow GBDC to supplement its own private investment capital with funds borrowed at favorable rates through the federal government.

  • Yield- With an annual dividend of $1.24 the yield is currently at 7.3%.

In a conference call held yesterday, management continues to believe that there are significant financing opportunities for them in the future. The key driver is an economic recovery which as management stated is going to be protracted and arduous. Nevertheless, economic recovery spells a more predictable and higher level of EBITDA for their portfolio of businesses. A large number of middle market loans will be maturing over the next two years and will need to be re-financed. Private equity hedge funds are seeking to employ their soon-to-be-expiring capital commitments as well in order to avoiding having to re-market new funds.

Perhaps the best description of the underwriting discipline that management is looking to is "Looking for credits where a flat economy is good enough."

That sounds like good guidance for all of us.

Happy Holidays!

Disclaimer: I, my family, and clients own positions in both AWF and GBDC.

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