As with all companies, some sources of income are better than others. One type of income common in leveraged finance forces BDCs to claim earnings, even though they don't have to have the cash to show for it.
Curious case of PIK income
There's more than one way to pay back a loan. A BDC can receive payment in cash, or payment-in-kind. A payment-in-kind is a non-cash payment wherein a company pays a debt by increasing its balance.
Suppose a BDC writes a $1 million PIK loan to a portfolio company at 10% annual interest for 10 years. When the loan is signed, the balance is $1 million. One year later, the loan grows to $1.1 million after 10% PIK interest is added to the balance. After another year passes, the balance will grow to $1.21 million. The interest continues to compound with the principal until the full balance is repaid at the end of 10 years.
PIK loans lure in BDC managers because of their higher interest rates, but higher yields come with added risks. First, the lender never receives any cash flow until a PIK loan is repaid, which could be several years after a BDC writes the loan. Secondly, because PIK loans do not require cash, it's essentially impossible to default on a PIK loan until the full balance comes due. It's possible a company will be in good standing on a PIK loan but not be in position to make actual cash payments when the loan matures in the future.
But we haven't even discussed the biggest risk: BDCs have to pay out 90% of income to shareholders, so they have to make cash distributions for PIK income for which they have yet to receive cash. This means BDCs with substantial PIK income usually have to borrow more money against income that they won't receive for many months or years, if at all.
Which BDCs make the most from PIK interest?
One way to measure the earnings quality of a BDC is by dividing its PIK income by its net investment income. Companies that have a high PIK interest to net investment income ratio may be at risk of cutting their dividend or overleveraging their balance sheets to cover distributions to shareholders.
This table compares PIK interest earned as a percentage of net investment income for some of the largest public BDCs:
PIK Interest / Total Investment Income
Main Street Capital
Apollo Investment Corporation
First Street Finance
Source: Company filings with the SEC.
Perhaps not surprisingly, the two companies with the least PIK income as a percentage of income -- Prospect Capital and Main Street Capital -- both cover their dividends with net interest income and trade at a nearly constant premium to book value. These two have been a favorite with investors because of their conservative dividend policies and quality historical underwriting.
The BDCs with higher PIK interest income trade at or near their book values and fail to cover their dividends. Fifth Street Capital has significantly reduced PIK interest as a percentage of its investment income over the years as troubled loans fall off the balance sheet. However, in recent quarters, its investment income hasn't covered its dividend, and it may soon have to cut the dividend it pays to shareholders. Likewise, Apollo Investment Group, one of the older BDCs on the market, had to cut its dividend last year to ensure it could continue to make distributions to investors.
A business development company is only as good as its dividend and earnings quality. Paying more attention to a BDC's income sources will help you separate the best and worst BDCs, and make better investments along the way.
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The article Not All BDC Income Is Created Equal originally appeared on Fool.com.
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