To DRIP or Not to DRIP (Seeking Alpha Article)

I just posted a Seeking Alpha article over here that outlines BDCs and whether or not reinvesting your dividends is worthwhile.

The companies to be examined for this article will be American Capital (ACAS), Apollo Investments (AINV), Ares Capital Corp (ARCC), Blackrock Kelso Capital Corp (BKCC), Kohlberg Capital (KCAP), Main Street Capital Corporation (MAIN), PennantPark (PNNT), Prospect Capital (PSEC), Solar Capital (SLRC) and Triangle Capital Corp (TCAP).

A look at High Dividend Stocks (BDC / Finance) and Ranking Them

(This article will also be cross-posted on Seeking Alpha, if you read the article there and have come back here, welcome to BDCR! If not, thank you for still reading. Due to some extensive work over these past few weeks, I now have some great historical data on the BDCR companies. This post is the first of hopefully many deep dives into the companies.)


It is quite common for a major financial website to post a link of "dividend darlings". A dividend darling list typically involves a group of companies that have a strong history of paying increasing dividends over their lifespan. If you look on Forbes, Investopedia or Seeking Alpha you will see lists containing some chosen companies.
This article will include a "dividend darling" list that is exclusively focused on BDCR-followed companies. Not only will the current dividend high-rollers be highlighted, but I will rank the companies based on history and dividend coverage. All of the information gathered is available on the SEC website and/or your favorite financial website (Yahoo, Google, DailyFinance, etc). I want to reward companies that have been around for awhile and ding those that are not paying and covering their dividends. This means that a company like American Capital (ACAS), which was once the top of the heap in terms of dividend payers, will now be more towards the bottom of the list.
Below is the criteria:

1. Is the company currently paying a dividend? I am penalizing a company that does not pay a regular dividend. I know owning ACAS over the past year with a 94% return would have been a far better total return, but I am looking at BDCs strictly on a yield-basis and not a total return basis for this article. 10 pts
2. Does the company have a strong dividend history? For example, Prospect Capital Corporation (PSEC) likes to publicize its history of dividend increases and consecutive dividends. One thing it fails to mention is that in May of 2010, the company slashed its dividend by 10 cents per quarter, skipped most of its June dividend and changed over to a monthly payout (which overall I believe was a good thing). This list will penalize a company for doing that. 3-6 pts (3 pts for never missing a dividend, 3 pts for never cutting a dividend)
3. Is the dividend currently covered by net investment income? I covered this in a previous post in which I explained why I believe it matters. Below you can see the updated chart. Again, the same situation applies where I multiplied a monthly dividend payer by 3 to turn it into a quarterly dividend. 3 pts
4. How long has the company been paying dividends? I believe companies that have successfully navigated the 2007-2009 period should receive an extra credit above those companies which may have IPO'd over the past two years. 1-2 years is 1 pt; 2-5 years is 2 pts; 5+ years is 3 pts

Given this format, the max score a company could receive is 22 (5+ years of consistent dividends covered by NII) and the minimum score is 1 (company is still in business). For the BDC-R companies, the range of scores was 21 as a max and 3 as a min.
click to enlarge image
Results

Discussion of Results
As you can see, most of the companies are in the higher range of the numbers. This is partially due to the sample selection (I do not track some of the newer BDCs at the moment) and the favorable market conditions for BDC companies.
The main negative on the scoreboard was dividend cuts. Only 5 of the companies listed here have not cut their dividend. Of those 5, PennantPark Investment Corporation (PNNT - first dividend June 2007) and Compass Diversified Holdings (CODI - July 2006) have been around for awhile. Solar Capital Ltd. (SLRC - March 2010) and Horizon Technology Finance (HRZN - December 2010) are new to the world.
The other major reason for taking away points is the fact that most of the companies listed do not cover their dividend with net investment income. This means that they are either not covering their dividend or are cannibalizing their portfolio to meet payout requirements. One such company is MVC Capital (MVC). It realized losses on portfolio companies at 23 cents per share so it could meet its dividend payment of 12 cents per share. By continuing this payout, it reduced its book NAV from 17.71 to 17.38 during the six month period ending April 30th 2011.
Only 7 out of the 26 companies are "safely" covering their dividend as of their last reporting dates, which safely means their NII is greater than or equal to their current dividend. These companies are PNNT, HTGC, Kohlberg Capital (KCAP), KKR Financial Holdings (KFN), Triangle Capital (TCAP), GLAD and MCG Capital Corporation (MCGC).
The Clear Winner
PNNT (PennantPark Investment Corp) comes out ahead of the pack with a solid dividend history and good earnings numbers. It scored a 21 out of a possible 22 and the only detraction was due to the firm's lack of longevity (only paying dividends since June 2007).
The first runner up is Hercules Technology Growth Capital. There has been a fair amount of good press on HTGC this year and it appears that the company has done a good job of backing up what people are saying about it Nicholas Marshi, one of the top posters on BDC companies on Seeking Alpha, did an extensive write-up on the company in March of this year.
Surprises
Former-troubled BDC KCAP (Kohlberg Capital) is also sitting high on the list. The company was hit with a shareholder lawsuit in 2010, a changing of auditors (it switched from Deloitte to Grant Thornton) and restatement of earnings (again check the SEC website for the filings). For example, the restated as of June 30th 2009 earnings adjusted total assets down by $25m, which slashed the NAV from 11.09 to 9.73 and gave more fuel to the arguments it had with its lender BMO. It appears that the company may have weathered the storm and could be worth a deeper look into its financial statements and conference call logs.
Disappointments
At the bottom of the list is EQS. While not a BDC, EQS was a strong dividend-paying stock for 8 years and at this point it is too early to tell if the new management will be able to revitalize the company. SAR (remember GNV Investment?) is also sitting at the bottom as it has yet to show any signs of breaking out of GNV's slump.

A Look at Dividend Coverage

Overview
The Dividend Coverage Ratio is a way to measure how "safe" a dividend is for a firm. For a BDC with a required minimum payout (to avoid taxes), this ratio becomes a little more meaningful. As you can see below, some BDCs will pay out more in dividends than they earned in their current quarter's Net Investment Income.

There are many formulas out there, but this site will use these formulas:

DCR  = Net Investment Income / Current Quarterly Dividend.

DC = Net Investment Income - Current Quarterly Dividend

I am using Net Investment Income because a BDC is required to have at least 70% of their holdings in qualified securities / cash. These investments are the life-blood of a BDC and while many firms generate fee income from structuring deals, these are more volatile. One other note, if a firm pays out dividends on a Monthly basis, I am adding together the past three months of dividends to get the amount. The second formula is useful because it shows you how much room a firm has to pay out its dividend

In the below chart, I have pulled the NII from the BDCR Index and compared that value with their current dividend payouts. In cases where NII is negative, the DCR will also be negative, this allows us to sort the results.


Results

Discussion of Table


As you can see, a large number of the firms are operating at the razor's edge when it comes to their payout ratio. While this is nice for fixed income investors, it may mean that a company is actually paying out their dividends at the expense of the firm. If a company cannot cover the dividend with investment income, it needs to generate the proceeds from another source(s).

• The first source would be from capital gains on the sales of a firm's assets. This dividend is good for a tax-paying investor in the short-term as it will be classified as a return of capital and taxed (in the US) at the long-term capital gains tax-rate (15% for most people, for the IRS view, please click this link). Return of capital dividends do require you to adjust your cost basis for your position though and that may not be desired from a book-keeping standpoint. For a BDC, this type of dividend payment may be bad as the firm has presumably sold off an income generating asset to meet a payout requirement. 
• A second source would be from the company tapping their Revolving Credit Facility (Revolver) to get the cash to payout to their investors. Again this may be a bad sign for the firm as they are increasing their interest expense and leverage without any offsetting gain.
• The final source is when a firm actually goes "Ponzi" and will begin issuing new shares to pay-off old shares. This does not happen on a large scale for long; most firms will cut their dividend or violate a lender covenant if they are in this situation. But, a good example would be AINV for 2008, you can see that their asset values and net investment income were tumbling, but the firm maintained its dividend and partially funded this dividend with proceeds from selling shares. AINV was not the only BDC to do this, but they are an easy target as they are still one of the largest.

A firm that has a DCR over 1 or a DC > 0 is a firm that is currently covering its dividend with its investment proceeds and that may be a sign of a responsible management team. There are some firms that are close to their ideal payout (KCAP for example) that may be correcting their balance sheets, but you should take a look at their dividend and NII history to come to your own conclusions. The best firms in terms of dividend coverage are KFN (which is not a BDC) and MVC. The worst are the firms that have already cancelled their dividend.

Net Investment Income Overview

Net Investment Income (NII) is one of the most important factors when evaluating a BDC. NII as a definition is a measure of the income received from investment assets (bonds, stocks, funds, loans and other investments) minus equivalent investment expenses. For a BDC, this number measures how well their investments are performing. As a simple way of breaking this information down, I am pulling in the balance sheet from TCAP's Q3 earnings release to illustrate.

Investment income:
Loan interest, fee and dividend income:
Non—Control / Non—Affiliate investments	6,654,541
Affiliate investments	1,044,088
Control investments	333,993
Total loan interest, fee and dividend income	8,032,622
Payment—in—kind interest income:
Non—Control / Non—Affiliate investments	1,338,018
Affiliate investments	231,525
Control investments	117,419
Total payment—in—kind interest income	1,686,962
Interest income from cash and cash equivalent investments	67,501
Total investment income	9,787,085
Expenses:
Interest expense	1,864,442
Amortization of deferred financing fees	469,394
General and administrative expenses	1,840,794
Total expenses	4,174,630
Net investment income	5,612,455

Basic line by line breakdown:

Non-Control / Non-Affiliate Investments - These represent the bread and butter investments of a BDC - extending capital (most of the time in the form of term loans) to firms to collect interest. You would expect the majority of a firm's NII to come from this line.

Affiliate Investments - This means that TCAP has some type of influence or relation to these companies. Such situations could be: a person in TCAP sits on the board of the company (or if an officer), holds either directly or indirectly 5% or more of the outstanding voting securities or if the affiliated company is an investment company, TCAP has seeded the company.

Control Investments - Will let the 1940 take it from here - "Control" means the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company. From what I have seen, a BDC likes to avoid controlling a firm as that is not the specialty of the BDC. Also, it tends to take considerable personnel power to both manage another company as well as your entire portfolio.

Payment in Kind Interest Income - Quick sub-note on this. http://en.wikipedia.org/wiki/PIK_loan

Interest Expense - This is the expense that the company pays on the leverage it issues (loans/bonds) to make investments. A BDC will take out a Loan (most likely a Revolver) because they make money off of the spread. If a BDC pays interest at LIBOR+200 and can lend that money out at LIBOR+500, it is doing OK. This is the same principal on how a traditional bank makes money. Take in deposits and pay a certain rate and lend money out at a higher rate. Remember, a BDC must be in compliance with a max 1:2 Leverage to Assets ratio (200% test).

Amortization of deferred financing fees - These are the costs incurred with issuing debt such as commissions paid to investment banks, auditors, lawyers, etc. These fees are amortized because of accounting reasons which you can easily lookup online.

General and administrative expenses - The incredible catch all which includes costs of doing business. For example, if a business professional is evaluating a potential portfolio company, they can expense (within limits) travel costs and acquisition costs.

What does this all mean?

Well, from looking at those lines, we see that TCAP has a positive NII and if you divide that by the number of outstanding shares, you get to a NII of 0.46 per share. This is important because that means TCAP is currently covering their dividend of 41 cents (now 42 cents) with their NII. This is important when you look at a BDC. There are a number of BDCs that currently have a dividend shortfall (future post). If a BDC is not covering their dividend with NII, then you have a problem with a BDC selling assets to make payments or even going Ponzi by paying out dividends from equity and leverage raises.