Idea Brunch with Nicholas Marshi of BDC Investment Advisors

Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Nicholas Marshi!

Nicholas Marshi is the chief investment officer of BDC Investment Advisors, a Los Angeles-based investment firm focused on investing in Business Development Companies (BDCs) and has managed an investment fund devoted to the sector for nearly twenty years. He is also the publisher and editor of BDC Publications, LLC, keeping himself busy with three subscription-based magazines dealing with different aspects of the BDC sector. 1) The BDC Reporter offers “News, Views, and Analysis” for professionals interested in digging deep into the how and why of individual BDC performance. 2) The BDC Credit Reporter tracks what is happening to the most underperforming portfolio companies BDCs hold and assesses what sort of losses might be coming. Credit is the biggest variable in BDC performance, so staying ahead of the curve is critical. 3) BDC Best Ideas is focused on actionable BDC insights for readers on what BDC securities might be worth buying (and avoiding). Before entering the BDC space, Mr. Marshi was a banker with Citibank and Kleinwort Benson; launched and managed two private equity funds acquiring lower middle market companies in Southern California and is the Managing Member of a building products company.

Nick, thanks for doing Sunday’s Idea Brunch! Can you please tell readers about your background and why you decided to launch BDC Investment Advisors?

Many, many moons ago, I had a success selling one of the companies in my private equity fund. I chose to manage the proceeds myself rather than turn them over to a money manager or place them in a CD. That brought me into contact with the public BDC sector, which was then coming into its own. I felt that given my background in lending and private equity I had a better chance of investing success than in most anything else out there. Being Citibank trained I took my investing very seriously and built up a BDC portfolio, wrote my own analyses and tracked my performance. This went on for a few years until at one point my business partner said, “Why don’t we take all this knowledge you have and launch a fund?”. At the time everybody seemed to be in the fund business and that’s what we did.

At the same time I began publishing the BDC Reporter, as a way to show any prospective investor the sort of research we were doing and our thought process. However, the BDC Reporter soon took on a life of its own so we spun it off into a different legal entity and offered it - and subsequently the BDC Credit Reporter and BDC Best Ideas - to anyone interested for the very reasonable sum of $50 a month for each. We are no Bloomberg. But we can proudly claim to have as our readers some of the movers and shakers amongst the BDC managers, as well as RIAs; hedge funds interested in the space; lawyers and accountants; BDC Board members keeping up with developments and individual investors.

Can you tell us a little more about your research and investment process?

I am an insecure investor. I always want to know as much as possible about the BDCs I might or might not invest in. So my M.O. is to read every filing, every press release, every conference call transcript that I can about the universe of now 46 public BDCs I am interested in: those generating income principally through lending. Where possible, I also talk to the BDC managers and anyone else willing to talk.

From there, I build tables of data. What I’m looking for in this mountain of information are the BDCs whose book value and income seem the most sustainable over the longer term. Given that I have no crystal ball, I have to rely on what has come before to make the determination of what the future holds.

In the last few years I have dug even deeper by familiarizing myself with the portfolios of every BDC, seeking to identify the companies most likely to impact the BDCs net asset value and earnings for good or ill. I spend a great deal of time on the back stories of companies not performing as one might have hoped to ascertain how that might play out on the BDCs involved in the quarters or years ahead. I’ve found that amongst the 7,000 or so BDC-financed companies less than 150 at any time are sufficiently large in terms of exposure and in deep enough credit trouble to materially impact BDC book value and income. Thanks to my research I like to think I can ascertain in advance most of the credit losses - ahead.

By the way, and I think this is something you rarely find out in the financial world: Pretty much all my research and my investment conclusions about the market and individual BDCs can be found in my 3 BDC Publications. For any self-directed BDC investor, there is plenty there to review and consider when making your own investment decisions. I’m warning you, though, that doing one’s homework in BDC-land is time-consuming when done right.

That’s the research process. When it comes to investing, it’s important to know that BDC stock prices fluctuate a great deal. I look for an entry point when those “good” BDCs my research has turned up are available at a relative bargain price. Most of the time I stay away from poorly performing BDCs however low their stock price has dropped. I typically assemble a portfolio of 10 to 15 individual BDC stocks and I also invest in BDC Baby Bonds. The latter were very good to us for many years as our fund is leveraged and we benefited from the interest rate arbitrage between the income on the bonds and the cost of margin borrowing.

Ideally, I do not trade in and out very much. Having and holding and re-investing those monthly or quarterly payouts is what generates superior returns. Patience is very important in BDC investing - a quality many investors lack, including myself at times.

When analyzing individual BDCs, which financial metrics or indicators do you prioritize, and why? For instance, how important are factors like net asset value (NAV) per share trends, dividend coverage (net investment income), portfolio credit quality (non-accrual levels), or fee structure in your assessment?

Fortunately or unfortunately, all investing - and BDCs are no exception - is as much art as science, regardless of all that data we pile up. Also, every individual metric that I and everyone else looks at can be misleading when taken in isolation. Oh, your non-accrual as a percentage is down! Is that because you’ve just written down a bunch of investments because you’ve given up hope of any recovery or because the companies are performing better? However, if I was to write an algorithm that would identify the best performing BDCs I’d use several metrics in combination: changes in Net Asset Value Per Share over the short, medium and long term; the percentage of portfolio assets under-performing and recurring earnings per share both current and expected and a host of others. However, the Holy Grail I’m looking for is a BDC which can increase its net book value over time; pay out a decent dividend and stay away from too much in the way of credit trouble. The data only provides hints - and sometimes misleading ones at that. At the end of the day no algorithm will do - a very human opinion is needed - one that takes into account a whole host of hard and soft facts.

Should more professional investors care about BDCs? Is there room for real outperformance investing in BDCs or are they mainly vehicles for individual investors to get dividend income?

Admittedly, BDC investing is not like VC investing in the sense that you’re not likely to see a company provide a return of 10X, 20X or 100x your initial stake. That’s partly because BDCs are handcuffed by their format. All earnings have to be paid out rather than retained and leverage is limited so unlike a bank which can have assets 10x or 14x its capital BDCs are limited to two to one and most self limit themselves to just over 1:1 leverage. That keeps BDCs from earning too much on a per share basis and then there’s always the risk of having your capital eroded by investment losses. The S&P BDC Index says that over the last 10 years the annual gain has averaged 8.7% - not bad, but not great.

With that said - and I know it’s counterintuitive - there is plenty of room for what you call “real outperformance”, even against the standard of the almighty S&P. Over the last 10 years, the S&P has generated a remarkable gain of 215% with dividends reinvested. In that same period, 9 of the 32 public BDCs around for that entire period have performed better, according to Seeking Alpha data. In fact, the best-performing BDC returned twice the total return of the S&P.

Oh, you might say - nobody invests for a decade. However, even over the last 5 years when the S&P 500 climbed 96%, 27 of 37 BDCs performed better - as much as three time better. For BDC investing, picking the right stocks and avoiding the wrong ones is critical which is why we don’t just “buy the index” and save ourselves all this research.

Ironically, investors who see BDCs just as vehicles to harvest dividends and fail to reinvest are missing out on the power of compounding.

One last point that’s worth mentioning: the structure of the BDC format makes it difficult for investors to lose too much money even if they repeatedly choose the wrong BDCs. Going back to that Seeking Alpha total return data. Over the last 5 years, not one of the BDCs involved ended up in the red. Over 10 years, there were only 4 losers out of 32 BDCs. Of course, that implies a buy-and-hold approach.

Investors who flit from BDC to BDC - as in any investing - can lose a bundle and have as volatility is high. This year the only BDC ETF fell 24% in a few weeks. In one month in March 2020, the sector dropped more than 50% in price. When Silicon Valley Bank failed, there was a 10% drop. During the GFC, the price of Ares Capital - then and now the largest public BDC - dropped 87%. If patience is important in BDC investing , so are nerves of steel. By the way, Ares and everybody else recovered from all those price collapses but some investors did not.

What are some common misconceptions or pitfalls you see when experienced investors first venture into the BDC asset class?

First, there are huge variations in how BDCs perform. Partly, that’s because BDCs operate in many different segments of the non-investment grade market. We’ve identified 5 distinctly different segments, each with very different economics; risks; and competitors. You really can’t compare a venture-debt BDC, principally lending to start-ups with no profit history with a BDC serving borrowers in the upper middle market involved with billion dollar loans.

Second, BDCs are not just lenders. They are also minority equity investors in the companies they lend to and when needed they can become turnaround specialists. At times, they even command and control portfolio companies. When evaluating a BDC you have to look beyond credit results. Everybody lumps public BDCs into the wider category of “Private Credit” but the reality is more complicated than that given their ability to be private equity investors when they choose to, or when they are forced to.

Third, many investors see BDCs as a so-called bond proxy and they invest looking for a safe, steady dividend like a bond. Unfortunately, that’s not the case even though BDC managers try to pay out a reliable and steady dividend. Over time, though, dividends will fluctuate with changes in interest rates; credit losses and changes in the BDCs own payout strategy

Given your decades of experience following BDCs I imagine you’ve gotten to know some of the investment teams quite well. Which BDC CEOs/teams do you admire the most? Are there any you recommend people avoid?

I wouldn’t want to speak ill of any management team, nor do I need to. Most of the organizations are staffed with sensible people; with multiple degrees and decades of experience. Moreover, the managers are incentivized by the nature of the BDC model to keep risk manageable so you don’t get too many wild-eyed types. However, if I HAD to choose 3 organizations I have a special regard for I’d call out Ares Capital, the biggest and one of the oldest BDCs; Saratoga Investment which rescued a near bankrupt BDC and has transformed it into a market leader in the lower middle market and Barings BDC, which has built up a highly diversified portfolio from scratch after buying out Triangle Capital and immediately selling all its investments. Still, there are many others. Is it coincidental that the BDCs I admire most are the ones that have performed best for me?

What are some interesting ideas on your radar now?

Right now, BDC prices are just recovering from Liberation Day and many are trading at healthy discounts to their price just 3 months ago. However, every other pundit recently is predicting a recession is in our future and we’re hearing more and more that credit is the wrong investment right now. We don’t think so but it is a time to be more careful than usual. With that in mind, there is one BDC I’m especially excited about now.