For Whom the NAV Works
Navonomics and walking the fine line between public and private BDCs
It’s no surprise to anyone that most public BDCs are trading materially below reported NAV. The market is saying one of three things:
1. The marks are too high. We do not believe that the underlying assets are worth 100 cents on the dollar, hence we will discount it.
2. The fee structure is not great for public market investors, hence we will discount it.
3. Both of the above.
So, in theory, and in isolation (more on this later), if the underlying assets are genuinely worth the book, buybacks should be a great use of capital. So why haven’t we seen BDC managers do this? One could argue that this is as much a story about incentives as it is about capital allocation.
As a shareholder in a BDC trading at a discount, the argument and the incentives for a buyback is straightforward:
If the reported NAV is real, then the buyback should be materially accretive. Consider a fund with $100 of NAV per share and 100 shares outstanding. This implies $10,000 of equity1. If it buys back 10 shares at $75, it spends $750 and leaves $9,250 of equity spread over 90 shares, so NAV per remaining share rises to about $102.78.
The above math makes sense if the reported NAVs are real. In the case that the underlying asset value is not $100, and is instead worth, say $80, then buying back at $75 is only mildly accretive. The equation really doesn’t work if the underlying asset value is at $70, where the buyback is destructive as now the management will be overpaying for their own assets.
Also, there would be two groups of shareholders with different objectives, both of whom should like the idea of a buyback. The long-term holder would want share value accretion. The shareholder who wants liquidity would want a tighter discount and a higher exit price. These are not identical incentives. A buyback would benefit the first group immediately if the marks are right, but would only help the second group indirectly if the market re-rates the stock upwards. In that case, both groups of shareholders get the benefits from the value accretion, and additionally from any narrowing of the discount.
Yet what looks like an obvious trade for the shareholders might not be as intuitive for the management. As the fund manager for this BDC that trades at a discount, the argument and the incentives aren’t really that straightforward:
A buyback would be a public certification of the marks, where the manager would effectively be saying: “we are so confident that the gap between the price and the NAV is irrational, that we are using real cash to arbitrage it.” There are reasons a manager would say that in an earnings call, but not want to act on this bet; because if, for any reason2, the stock still does not re-rate upwards, or if later the marks come down, management looks worse off than it did before the buyback.
The management looks worse, because now they’ve not only used up scarce liquidity, but effectively also raised the leverage. Even if that is mathematically accretive in the moment, it could reduce flexibility for the future. The manager may prefer to keep cash for new investments, dividends, or simply protection in a stressed market. Less equity and higher effective leverage could also result in knock-on effects; re-ratings by creditors and credit agencies can lead to deteriorating access to debt markets.
Essentially, for shareholders, the buyback works if the repurchase price is below true NAV. A market re-rating helps, but it is not what makes the trade accretive. For managers, the re-rating matters much more as this is as much a signaling exercise as a capital allocation one. Without the market’s endorsement, the company may just have spent cash defending a book value the market still distrusts, leaving behind a smaller vehicle with less flexibility and a more exposed credibility problem.
At the beginning, we said that buybacks should be great for public BDCs in theory, and in isolation.
Publicly traded BDCs clear in the market every day, even when they trade below NAV. Privately traded credit funds, on the other hand, are periodically redeemed in intervals that are capped, but at NAV. In this broader platform structure for the parent private credit firm, where both vehicles may share portfolios with similar underlying assets, the BDCs just might not have the luxury to make this capital allocation in isolation.
Because by making a bet on your publicly traded vehicle that you believe is undervalued relative to NAV, the signal you are sending to the market about the marks and the liquidity for the private vehicle is that a real market-clearing price does exist below the stated book value. This makes the logic of redemptions from private funds at NAV even stronger. In an already tense environment of limited liquidity and gated redemption requests for privately traded funds, the dynamics could become much more difficult to manage.
Notes:
Not considering leverage. 1. For a 1:1 debt to equity, the leverage ratio moves from 1.0x to 1.08x. The need for the reported NAV to be real is even more pertinent.
This could be for any reason outside of the manager’s control, macro factors, a credit crunch, commodity shocks, missteps in other parts of private equity, private credit.
Asset sales can be structured in a way as to not increase leverage. Blue Owl reportedly paired repurchases with a $1.4 billion asset sale to create balance-sheet flexibility and reduce leverage