The decision to grant secured loans to Blackstone (NYSE:BXSL) my second largest business development company after Hercules Capital (HTGC) was motivated by three fundamental factors. BDC’s net asset value per share has increased, it continues to exceeded its quarterly base dividend and underwriting quality remains extremely high with non-accrual loans at 0.1% at the end of its third quarter of fiscal 2023. BDC last declared a dividend quarterly cash basis $0.77 per share, maintained unchanged sequentially, for an annualized forward dividend yield of 11.2%. Importantly, this was covered 123% by Q3 net investment income from $0.95 per share. That’s growth of 19% year over year, but a sequential decline of 11 cents from $1.06 per share in the second quarter.
This means that dividend coverage has increased from 138% in the second quarter, as the net asset value at $26.54 per share increased by 3% over one year. Net asset value per share increased by 24 cents sequentially to maintain what has been a steady rise in net asset value since the start of 2023. This growth is expected to continue, with the dividend expected to be maintained at its current level in the near term. There was no indication from management during their third quarter report call for results that they intend to increase the base distribution, with a focus on defending NAV and protecting investor capital.
Credit underwriting quality, bad loans and investment activity
BXSL’s investments at fair value stood at $9.5 billion at the end of the third quarter, up approximately $200 million sequentially as overall health indicators remained strong. Unaccounted loans remained below 0.1% of fair market value and amortized cost, with the portfolio diversified among 188 companies, an increase of 8 companies from 180 in the second quarter. BXSL’s non-accruals are among the lowest in the entire BDC sector and highlight the strength of its underwriting.
When aggregated with its investment category”BBB-“Fitch Credit Rating, BXSL is a strongly defensive ticker heading into a year where interest rates will play a more limited role in generating investment income. BXSL’s average loan-to-value ratio has increased slightly by 40 basis points sequentially to 46.9%, but the fundamentals of its portfolio companies are ahead of those of its private credit peers. The EBITDA margins of its portfolio over the last 12 months are 20% higher than its peers, with growth twice that of its peers.
BXSL’s focus on large mid-market companies is attractive because it incorporates lower credit risk, which means fewer defaults. BXSL successfully tilted its portfolio toward larger, higher-growth companies and achieved a competitive annualized return on equity of 14.4% on its third-quarter NII. Indeed, 99% of funds invested during the first quarter were allocated to senior securities secured at an average loan-to-value ratio of 35.9%.
2024 will test the Goldilocks economy
Net funded investment activity in the third quarter was $185 million, a huge increase from the previous four quarters. Indeed, investment commitments of $656 million during the third quarter were higher than those of the previous three quarters combined. This involves preparing for continued growth in a falling rate environment. To be clear, given that BXSL’s portfolio was 98.8% invested in floating rate investments at the end of the third quarter, BDC should still be able to generate or maintain the investment income of a larger portfolio, even if interest rates fall next year.
The potential decline in NII and NAV following an interest rate cut next year is what keeps me up at night. The most successful BDCs will be those able to continually expand their portfolio while keeping non-accruals low to maintain NAV growth. The fear is that some BDCs, faced with lower interest rates and a potentially more turbulent economy, will see their in-kind income increase and their unaccrued loans increase. This will force some to essentially pay their dividends from net asset value. BXSL saw its PIK income as a percentage of total investment income fall to 3.87% from 4.85% in the year-ago quarter, a decline of 97 basis points.
BXSL’s debt-to-equity ratio also declined and stood at 1.08x at the end of the third quarter with a funding profile heavy in fixed-rate unsecured bonds that only begin maturing in January 2026 , the date on which $800 million comes due. The Fed’s December dot chart showed interest rate cuts worth 75 basis points next year, a move that would of course reduce the cost of its variable-rate loans, but would have a greater negative impact on its almost 100% variable rate portfolio. The pace and intensity of interest rate cuts will be the primary determinant of BDC value creation next year, and BXSL is a buy on any dip as a highly defensive play on the potential reversal of 2024 on what has so far been a Goldilocks economy for BDCs.