Business development companies, known as BDCs, have performed well since the rate hikes began. They thrive during periods of rising interest rates, while REITs struggle. Why? Because they usually provide high yields compared to the latter.as REIT Sector (Virtual NetworkQ) fell more than 6% last year and 7% last month, and the BDC ETF (us) has returned quite well over the last year, around 16%, and is up 1.4% over the past 30 days. That’s because many investors are now looking for higher-yielding investments while awaiting a decision from the Federal Reserve on when to cut interest rates.
Which brings me to Runway Growth Finance (NASDAQ: RWAY). I’ve discussed this BDC with some of my readers, and honestly it’s not well-recognized. There’s a lot of coverage on Seeking Alpha. The stock currently has just 133,000 followers, which is very low compared to some of its more popular peers Ares Capital (Asian Studies Center) and Main Street Capital (main), over 72k and 68k respectively. To be fair, RWAY is a fairly new BDC, having IPOed in 2015, only 8 years ago. In my opinion, this BDC is a sleeper bond, so let’s take a look at why you should consider this high-yield bond in your portfolio.
Who is Runway Growth Finance?
RWAY is a BDC that prefers investing in companies operating in the technology, life sciences, healthcare, products industries, as well as information, business and select consumer services. They like investing in these industries because these organizations are committed to shaping the way we live, work and do business. Since 2015, RWAY has supported more than 60 companies in these industries and provided financing to more than 72 companies with total loan commitments of $2.3 billion. Simply put, BDCs borrow debt at fixed rates and make loans to companies in their portfolio at floating rates. This is why BDCs thrive in a high interest rate environment, while REITs do the opposite. Many BDCs have floating rate portfolios, which means that while interest rates are still high, it is additional income for them.
RWAY differentiates itself from other BDCs in that it focuses on late-stage and growth companies, providing risk mitigation across economic and market cycles, resulting in stable portfolio returns and lower credit losses. These companies also have strong insider ownership and offer unique portfolio expansion opportunities. RWAY typically invests in companies with loan amounts of $1 billion to $100 million.
Growing and diversified investment portfolio
The company’s largest industry is health care technology, accounting for 24%, with applications software and human resources and employment services ranking second and third, accounting for 10% and 9%, respectively. Since the company is headquartered in California, it makes sense that the majority of its life sciences portfolio is located in the Western United States. In addition to diversification, another thing I like about RWAY is that 100% of their loans are in floating rate investments, with 99% invested in first lien loans and the remaining 1% invested in second lien loans. By comparison, popular peer and largest BDC Ares Capital has 42% invested in first-lien loans and 68% in floating-rate debt.
As a result, the company seeks and prefers to invest in first-lien loans, which is an important factor, especially given the current macro environment. The reason is that although business development companies’ net profits increased last year, some business development companies also saw increases in non-accrual loans during the same period. As interest rates rise, they will demand more income from their variable-rate portfolios, and tenants will have a higher propensity to default on their loans. This in turn means less money is collected from tenants, which equates to less revenue for the BDC, which is ultimately reflected in reported earnings. Investing in a first-lien loan gives RWAY priority over all other debt holders, reducing the likelihood of this happening.
Strong management team
One thing to note is that RWAY is externally managed, similar to ARCC. This is important because investors generally prefer internally managed companies because they are more aligned with shareholders. Investors must also be aware of the additional costs associated with outside management.
But aside from being a fairly new BDC, the RWAY management team is still strong. In the current economic climate, a good management team is very much needed to successfully survive the economic downturn. Especially if the country does go into recession.
The company’s founder and CEO David Spreng is currently on temporary leave to undergo a medical procedure. Their founders served on the boards of 11 public companies before joining RWAY. Runway Growth Finance Corp. is currently led by former Chief Information Officer Greg Greifeld, who has been with the company since 2016. Greifeld previously held a variety of roles at JPMorgan Chase & Co. (JPM), including technology, media, investment banking and special investment groups. So while their interim CEO is new, he has extensive experience working at behemoths like JPMorgan Chase.
conservative balance sheet
As BDCs’ revenues increase, they often reward shareholders by supplementing and increasing their dividends. But one thing investors must pay attention to is debt maturity. If interest rates do continue for an extended period of time as stated, some people may have to refinance their debt at higher rates. Although inflation is trending lower than last year, it remains sticky. That could prompt the Fed to raise interest rates further, but markets believe the Fed will keep rates steady for the rest of the year. I don’t have a crystal ball, so I can’t say whether they will, but I think it all depends on the data. If inflation remains high and CPI picks up, I may raise rates again at the next meeting.
If so, businesses will certainly feel more pain in the short term. That’s why a strong balance sheet is important when looking at current high-yield investments. Unlike peer ARCC and popular monthly payer MAIN, RWAY has no debt maturities until April 2026. Both MAIN and ARCC have debt maturities in 2024 and 2025. Below I’ve created RWAY’s debt maturity schedule from now until the end of the year 2027.
BDC has $25 million in notes due in April. The bonds have an average interest rate of 8.54% and a maturity amount of $70 million at the end of the year. The loans have an average interest rate of 4.25% and will have a total maturity amount of $90 million by 2026. I think it’s safe to say that interest rates will be even lower by then, so I’m not worried about that at all. Additionally, the company has enough cash on its balance sheet to cover this charge, with $228 million in liquidity, including unrestricted cash and cash equivalents. RWAY has a total of $152 million in notes due in 2027. The average interest rate on these notes is 7.5%.
In addition, RWAY has been reducing leverage, and its leverage ratio is among the lowest in the industry within the D/E target range of 0.8-1.1x. They also managed to reduce leverage from 1.04x to 0.97x quarter-over-quarter and improve asset coverage from 1.96x to 2.03x, which is impressive considering the current environment. All investments in the second quarter were financed through leverage as part of its strategy to achieve future non-dilutive portfolio growth.
As of this writing, RWAY currently yields over 12%. BDC currently pays a $0.40 dividend, and during Q2 earnings, management announced an additional $0.05 per share, to be paid in conjunction with the regular dividend, for a total of $0.45. Their net income and profits performed well, with NII of $0.49 and revenue of $41.9 million. Total investment income and net investment income increased by 67% and 36% respectively year-on-year in this quarter. Net investment income increased to $19.7 million from $14.5 million. Additionally, they managed to increase their NAV from $14.07 to $14.17, but this was down from $14.22 at the end of 2022.
Judging from the rise in investment income, BDC is highly sensitive to rising interest rates, serves the company well, and is also beneficial to shareholders. With this in mind, the company has raised its dividend a total of 5 times since rates began rising from $0.27 to the current level of $0.40. Additionally, they have announced a total of 3 additional statements since the beginning of 2023.
The biggest risk BDC currently faces is an increase in non-accrual loans. These loans are from tenants that have not been paid and have been in non-accrual status for at least 90 days. Some BDCs have reported an increase in non-accrual expenses over the past few quarters as interest rates have risen rapidly. RWAY reported zero credit losses year-to-date in 2023. With talk of a recession seemingly heating up recently, management expected volatility to continue in the second half of the year, and that’s already happened. The company plans to actively manage its investment portfolio as financial conditions tighten. RWAY had only one company in non-accrual status at the end of the quarter. If interest rates continue to rise and remain high, BDC may see more companies in non-accrual status.
Although this BDC is fairly new and unknown, the company appears to be on the right track and could be a potential long-term investment for those focused on dividends. In my opinion, BDC is poised for growth and currently offers investors a safe, high yield of over 12%. Additionally, they have a growing portfolio focused on first-lien loans, along with a conservative balance sheet and good debt maturities. If interest rates do stay high, RWAY will continue to benefit from its sensitivity to interest rates. The company is also trading below NAV, which is rare these days as many companies trade above NAV. Investors looking for a potential star in the high-income and BDC space should consider adding RWAY to their portfolio.