Carlyle Secured Lending: Exceptional Dividend Yield, Solid Net Investment Income Coverage

Carlyle Secured Lending Inc (NASDAQ:CGBD) reported another set of solid quarterly results earlier this week. From these results it is clear that the BDC continued to perform well, and the dividend remains adequately covered by net investment income (NII). However, like many other BDCs, Carlyle Secured Lending saw a decline in net asset value (NAV) in the second quarter of 2023. This decline in NAV might justify the slight discount to NAV at which the BDC is currently trading i.e. investors are already factoring in NAV declines into the share price.

Nevertheless, given the strong fundamentals of the BDC and its attractive dividend yield, Carlyle Secured Lending should be added to the watchlist of income investors with the risk appetite for investing in high yielding BDCs.

Carlyle Secured Lending’s Portfolio

In my recent article on Goldman Sachs BDC (GSBD), I discussed the substantial increase in the higher risk segment of its portfolio and the risk this poses to investors in the BDC. Carlyle Secured Lending has similarly reported an increase in its internal risk rating category 3 loans albeit not to the same extent as Goldman Sachs BDC. In the case of Carlyle Secured Lending, category 3 loans as a percentage of the BDCs total portfolio increased from 12.9% in the first quarter of 2023 to 14.9% of its total portfolio in the second quarter of 2023.

Carlyle Secured Lending includes loans in risk category 3 where the borrower is operating below expectations and the level of risk to the BDCs cost basis has increased since the time of origination. It notes that in these cases the “borrower may be out of compliance with debt covenants” albeit that payments are generally current. This definition indicates that risk category 3 at Carlyle Secured Lending is not comparable to risk category at Goldman Sachs BDC, instead its definition of category 4 aligns more closely with GSBD’s category 3. Investors interested in both these BDCs should thus be cautious not to take a more pessimistic view of Carlyle Secured Lending whose category 3 portfolio represents double the category 3 portfolio for GSBD.

Carlyle Secured Lending’s category 4 as a percentage of its total portfolio represents only 2.3% of its total portfolio. Management defines its internal risk as category 4 where the “borrower is operating materially below expectations and the loan’s risk has increased materially since origination. In addition to the borrower being generally out of compliance with debt covenants, loan payments may be past due, but generally not by more than 120 days.” This category aligns with the definition of risk category 3 at GSBD. Promisingly Carlyle Secured Lending nearly halved the percentage of its overall portfolio that is classified in this higher risk category.

In recent months, there has been a marked decline in new originations from the BDC which might concern some longer-term investors. These declines in new originations have contributed to sales and repayments exceeding new originations in the two previous quarters with net investment activity for the first and second quarters of 2023 being negative. In its second quarter earnings call management has indicated that for the time being it remains focused on the credit fundamentals. In my view, given the overall increase in higher risk category loans and several borrowers starting to perform below expectations the more cautious approach by management seems wise.

In the second quarter, NAV per share declined from $17.09 per share in the first quarter to $16.73 per share in the second quarter of 2023. The decline in NAV was largely due to a markdown in one of the BDCs healthcare services investments, American Physician Partners. These kinds of markdowns are not uncommon and do not give rise to any substantial concern in my view.

However, for me personally, the equity portion of a BDCs portfolio often raises the most concerns given the inherent difficulty in valuing such positions. The value of these positions may occasionally need to be adjusted by a BDC resulting in a decline in NAV. The equity portion of Carlyle Secured Lending is only around 6% of its total portfolio, meaning that any possible write-downs there would have a more limited impact than at other BDCs where these portfolios are often bigger.

The Dividend and its Safety

Carlyle Secured Lending currently offers an attractive dividend yield of just over 9.5% which is the second lowest of the major BDCs included in the peer comp charts below. However, when factoring in special dividends, the dividend yield would exceed 11%. While a special dividend is more likely to be reduced than an ordinary dividend, Carlyle Secured Lending has a long history of regularly paying special dividends. The BDC has paid a special dividend each quarter since the second quarter of 2020 and before that had a history of declaring at least one special dividend per year.

The BDCs one-year average NII coverage ratio at more than 140% is also by far the highest of any of the major BDCs considered in the peer comp charts below. This trend has also persisted in the second quarter of 2023 with the BDC reporting NII per share of $0.52 and an ordinary dividend of $0.37. If the special dividend is included in the calculation the total NII coverage ratio for the second quarter of 2023 was still around 118%. This means that both the dividend and the special dividend were well covered in the past quarter and decreases the likelihood of a dividend cut.

Nevertheless, the BDC is currently adopting a balanced approach between distributions to shareholders and the retention of NII to protect the BDCs NAV. In its earnings call management has noted that –

[the] total dividend level of $0.44 allows us to build NAV in the face of an increasingly complex macroeconomic environment….we remain highly confident in our ability to comfortably meet and exceed our $0.37 base dividend and continue paying out supplemental dividends each quarter.

These remarks should be seen as positive for income investors seeking stable dividends. In my view, the significant NII coverage certainly lends credibility to these comments made by management and provides a good buffer to protecting the dividend even in the event that the BDC should face some headwinds up ahead.

Valuation

Carlyle Secured Lending is currently trading at a slight discount to NAV of around 7%. This compares well to its other BDC peers and is a much lower discount to NAV than the BDCs 3-year average discount to NAV of around 20%. Despite being valued higher than its historical average, I am of the view that this improved valuation level is justified by the BDCs solid fundamentals.

That being said, the BDC is also not undervalued in my assessment. The slight discount to NAV may be justified by concerns over the slight decline in NAV albeit that these declines might well reverse in the third quarter. I will personally be monitoring NAV growth in upcoming quarters even though I am not particularly concerned about the decline in NAV this past quarter.

Conclusion

In my view, Carlyle Secured Lending reported strong quarterly results, reinforcing its solid performance and dividend coverage. While the rise in loans classified as higher-risk loans, especially in category 3, warrants investors’ attention, management’s prudent credit focus is reassuring. Therefore, I am not overly concerned with the credit quality of Carlyle Secured Lending at this time.

The dividend also continues to be well covered by NII and management seems committed to maintaining both the ordinary and the special dividend. While management has indicated an approach in which NAV growth through earnings retention will be balanced with the dividend payout, this does not suggest any dividend cut at the moment.