Capital Southwest (CSWC): BDC Buzz Initiates Active Coverage

The following is a quick CSWC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

I have added Capital Southwest (CSWC) to active coverage and included in the BDC Google Sheets along with its Baby Bond that trades publicly on the NASDAQ under the symbol “CSWCL”. CSWC is an internally managed BDC with a $524 million portfolio with mostly first-lien debt positions and equity investments providing realized gains especially in its lower middle market investments similar to Main Street Capital (MAIN).

CSWC has increased its regular quarterly dividend each quarter since 2015 and equity participation is partially responsible for supporting continued quarterly supplemental dividends of $0.10 per share. The current dividend yield is around 9.5% (MAIN is currently 7.1%) which takes into account the recently announced $0.39 quarterly regular dividend and quarterly supplemental dividends of $0.10.

I will have a public article next week on Seeking Alpha discussing the initiation of active coverage. It is important to note that public articles will NEVER discuss specific dividend coverage levels, risk rankings, Target Prices, buying points, EPS/NII projections, etc. as that information is exclusively for subscribers of Premium Reports.

Summary

  • CSWC has ‘Level 1’ dividend coverage mostly due to its ability to leverage its internally managed cost structure.
  • CSWC has been included in the suggested ‘Total Return’ portfolio due to its debt portfolio that is mostly first-lien positions and the potential for realized gains from its equity investments, especially in its lower middle market investments.
  • CSWC continues to increase leverage growing its per-share economics. I am expecting continued supplemental dividends and portfolio growth driving increased regular dividends over the coming quarters.
  • Management is expecting higher expenses in calendar Q2 2019 due to “seasonal operating expenses” and has been taken into account with the previously discussed financial projections.
  • Subsequent to quarter-end, CSWC exited its investment in Prism Spectrum Holdings that resulted in a realized gain of $226,000.
  • CSWC has a history of stable portfolio credit quality that delivers a consistent and growing stream of recurring interest income with the potential for increased earnings through higher leverage and its I-45 Senior Loan Fund.
  • CSWC had undistributed taxable income generated by excess income and capital gains accumulated through March 31, 2019, of approximately $20 million or $1.14 per share.
  • My primary credit concerns include its positions in AG Kings Holdings Inc., American Addiction Centers (AAC), and American Teleconferencing Services.
  • As of March 31, 2019, only AG Kings was on non-accrual status with a fair value of $8.3 million, representing 1.6% of the total portfolio or 2.6% of NAV per share.
  • American Teleconferencing Services (“ATS”) is an investment also held by MAIN that operates as a subsidiary of Premiere Global Services (“PGi”). ATS was marked down during calendar Q1 2019 but still accounts for 1.1% of the portfolio and 1.7% of NAV per share and needs to be watched. On January 28, 2019, Moody’s downgraded PGi’s debt to Caa2.
  • On July 1, 2019, AAC submitted a plan to the NYSE regarding the company’s efforts to improve its total market capitalization, following notice on May 17, 2019 from the NYSE that its stock was at risk of being delisted.
  • There is a good chance that AAC will be selling its real estate assets to avoid bankruptcy and is likely why CSWC has only slightly marked down its first-lien loan. AAC still accounts for around 1.6% of CSWC’s portfolio and 2.6% of NAV per share
  • Equity participation is partially responsible for growing its NAV per share as well as ‘recurring non-recurring’ income, which contributes to the growing amount of undistributed spillover income and gains used to support supplemental dividends.

 

On September 30, 2015, the company completed the spin-off of CSW Industrials, Inc. (CSWI) that is now an independent publicly-traded company. As shown below, there were many reasons for the spin-off including investment concentration issues in assets that did not provide support to pay a “meaningful dividend”:

 

However, the company was able to create significant value for shareholders through the transaction and continues to rotate the portfolio into income-producing assets.

 

“Executing our investment strategy under our shareholder-friendly, internally-managed structure closely aligns the interest of our board and management team with that of our fellow shareholders in generating sustainable, long-term value through recurring dividends, capital preservation, NAV per share growth, and operating cost efficiency. While generally fixed nature of our internally managed BDC cost structure improved operating leverage to 2.8% by the end of the year. These factors both contributed to the substantial year-over-year growth in dividends paid to our shareholders.”

CSWC Dividend Coverage Discussion:

CSWC has the ability to leverage its internally managed cost structure. CSWC has a history of stable portfolio credit quality that delivers a consistent and growing stream of recurring cash interest income with the potential for increased earnings through higher leverage and its I-45 Senior Loan Fund. CSWC had undistributed taxable income generated by excess income and capital gains accumulated through March 31, 2019, of approximately $20 million or $1.14 per share.

“Our operating leverage, continues to improve and look toward our target of sub 2.5%. As of the end of the quarter, operating leverage was 2.8% down from 2.9% at the end of the prior quarter, and 4.9% as of the end of fiscal year 2016. We continue to actively manage operating costs in lockstep with portfolio growth and expect to achieve our target operating leverage over the next several quarters. With all senior professionals and corporate infrastructure largely in place, portfolio growth from here should continue to improve our operating leverage, due to our internally managed structure.”

Management is expecting higher expenses in calendar Q2 2019 due to “seasonal operating expenses” and has been taken into account with the previously discussed financial projections:

“Looking ahead to the June 30, 2019 quarter, we do expect to incur certain seasonal operating expenses such as payroll taxes associated with our annual bonus payment and annual shareholder meeting expenses that are incurred.”

CSWC continues to increase leverage growing its per-share economics quarter-over-quarter which is the primary driver for continued higher returns to shareholders. I am expecting continued supplemental dividends and portfolio growth driving increased regular dividends over the coming quarters.

“We continue to grow dividends as we continue to migrate the balance sheet towards target leverage levels through thoughtfully building a portfolio of well performing income generating assets. The regular dividend of $0.39 per share for the current quarter ending June 13 announced in last night’s press release marks our fourteenth consecutive quarterly regular dividend increase. We continue to focus on growing our regular dividends in a sustainable manner demonstrated by our cumulative regular dividend coverage of 105% over the last 12 months, 104% since the launch of our credit strategy four years ago. We are pleased to report that our assets, income and shareholder dividends grew substantially throughout the year, producing a 37% total return to shareholders, driven by a 24% increase in stock price and $2.27 per share in dividends paid out to shareholders during the fiscal year.”

Its I-45 Senior Loan Fund accounts for 13% of the portfolio and is a joint venture with MAIN created in September 2015. The portfolio is 94% invested in first-lien assets with CSWC receiving over 75% of the profits providing 15% annualized yield:

“Overall, we have been pleased with the solid performance of I-45 over the past 3.5 years. We and our partner in I-45, Main Street Capital, have invested approximately $500 million through the fund and have harvested 50 exits generating $196 million in proceeds at a weighted average IRR our on the exit for the 11.4%. Our senior loan fund, I-45 also continued its solid performance producing a 15% annualized yield on our capital in the fund for the quarter.”

 

The updated projections assume a mostly stable portfolio yield of around 11% which is lower than the yields on new investments during the previous quarter:

“Our originations this quarter consisted of $28 million in Senior Secured 1st Lien Debt with a weighted average yield of – weighted average yield to maturity of 12.5% and 1 million in equity.”

Since March 31, 2019, as shown below, CSWC has completed three new transactions totaling $23 million in senior secured first-lien debt at lower yields and exited one portfolio company for the total proceeds of $20 million.

“Our pipeline remains strong and we can currently have several lower middle market deals signed up with expected closings in late June and July.”

Its regular quarterly dividends are covered mostly through recurring cash sources:

Similar to MAIN, the supplemental dividends are typically covered by realized capital gains and over-earning the regular dividend:

“We generated $0.42 per share of pre-tax net investment income and paid a regular dividend of $0.38 per share. Additionally, we distributed $0.10 per share through our supplemental dividend program funded by our sizable undistributed taxable income balance or UTI, which was generated by excess income and capital gains accumulated from our investment strategy today. As of March 31, 2019, we had approximately $20 million or $1.14 per share in UTI, providing visibility to continuing the quarterly supplemental dividend program well into the future. This program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio. The program will continue to be funded from our UTI earned from both realized gains on debt and equity, as well as undistributed net investment income earned each quarter in excess of our regular dividends.”

Subsequent to quarter-end, CSWC exited its investment in Prism Spectrum Holdings that resulted in a realized gain of $226,000:

 

On April 25, 2018, the Board of Directors unanimously approved the application of the modified asset coverage requirements and the minimum asset coverage ratio applicable to the company was decreased from 200% to 150%, which became effective April 25, 2019.

“The Board of Directors also approved a resolution which limits the Company’s issuance of senior securities such that the asset coverage ratio, taking into account any such issuance, would not be less than 166%.”

Management is targeting a debt-to-equity ratio between 1.00 and 1.20 which is taken into account with the previously discussed financial projections:

“Let’s say, you utilize 90% of the credit facility, you are basically within our target leverage of 1.0 to 1.2. So, having that capital deals, okay, we’ve raised the capital irrespective of what happens in the market, the capital markets to approach target leverage is important to us strategically.”

“During the year, we also made significant progress towards diversifying our capital sources, while reducing the cost of our debt capital. We increased commitments on our revolving line of credit to $270 million as of the end of the year from $180 million at the beginning of the year, while also meaningfully decreasing the cost of the credit facility and amending the terms to allow for the additional leverage now allowable under the Small Business Credit Availability Act.”

In December 2017, CSWC issued $57.5 million in aggregate principal amount of 5.95% Baby Bond Notes due 2022 that trade publicly on the NASDAQ under the symbol “CSWCL” and have been included in the BDC Google Sheets. In June 2018, the company established its “At-The-Market” (“ATM”) debt distribution agreement to issue up to $50 million in additional notes including $19.5 million during the last year:

“During the year, we also issued $19.5 million in additional baby bonds through our debt ATM program. We raised $13.2 million through our first equity offering since our IPO in 1961 and we raised an additional $5.5 million in equity through the launch of our equity ATM program. Subsequent to year-end, we further upsized our revolving line of credit by adding an additional commitment for $25 million from a new lender resulting in the current total of $295 million in commitments from 10 lenders in our facility.”

On May 23, 2019, the company announced the expansion of total commitments under its revolving credit facility from $270 million to $295 million. The recent increase was executed under the accordion feature which allows for an increase up to $350 million in total commitments.

“On Slide 21, we lay out our multiple pockets of capital. As of the end of the quarter, we had approximately $141 million in cash and undrawn commitments available between our balance sheet and I-45 with the earliest debt maturity at December 2022. I should also note that subsequent to quarter-end, we added an additional $25 million commitment from a new lender to our credit facility, increasing total commitments to $295 million and our total cash and undrawn commitments between our balance sheet and I-45 to over $160 million. We feel good about our liquidity and capital structure flexibility and believe that it will allow us to thoughtfully grow our investment portfolio.”

On March 4, 2019, CSWC established its equity ATM program of slowly issuing small amounts of shares at a premium to book value/NAV and accretive to shareholders. During calendar Q1 2019, the company sold 263,656 shares of its common stock under the ATM program at a weighted-average price of $21.47 per share (~16% premium to previous NAV), raising $5.5 million of net proceeds after commissions to the sales agents on shares sold. Management will likely continue to use the ATM program for raising equity capital, rather than larger equity offerings. This approach is beneficial for many reasons including being more efficient, delivering higher net proceeds to the company and less disruptive to market pricing.

“CSWC launched its initial equity ATM program and raised $5.5 million. We believe our equity ATM program is a prudent and cost-effective way to issue equity over time at tight spreads to the latest trade, while selling equity on a just-in-time basis so it can be thoughtfully invested in income generating assets. We certainly intend to do that by growing the portfolio, but we want to be, and we use the word prudent, we want to be prudent and diligent of raising kind of on a just-in-time basis and certain amount of equity, again, allowing us to get to target leverage in a reasonable timeframe, but being diligent about being in on a just-in-time basis some level of equity into the capital structure. ”

October 4, 2018, CSWC announced that it completed an offering of 700,000 shares at a net price of $18.90 per share for total net proceeds of approximately $13.2 million.

CSWC Risk Profile Discussion:

My primary credit concerns for CSWC’s portfolio include its positions in AG Kings Holdings Inc., American Addiction Centers (AAC), and American Teleconferencing Services. As of March 31, 2019, only AG Kings was on non-accrual status with a fair value of $8.3 million, representing 1.6% of the total portfolio or 2.6% of NAV per share. This investment is still marked at 91% of cost and was discussed on the recent call:

“The company [AG Kings] is kind of performing generally the same. The management team is doing a great job, managing a tough business, and the lender group is supportive of the business and kind of working through the situation. So, that’s really all I can say about the company itself, but we brought the valuation down slightly this quarter, which you will see in the K.”

American Teleconferencing Services, Ltd. (“ATS”) is an investment also held by MAIN that operates as a subsidiary of Premiere Global Services (“PGi”), offering conference call and group communication services. As shown in the previous table, ATS was marked down during calendar Q1 2019 but still accounts for 1.1% of the portfolio and 1.7% of NAV per share and needs to be watched. On January 28, 2019, Moody’s downgraded PGi’s debt to Caa2:

Moody’s: “The downgrade of the CFR reflects Moody’s view that PGi’s EBITDA will deteriorate significantly over the next 12 months. Given PGi’s challenges, Moody’s believes that the company’s ability to meet covenants beyond 2Q 2019 is highly uncertain and the capital structure is unsustainable. The risk of default and debt impairment is high given the continuing erosion in revenues and EBITDA. PGi has proposed amendments to its existing credit agreements to waive the total leverage covenant for 2Q 2019 and a potential going concern qualification requirement in its 2018 financial statements. The company also expects to complete the sale of certain non-core assets in the near term, which management believes, along with the equity support, will provide the company adequate liquidity through 2019 to execute on its plans to commercially offer a new UCaaS offering. The continuing support from financial sponsors’ is credit positive. However, Moody’s believes that the proposed amendment and equity infusion will only improve PGi’s liquidity on a short-term basis.”

As of March 31, 2019, the portfolio (excluding the I-45 SLF) was weighted approximately 79% in the lower middle market (“LMM”), and 21% of the upper-middle market (“UMM”) on a cost basis. The leverage ratio of its UMM portfolio increased to 4.8 times, which was up from 3.8 times in the prior quarter, driven primarily by the underperformance in American Addiction, which increased its debt-to-EBITDA leverage ratio significantly quarter-over-quarter.

“Excluding this company’s underperformance, the leverage ratio through our security for the upper middle market portfolio would have been flat to last quarter at 3.8 times.”

American Addiction Centers is a provider of inpatient and outpatient substance abuse treatment services operating facilities located throughout the United States and is a subsidiary of AAC Holdings, Inc. (AAC) to which CSWC has invested $8.9 million slightly marked down to $8.4 million. On June 14, 2019, Michael Nanko, President and Chief Operating Officer of AAC resigned from his positions according to an AAC filing with the SEC. Mr. Nanko leaves AAC one month after CEO Michael Cartwright and CFO Andrew McWilliams conducted a call with investors to map out a 10-year strategy for the company to reverse a slide that began in 2015.

On July 1, 2019, AAC submitted a plan to the NYSE regarding the company’s efforts to improve its total market capitalization, following notice on May 17, 2019 from the NYSE that its stock was at risk of being delisted as its average market capitalization was less than the required $50 million over a 30-day trading period.

AAC received waiver defaults to remain operating but needs to improve its positive cash flows/EBITDA to avoid a bankruptcy/restructuring. CSWC management discussed its investment in AAC on the recent call:

“I’m just reiterating what you can go to their website and what you could hear them say is terrible market, but Google changed their algorithm, which affected their senses flow, patient flow or missions I should say in the fourth calendar quarter of last year. So, that brought on EBITDA pretty substantially kind of fourth quarter and into the first calendar quarter of this year. So, they are rebuilding from there. They have cut a bunch of cost, which we think is smart and they are rebuilding the admissions across their national franchise and so LTM EBITDA has come down, so leverage has gone up. They have got a very large real estate portfolio that I believe the market use and the management team says is worth in excess of the 1st Lien Debt, which is why that debt I think remains in the low-to-mid 90s kind of quoted level.”

However, there is a good chance that AAC will be selling its real estate assets to avoid bankruptcy and is likely why CSWC has only slightly marked down its first-lien loan. AAC still accounts for around 1.6% of CSWC’s portfolio and 2.6% of NAV per share.

“Despite its underperformance, we continue to feel reasonably confident about our 1st Lien position in the company, due to the value of its national substance abuse treatment franchise, managements operational efficiency initiatives, the tremendous demand for drug addiction treatment in the U.S., and the company’s large real estate portfolio associated with its street facilities.”

On March 15, 2019, S&P Global Ratings downgraded AAC Holdings Inc.’s issuer credit rating to CCC from B- after the company took out a $30 million term loan.

The outlook is negative for AAC, which provides substance use treatment services for people with drug and alcohol addiction, and co-occurring mental and behavioral issues in the U.S. S&P Global Ratings said the downgrade reflects an increased risk of default and risk that AAC’s liquidity will not be sufficient over the next 12 months as the loan matures in about one year. The rating agency expects AAC to monetize its real estate assets to repay the new term loan March 31, 2020, and fund its operations in 2019. It believes there are risks that proceeds from a potential sale-leaseback may not be sufficient to cover operating needs and repay the term loan. S&P Global Ratings noted that AAC’s solvency heavily depended on executing its cost-saving initiatives. The Brentwood, Tenn.-based healthcare facilities provider implemented a cost-reduction plan in December 2018 to improve liquidity and reduce operating expenses. The company said in its fourth-quarter earnings report that it has continued its expense savings initiatives into 2019, which combined with cost savings plan announced in 2018, will save about $30 million for the company. According to the rating agency, AAC faces significant operational uncertainties as the company works to improve its census. Another main constraint for AAC was weak free cash flow, which could be further impacted by litigation risk.

“Within our internal investment rating process, the changes for the quarter included an upgrade from 2 to 1 for the 1st Lien secured loan to Environmental Pest Service, due to the company’s strong performance and a downgrade from a 2 to 3 from a 1st Lien Senior Secured loan to American Addiction due to its underperformance. As a reminder, all investments upon origination are initially signed in an investment rating of 2 on a 4-point scale with 1 being the highest rating, and 4 being the lowest rating. Overall, we are pleased with the performance of the investment portfolio. As of the end of the quarter, of the 36 loans in the portfolio, we had 4 with the highest rating of 1, representing 17% of invested capital. We had 29 loans rated at 2, representing 77% of the invested capital. And we had 3 loans rated at 3, representing 6% of the invested capital. As of the end of the quarter, we had no loans rated at 4 in the portfolio.”

The portfolio has energy/oil-related exposure of around 1.9% and commodities/mining exposure of 1.6%. The energy investments are considered “midstream” as compared to “upstream” which usually involves more commodity-related risk.

 

As the portfolio has grown, the percentage of its debt investments (excluding I-45 SLF) represented by the lower middle market has increased by design to 78% and first-lien accounts for 86%:

“While we have increased the percentage of the portfolio represented by the lower middle market, we have also continued to heavily emphasize Senior Secured 1st Lien Debt in our investment strategy. As of the end of the quarter, we had 86% of our on-balance sheet credit portfolio in 1st Lien Senior Secured Debt.”

 

 

Its I-45 Senior Loan Fund accounts for 13% of the portfolio and is a joint venture with MAIN created in September 2015, 94% invested first-lien.

“the I-45 portfolio was 94% 1st Lien with diversity among industries at an average hold size of 2.1% of the portfolio. The I-45 portfolio had a weighted average EBITDA of approximately 68 million, and a weighted average leverage through the I-45 security of 3.9 times, which was up from 3.7 times at the end of the prior quarter. Here as well, the increase in the portfolio weighted average leverage was influenced by the underperformance of American Addiction. Without this underperformance, weighted average leverage of the portfolio would have been 3.6 times, which was down from 3.7 times at the end of the prior quarter.”

“In the upper middle market, over the past year or so we have been in an environment where it has been difficult to find value in syndicated loans. For the syndicated deals we have found acceptable from a risk return perspective, we have often chosen to pick small positions of approximately $5 million, which fit well into the I-45 portfolio. To the extent that syndicated spread widened, terms improve and we identify our especially attractive opportunities to invest in the upper middle market syndicated loans. We have the ability through our loan relationships with syndicate banks to capitalize on such opportunities either through additional exposure on our balance sheet or through I-45.”

CSWC has been included in the suggested ‘Total Return’ portfolio due to its debt portfolio that is mostly first-lien positions and the potential for realized gains from its equity investments, especially in its lower middle market investments(similar to MAIN). Equity participation is partially responsible for growing its NAV per share as well as ‘recurring non-recurring’ income, which contributes to the growing amount of undistributed spillover income and gains used to support continued supplemental dividends.

“In our core lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a highly performing and granular portfolio of equity co-investments is important to driving growth in NAV per share and aids in mitigating future credit losses. At the same time, our capability and presence in the upper middle market provides us the ability to opportunistically invest in a more liquid market when attractive risk-adjusted returns exist. Slide 12 illustrates our history of value creation from September 2015 to the date of our spin-off of CSW Industrials making Capital Southwest purely of middle market lender. Total value, which we show here as net asset value plus cumulative dividends paid has increased $5.03 per share to a value of $22.71 per share as of March 31, 2019 from $17.68 per share as of the spin-off. Our increasing regular dividend coupled with the supplemental dividend program and a well-performing investment portfolio should continue to create attractive long-term returns for our shareholders. During the year, we continued to advance the credit strategy we laid out for our shareholders over four years ago of prudently building a well performing credit portfolio through conservative late-cycle underwriting principals. We continue to be committed and excited about our core investment strategy of building a predominantly lower middle market portfolio consisting largely of Senior Secured 1st Lien Debt with equity co-investments across the loan portfolio, where we believe significant equity upside opportunity exists. The portfolio as a whole continued to perform well this quarter generating $3.6 million in net appreciation, which was the primary driver of our NAV per share growth to $18.62 per share”

“In the lower middle market, our robust origination platform continues to generate solid deal flow allowing us to close on some highly attractive opportunities from a risk return perspective. We believe that maximizing the top of our origination funnel is critical to generating strong credit investment performance over time as it ensures that we consider a wider array of deals allowing us to employ our conservative underwriting standards in a competitive market, and thoughtfully build a portfolio that will perform through the economic cycle. Our investment strategy has remained consistent since its launch in January 2015. We continue to focus on a blend of both lower middle market and upper middle market assets, providing us strategic flexibility as we have built the robust capability to seek attractive risk-adjusted returns in both markets.”

Q. “We’ve seen a continued escalation in the trade war, seemingly now and not just with China, but with other trading partners. Just wondering how much you are hearing this from your portfolio company management teams if at all if they see business as a threat or potential threat to any business?”

A. “Yes, it’s definitely something that the management teams in our portfolio that have inputs there and shipping in the country are paying attention to. We’ve looked at our portfolio and the general comment I would make is, you know the companies in the portfolio that it could is or could affect the cost structure. They’ve really all been situations where the price increase that they would need to pass on to the customer is small enough and they are in markets where we think that they could pass it on. So, as you hear that you hear that obviously in the Reuters account in news cycle of consumer prices and producer prices going up as a result of the tariffs. With respect to our portfolio, we feel pretty good that our companies that are effective can pass us on to their customers.

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated CSWC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

Building A Retirement Portfolio With BDCs

The following is a quick update that was previously provided to subscribers of Premium Reports along with business development companies (“BDC”) target prices, dividend coverage and risk profile rankings, potential credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs.

Summary

  • A typical advisor charges 1% or more of the portfolio value per year for what most people can do themselves.
  • Interest rates will likely remain low, and investors will continue to have equity investments to generate an adequate yield from their portfolios.
  • BDC stocks are averaging 10.6% annual yields and their safer Baby Bonds are averaging 6.2% and this update discusses allocations of each for a balanced portfolio.

Typical Steps to Creating a Retirement Portfolio

  1. Set a realistic budget.
  2. Calculate the amount of pre-tax income needed from your investment portfolio.
  3. Assess risk tolerance including asset allocations.

A typical advisor charges 1% or more of the portfolio value per year for what most people can do themselves. To keep it simple, this article uses corporate/government bond funds and Baby Bonds that pay a set amount of interest and return the principal at the end of the period. These securities are less volatile and less risky than stocks.

  • Please see below for discussions of yield and allocations.

How much of your portfolio should be in stocks and bonds?

Your portfolio allocations depend on a few factors, including your age. Historically, investment advisors used the “100 minus your age” axiom to estimate the stock portion of your portfolio.

  • For example, if you’re 50, 50% of your portfolio should be in stocks.

That has been revised to 110/120 due to the change in life expectancy and lower interest rates for risk-free and safer investments. Today, 10-year treasury-bill yields just over 2% annually compared to 10% in the early 1980s. Please see Bloomberg article “U.S. Is Heading to a Future of Zero Interest Rates Forever” from earlier this week.

For the table above, I have used 120 as I believe interest rates will remain low given the various policies from central banks and investors will continue to have equity investments for an adequate yield from their portfolios.

The following chart uses a different approach that seems more aggressive and is discussed in “Is your retirement portfolio too heavily invested in equities?” from MarketWatch earlier this month.

Bond Funds & Baby Bonds

There are plenty of choices when it comes to bonds, including government bonds such as treasuries, municipal bonds, or corporate bonds. Within each of those categories, there is a wide variety of maturities to select from, ranging from a matter of days to 30 years or more. And, there is a full range of credit ratings, depending on the strength of the bond’s issuer.

To make it easy, many investors use a bond-based mutual fund or ETF that fits their needs. The primary reasons for allocating a portion of your portfolio to bonds are to offset the stock volatility and a reliable income stream as compared to capital gains or beating the market.

For my portfolio, I have various bonds some of which are related to my personal tax situation and likely not applicable to most.

Below is a list of typical safer investment-grade bond funds currently with annual yields around 2.7% to 3.0%. I will discuss further in upcoming posts if subscribers are interested, let me know in the comments.

There are plenty of higher yield bond funds that typically invest in non-investment grade assets such as HYG and JNK that were discussed in my article from last week “Search For Yield: Bond Funds Vs. BDCs Paying 10%+“. Currently, HYG and JNK are yielding 5.2% and 5.6%, respectively.

 

I invest in BDC Baby Bonds (currently averaging 6.24% yield as shown below) and Preferred Stocks for higher yields including some that are considered investment grade. Please read “Baby Bonds For BDCs: Price Stability” for previous discussions and information about these investments. The following is from the BDC Google Sheets and is what I use to make purchases when increasing my allocations:

 

What is a BDC?

Business Development Companies (“BDCs”) were created by Congress in 1980 to give investors an opportunity to invest in private small and mid-sized U.S. companies typically overlooked by banks. Most BDCs are publicly traded with a highly transparent structure subject to oversight by the SEC, states and other regulators, providing investors with higher than average dividend yields (most between 7% and 13% annually, see details below) by avoiding taxation at the corporate level. This allows them to pass along ordinary income and capital gains directly to the shareholder.

Their non-bank structure gives them the flexibility to invest in multiple levels of a company’s capital structure and most are Regulated Investment Companies (“RICs”) where capital gains, dividends and interest are passed onto shareholders avoiding taxation at the corporate level. However, they are required to distribute at least 90% of interest, dividends, and gains earned on investments. RICs are also required to distribute 98% of net investment income to avoid paying a 4% excise tax.

BDCs are limited in the amount of financial leverage they can use which is typically much lower than banks and REITs. They are required to diversify their holdings and to have at least 70% of total assets considered as “qualifying assets,” and offer managerial assistance to the businesses that they invest in.

Safer BDCs are currently averaging 9.2% yield compared to the average which is closer to 10.5% but patient investors can get higher yields by taking advantage of volatility.

Why do I like BDCs?

I like the idea of investing in companies that provide capital to smaller private businesses often unable to get growth capital from typical banks. Also, BDC stock pricing can be volatile which can be a good thing for investors that watch closely and take advantage of ‘oversold’ conditions.

BDC fundamentals remain strong/stable including a healthy U.S. economy, low market defaults and most BDCs focused on protecting shareholder capital with first-lien assets and protective covenants.

Also, most BDCs have excellent diversification by sector and have built their portfolios and balance sheets in anticipation of a recession with investments supported by high cash flow multiples and protected by protective covenants and first-lien on assets for worst-case scenarios.

The following is from a previous call with ARCC management:

As we look at the portfolio and evaluate the economy, we continue to approach the market with the belief that we are late in a credit cycle, and that economic growth is slowing. As a lender, these are perfectly healthy conditions for underwriting and strong portfolio performance. However, we do believe that slowing economic growth can challenge weaker companies. And if this thesis proves itself out it should benefit Ares Capital as more differentiation among credit managers is a good thing for established companies like ours which has resources and access to capital that surpasses our peers. A more fundamental credit downturn can be a significant market opportunity for us. We have been able to consolidate market share during times of distress, and outperform other credit managers. And we’re positioning ourselves to take advantage of this if an opportunity arises.

To be a successful BDC investor:

For investors that are looking to build a portfolio that includes BDCs, please consider the following suggestions:

  • Identify BDCs that fit your risk profile by reading the BDC Risk Profiles report along with the individual Deep Dive Reports for each BDC.
  • Use the BDC Google Sheets to purchase BDCs below or close to the ‘Short-Term Target Price’.
    • Dipping your toe in: it is important for new investors to be patient and start with a small amount of shares using limit orders. Initiating a position will likely help with gaining interest and following the stock (and management team) to develop a comfort level for future purchases.
    • Opportunity cost: Keep in mind that while you are waiting for lower prices, BDCs are paying dividends.
    • Dollar averaging purchases: Eventually, there will be a general market and/or sector volatility driving lower prices providing opportunities to lower your average purchase prices.

The information in this article was previously made available to subscribers of Premium Reports, along with:

BDC IPO: Owl Rock Capital (ORCC) $7 Billion Portfolio 82% First-Lien

The following is a quick update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Quick Update:

NEW YORK (July 17, 2019) – Owl Rock Capital Corporation, Inc. (“ORCC”) today announced that it priced its initial public offering of 10,000,000 shares of common stock at $15.30 per share. Shares of common stock of ORCC are expected to begin trading on the New York Stock Exchange on July 18, 2019, under the symbol “ORCC.” ORCC also granted the underwriters an option to purchase up to an additional 1,500,000 shares of its common stock. The closing of the offering is subject to customary closing conditions and the shares are expected to be delivered on or about July 22, 2019.

 

Upcoming ORCC IPO:

Owl Rock Capital Corporation (ORCC) is an externally managed BDC with investments in 81 portfolio companies valued at $6.8 billion that expects its initial public offering to be priced tomorrow:

  • Expected pricing of $15.30-$16.30 per share (a premium to its estimated NAV per share of  $15.27 to $15.30).
  • Size of offering 9.5 million shares, raising ~$150M based on midpoint of anticipated range; expects green shoe option of 15%.
  • Plans to use proceeds to pay down outstanding debt, to make investments according to its investment objectives, and for general corporate purposes.

Owl Rock Capital Partners, together with its subsidiaries, is a New York-based direct lending platform with approximately $13.4 billion of assets under management as of March 31, 2019.

Upcoming ORCC Distributions

On May 28, 2019, the Board declared a distribution of $0.31 per share, for shareholders of record on September 30, 2019, payable on or before November 15, 2019. This distribution is only payable if this offering has commenced on or before September 30, 2019. The Board also declared the following special distributions which are only payable if this offering has commenced on or before September 30, 2019. Newly offered shares WILL be entitled to receive these distributions (as well as the $0.31).

Assuming that the regular quarterly dividend remains at $0.31 per share would imply that new investors will receive a total of:

  • $0.33 per share for Q3 2019
  • $0.35 per share for Q4 2019
  • $0.39 per share quarterly in 2020

The expected annualized dividend yield for ORCC using the expected offering price of $15.30 to $16.30 per share:

  • 8.1% to 8.6% for Q3 2019
  • 8.6% to 9.2% for Q4 2019
  • 9.6% to 10.2% for 2020

It should be noted that newly offered shares will NOT be entitled to receive this distribution:

“On June 4, 2019, our Board declared a distribution of 100% of our net investment income for the quarter ended June 30, 2019 (excluding unrealized gains/losses), calculated in accordance with U.S. GAAP, for shareholders of record on June 14, 2019, payable on or before August 15, 2019.”

Preliminary Estimates of Results as of June 30, 2019

As of July 8, 2019, ORCC estimates that its net asset value (“NAV”) per share as of June 30, 2019 was between $15.27 per share and $15.30 per share.

The company estimates that its dividend was between $0.43 per share and $0.45 per share, calculated using 270,188,960 outstanding shares as of the record date of June 14, 2019. Subsequent to the record date, the Company issued 103,504,284 common shares in connection with its final capital drawdown of $1.58 billion which proceeds funded on June 17, 2019.

The company estimates its net investment income (“NII”) per share for the three months ended June 30, 2019 was between $0.41 per share and $0.43 per share, calculated using 284,750,732 weighted average shares for the three months ended June 30, 2019.

ORCC Management Fees

The management fee is 1.5% and excludes cash and after the offering, the advisor is entitled to pre-incentive fees NII of 17.5% with a hurdle rate of 6% annually as well as 17.5% of cumulative realized capital gains:

“The second component of the incentive fee, the capital gains incentive fee, payable at the end of each calendar year in arrears, equals 17.5% of cumulative realized capital gains from the date an Exchange Listing becomes effective (the “Listing Date”) to the end of each calendar year, less cumulative realized capital losses and unrealized capital depreciation from the Listing Date to the end of each calendar year, less the aggregate amount of any previously paid capital gains incentive fee for prior periods.”

ORCC Risk Profile

As of March 31, 2019, based on fair value, the portfolio consisted of 81.7% first lien senior secured debt investments, 16.5% second lien senior secured debt investments, 0.4% unsecured debt investments, 1.2% investment funds and vehicles, and 0.2% equity investments.

Credit quality seems fine with no investments on non-accrual status but 6.1% with “Investments Rating 3” which is a borrower “performing below expectations and indicates that the loan’s risk has increased somewhat since origination or acquisition”:

“As of March 31, 2019, 99.6% of our debt investments based on fair value in our portfolio were at floating rates. As of March 31, 2019 we had investments in 81 portfolio companies with an average investment size in each of our portfolio companies of approximately $84.3 million based on fair value. As of March 31, 2019, our portfolio was invested across 27 different industries. The largest industries in our portfolio as of March 31, 2019 were professional services and internet software and services, which represented, as a percentage of our portfolio, 9.8% and 9.4%, respectively, based on fair value.”

The portfolio has oil, energy and gas exposure of around 6.4%:

“As of March 31, 2019, our weighted average total yield of the portfolio at fair value and amortized cost was 9.4% and 9.4%, respectively, and our weighted average yield of debt and income producing securities at fair value and amortized cost was 9.4% and 9.4%, respectively. As of March 31, 2019, our portfolio companies, excluding the investment in Sebago Lake and certain investments that fall outside of our typical borrower profile, representing 98.8% of our total portfolio based on fair value, had weighted average annual revenue of $455 million and weighted average annual EBITDA of $80 million.”

Select ORCC Historical Financial Information

I will fully assess dividend coverage after the company reports June 30, 2019, results. Historically, its portfolio yield and NAV have been mostly stable:

Stock Repurchase Plan, Use of Leverage & Capital Structure

On July 7, 2019, the Board approved the Company 10b5-1 Plan, to acquire up to $150 million in stock at prices below NAV per share:

“We intend to put the Company 10b5-1 Plan in place because we believe that, in the current market conditions, if our common stock is trading below our then-current net asset value per share, it is in the best interest of our shareholders for us to reinvest in our portfolio. The Company 10b5-1 Plan is intended to allow us to repurchase our common stock at times when we otherwise might be prevented from doing so under insider trading laws. The Company 10b5-1 Plan will require Goldman Sachs & Co. LLC, as our agent, to repurchase shares of common stock on our behalf when the market price per share is below the most recently reported net asset value per share (including any updates, corrections or adjustments publicly announced by us to any previously announced net asset value per share). Under the Company 10b5-1 Plan, the agent will increase the volume of purchases made as the price of our common stock declines, subject to volume restrictions.”

As of March 31, 2019, ORCC had a debt-to-equity ratio of around 0.68 and neither the Board nor the shareholders are being asked to approve a reduced asset coverage ratio which means a maximum debt-to-equity ratio of 1.00. Also, before incurring any such additional leverage, the company would have to renegotiate or receive a waiver from the contractual leverage limitations under the existing credit facilities and notes:

“We currently have in place the Revolving Credit Facility, the SPV Asset Facility I, the SPV Asset Facility II, the SPV Asset Facility III and the CLO Transaction and in the future may enter into additional credit facilities. In addition, we have issued the 2023 Notes and the 2024 Notes. As of March 31, 2019, we had $2.8 billion of debt outstanding (which includes a subscription line revolving credit facility (the “Subscription Credit Facility”), which was paid down with proceeds from the capital call drawdown notice we delivered on June 4, 2019, and terminated on June 19, 2019 but does not include the 2024 Notes issued on April 10, 2019, or the CLO Transaction closed on May 28, 2019), with $290.7 million available under our existing credit facilities. As of March 31, 2019, our asset coverage ratio was 245%. Following the receipt of proceeds from the capital call drawdown notice we delivered on June 4, 2019 and from this offering and the repayment of indebtedness upon receipt of these proceeds, we expect our asset coverage ratio to be approximately 562% based on the value of our total assets as of June 27, 2019.”

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated ORCC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

BlackRock TCP Capital (TCPC) Q1 2019 Update

The following is a quick TCPC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

 

Summary

  • On May 1, 2019, the Board re-approved its stock repurchase plan to acquire up to $50 million of common stock at prices below NAV per share. The stock is currently trading slightly above NAV and repurchases could be financed through increased leverage.
  • Management indicated that the shareholder approval to increase leverage will likely drive higher earnings and “will continue to assess our dividend policy going forward”.
  • NAV per share increased by $0.05 or 0.4% due to overearning the dividend by $0.04 and unrealized gains of $0.02 per share “primarily from generally tighter spreads” partially offset by a markdown on Green Biologics. There were no investments on non-accrual.
  • The overall credit quality of the portfolio remains strong, with 92% of the portfolio in senior secured debt (mostly first-lien positions) and low non-accruals and low concentration risk.
  • On February 8, 2019, shareholders approved higher leverage and reducing fees including management fee to 1% (on leveraged assets) and incentive fees to 17.5%.
  • The updated projections take into account the recently reduced rate on its SVCP Facility by 0.25% to LIBOR + 2.0%.

 

For the quarter ended March 31, 2019, TCPC reported between base and best case projections covering its dividend by 110% that included $0.04 per share of income related to prepayment premiums and accelerated original issue discount amortization. There was lower-than-expected portfolio growth but overall portfolio yield remained stable at 11.4%.

Howard Levkowitz, TCPC Chairman and CEO: “Our solid performance in the first quarter underscores what our shareholders have come to expect from TCPC: disciplined investing, strong credit quality and consistent dividend coverage. During the first quarter, we originated $150 million of new investments, further diversifying our portfolio and maintaining credit quality; none of our debt investments were on non-accrual as of March 31, 2019. Importantly, we covered our dividend for the 28th consecutive quarter as a public company. We will continue to leverage our expanded deal flow and resources that we are accessing as part of BlackRock to benefit our clients and to generate strong risk-adjusted returns for our shareholders.”

 

Prepayment-related income remained lower partially due to the vintage of investments that were repaid during Q1 2019.

 

On February 8, 2019, shareholders approved the reduced asset coverage ratio allowing higher leverage and reduced management fee to 1.00% on assets financed using leverage over 1.00 debt-to-equity, reduced incentive fees from 20.0% to 17.5% and hurdle rate from 8% to 7% as well as “continue to operate in a manner that will maintain its investment grade rating”.

“Regulatory leverage at year-end, which is net of SBIC debt, was 0.86 times common equity on a gross basis and 0.84 times net of cash and outstanding trades. In connection with our vote to reduce our fee rates in February, our shareholders also approved a reduction for minimum asset coverage ratio from 200% to 150%, which went into effect on February 9th. As a result, we now have additional flexibility to modestly increase our leverage, should it be prudent in the investment environment.”

TCPC continues to lower its cost of capital and in May 2019, expanded its credit facilities by $50 million each for a total increase in capacity of $100 million as well as reducing the rate on its SVCP Facility by 0.25% to LIBOR + 2.0% and extended its maturity to May 6, 2023. As of March 31, 2019, available liquidity was $245 million, including $229 million in available leverage capacity and $27 million in cash and cash equivalents, reduced by approximately $10 million in net outstanding settlements of investments purchased.

“We had total liquidity of $245 million at quarter end. This included available leverage of $228.5 million and cash of $26.8 million. We were pleased to expand both of our credit facilities by $50 million each for an aggregate increase of $100 million and to reduce the interest rate of our SVCP facility by 25 points to LIBOR plus $200 million. We also extended the maturity of our SVCP facility to May 2023. Increasing our credit facility capacity further expands our diverse leverage program, which includes two low cost credit facilities, two convertible note issuances, a straight unsecured note issuance and an SBA program.”

 

On May 1, 2019, the Board re-approved its stock repurchase plan to acquire up to $50 million of common stock at prices below NAV per share, “in accordance with the guidelines specified in Rule 10b-18 and Rule 10b5-1”. During Q1 2019, there were only 9,000 shares repurchased and in 2018, the company repurchased only 73,416 shares for a total cost of $1.0 million. There is a good chance that the company will repurchase additional shares if the stock price declines below NAV again (reduced asset coverage ratio can be used for accretive stock repurchases).

TCPC management continues to take a higher quality approach including selective portfolio growth, with adequate protective covenants, at higher yields for improved dividend coverage. I am expecting the company to maintain its portfolio yield over the coming quarters:

“Both new and exited investments during the quarter co-incidentally had a weighted average effective yield of 10.1%. The overall effective yield on our debt portfolio at quarter end remained unchanged from the prior quarter at 11.4%.”

TCPC currently does not have a “joint venture” or “senior loan program” that uses off-balance sheet leverage to increase its overall portfolio yield. BDCs are allowed a maximum of 30% of investments to be considered ‘non-qualified’ that would include these types of investments:

From previous call: “We may consider doing some other things with 30% bucket. We’ve just have a very cautious approach to how we use that and wanted to make sure that it’s something that really fit with our strategy. So, the way we think about it is, it really is a continuation of what we’ve been doing, albeit with the resources of the world’s largest asset manager in many ways to help us do what we’ve been doing.”

Previously, TCPC completed a direct equity offering of 2.3 million shares in an effort to increase the ownership of longer-term institutional investors similar to the converted $30 million note and institutional support from CNO Financial Investments Corp. (CNO). CNO is an NYSE listed insurance holding company with over $30 billion in assets and is committed to investing more than $250 million of capital that will be deployed over time in TCP’s managed funds.

Risk Profile Update:

The overall credit quality of the portfolio remains strong, with 92% of the portfolio in senior secured debt (mostly first-lien positions) and low non-accruals and low concentration risk:

“At quarter end, our portfolio had a fair market value of $1.6 billion, 92% of which was in senior secured debt. We held investments in 95 companies across a wide variety of industries. Our largest position represented only 3.4% of the portfolio and taken together, our five largest positions represented only 15.8% of the portfolio. Diversification always has been and always will be an important factor in how we construct our portfolio. To further demonstrate our emphasis on diversification. As you can see on the chart on the left side of Slides 6, our recurring income is distributed across a diverse set of portfolio companies. We are not reliant on income from any one portfolio company. In fact, on an individual company basis, well over half of our portfolio companies each contribute less than 1% to our recurring income.”

 

As mentioned earlier, management has been slowly growing the portfolio (or shrinking if needed) and only investing in “the right type of structures with protections including covenants”.

“The direct relationships we form with borrowers as part of this process help to protect TCPC and its shareholders. The BlackRock TCP team is structured so that deal team members source, structure and monitor investments to ensure interests are aligned over the life of an investment. And finally, our team has deep experience in both performing and distressed credit, and we draw upon this expertise to structure deals that are downside protected. In closing, we remain relentlessly focused on generating superior risk adjusted returns for our investors, while preserving capital with downside protection.”

For Q1 2019, net asset value (“NAV”) per share increased by $0.05 or 0.4% (from $14.13 to $14.18) due to overearning the dividend by $0.04 per share and net unrealized gains of $1.1 million or $0.02 per share “primarily from generally tighter spreads” partially offset by a $2.5 million markdown on Green Biologics.

“Net unrealized gains of $1.1 million or $0.02 per share resulted primarily from a partial recovery following the market volatility at year-end. This was offset in part by a mark down of $2.5 million on our investment in Green Biologics. Net realized losses were $0.3 million in the quarter.”

As mentioned in the previous report, its debt investments in Green Biologics were restructured into common equity and discussed on a previous call: “Green Bio missed projections, but received an equity infusion from its strategic owner during the quarter.”

As of March 31, 2019, there were no investments on non-accrual status. During Q4 2018, the company exited its pre-IPO legacy loan to Real Mex that resulted in $25.8 million of realized losses. As discussed in previous reports, its loan to Real Mex was part of the legacy pre-IPO strategy and had generated significant income prior to the disposition.

Kawa Solar Holdings was previously on non-accrual but restructured in Q3 2018 and is now in the process of “winding down”:

Q. “I just wanted to just touch a little bit on our Kawa Solar was marked down again. And you’ve got the one debt piece of revolver that’s marked to 27%. I’m just wondering if you see that as a risk of potentially going on non-accrual.”

A. “Right now, the loans been restructured, it’s a 0% coupon. So it’s effectively right now just a claim we have as the company winds down. It did get marked down a little bit. But the majority of the movement in the quarter was actually $8 million pay down, which we applied against cost. This is a lengthy wind down in the business where there’s some long term obligations that we want to be very careful and how we wind those out. So we get our pay downs. The $8 million was a good example of success a in that effort. And it will stretch over the length of time of those contracts, which are longer term. So we do expect more pay downs that actually is the focus of the wind down. And as we do it, we’ll try to discern the pay down from the markdown, because that’s an important distinction on each quarterly basis.”

From previous call: “The effort and going forward is just to harvest the remaining assets [of Kawa Solar Holdings] which are mostly comprised of cash if you will. The way I think about this is really it’s a receivable that we’re winding down versus an operating entity which also explains the change in the rate to effectively zero percent on the remaining assets. So that one is really wind down, then you will see that decreasing over time versus being an operating entity. But the Lion’s share of the effort to exit has been completed as of the latter part of Q3 last year.”

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated TCPC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

TPG Specialty Lending (TSLX) Q1 2019 Update

The following is a quick TSLX Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • On February 18, 2019, PayLess Inc. filed for Chapter 11 and during Q2 2019, its $14 million ABL term loan was repaid in full resulting in 18% IRR and taken into account with the updated projections.
  • As predicted, its $25 million ABL-DIP loan to Sears was fully repaid in connections with the bankruptcy court approving the sale of its assets to ESL Investments for $5.2 billion. However, TSLX invested an additional $75 million in Q1 2019.
  • For Q1 2019, TSLX reported just below base case due to continued lower leverage and much lower-than-expected “other fees” income which includes prepayment fees and accelerated amortization of upfront fees.
  • Credit quality remains solid with 100% performing portfolio of 97% true first-lien. NAV per share increased by 0.6% partially due to unrealized appreciation “primarily due to a tightening spread environment and positive credit-related adjustments.”
  • The Board adjusted the 10b5-1 Repurchase Plan to allow for repurchases “just below 1.05x the most recently reported net asset value per share, less the amount of any supplemental dividend declared for that quarter” which is around $17.15.
  • Previously, TSLX increased its target debt to equity target range from 0.75x-0.85x to 0.90x-1.25x potentially driving a quarterly dividend increase from the current $0.39 to between $0.45 and $0.55 depending on leverage and new asset yields.

TSLX Dividend Coverage Update:

TSLX has covered its regular dividend by an average of 140% over the last four quarters, growing undistributed taxable income and capital gains to $1.19 per share.

“As we said before, if we believe there is a sustainable increase in the earnings power of the business by operating in our target leverage range for an extended period of time, then we would look to resize our base dividend in context of the underlying earnings power of the business to ensure we’re optimizing cash distribution and satisfying risk related distribution requirements. We will continue to monitor undistributed taxable income and gains closely as part of our ongoing review of our distribution strategy.”

The company only experienced $33 million of repayments and exits during Q1 2019 resulting in lower “other fees” income which includes prepayment fees and accelerated amortization of upfront fees. This along with lower leverage were the primary drivers for lower dividend coverage in Q1 2019 and special/supplemental dividend of $0.01 per share payable in June which was below the base case projected.

“Total investment income was $52.5 million, down from $74.7 million in the prior quarter, primarily due to elevated level of activity-related fees earned during Q4. Interest and dividend income was $49.5 million, down $2.5 million from the previous quarter given a slight decrease in the average size of our investment portfolio. Other fees, which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were $0.8 million compared to $21.2 million in the prior quarter, which experienced record high repayment levels.”

For Q1 2019, TSLX reported just below base case projections due to continued lower leverage and much lower-than-expected fee income during the quarter but covering its dividend by 105%. Previous quarters typical have higher “other fees” income which includes prepayment fees and accelerated amortization of upfront fees. Annualized ROE for the first quarter 2019 was 10.0% and 14.5% on a net investment income and a net income basis, respectively.

During Q1 2019, there was a slight decline in its portfolio yield (from 11.7% to 11.6%) due to new investments at lower yields.

TSLX management continues to produce higher returns by investing in distressed companies through excellent underwriting standards that protect shareholders during worst-case scenarios including call protection, prepayment fees and amendment fees backed by first-lien collateral of the assets. Historically, higher returns have been partially driven by these strong financial covenants and call protections during periods of higher amounts of prepayments (discussed below) and worst case scenarios. However, similar to previous reports, the base case projections do not include large amounts of fee and other income related to early repayments.

“At quarter end, nearly a 100% of our portfolio by fair value was sourced through non- intermediary channels. This allows us to structure meaningful downside protection on our debt investments. To provide some numbers around this, at quarter end we maintained effective loading control on 81% of our debt investments average 2.1 financial covenants per debt investment and had meaningful call protection on their debt portfolio of 103.4 as a percentage of fair value as a way to generate additional economics as our portfolio get repaid in the near term.”

TSLX Risk Profile Update:

As of March 31, 2019, 100% of the portfolio was meeting all payment and covenant requirements. First-lien debt remains around 97% of the portfolio and management has previously given guidance that the portfolio mix will change over the coming quarters with “junior capital” exposure growing to 5% to 7%.

“As of March 31, 2019, the portfolio based on fair value consisted of 97.4% first-lien debt investments, 0.2% second-lien debt investments, 0.1% mezzanine debt investments, and 2.3% equity and other investments.”

As predicted, net asset value (“NAV”) per share increased by $0.09 or 0.6% (from $16.25 to $16.34) partially due to unrealized appreciation that “resulted from an increase in fair value, primarily due to a tightening spread environment and positive credit-related adjustments.”

“The difference between this quarter’s net investment income and net income was primarily driven by unrealized gains of $0.11 per share from the impact of tightening credit spreads and the valuation of our portfolio and mark-to-market gains of $0.05 per share related to our interest rate swaps from the flattening of the forward LIBOR curve. Reported net asset value per share at quarter end was $16.34, an increase of $0.21 compared to the prior quarter after giving effects of the impact of the Q4 supplemental dividend which was paid during Q1. Net asset value movement this quarter was primarily driven by unrealized gains related to a partial recovery of credit spreads following year-end volatility and the flattening of the forward curve as discussed.”

On February 18, 2019, PayLess Inc. filed for Chapter 11 and during Q2 2019, its $14 million ABL term loan was repaid in full resulting in 18% IRR and taken into account with the updated projections:

“On February 18, 2019, Payless filed voluntary petition for relief under Chapter 11 of the bankruptcy code given the continuing challenges facing brick and mortar retailers. Post quarter end, we were fully repaid on our loan which resulted in an unlevered – gross unlevered IRR of 18% on our investment.”

It is important for investors to understand that one of TSLX’s strategies for higher IRRs is investing in distressed retail asset-based lending (“ABL”) as “traditional brick and mortar retail gives way to the rise of e-commerce”. Historically, borrowers have paid amendment fees to avoid even higher prepayment fees if they decided to refinance. Also, the amendments included additional “borrowing base” providing increased downside protection on the investment. This strategy continues to drive higher fee income including prepayment and amendments fees. See the end of this report for previous examples.

“Retail ABL continues to be one of our various themes given the ongoing secular trends in our platform’s differentiated capabilities and relationships in this area. As the direct lending asset classes become increasingly competitive, we have continually developed and evolved our investment themes in order to generate a robust pipeline of strong risk-adjusted return opportunities.”

“What really matters is, how we think the inventory will liquidate as it compares to what – where we are lending against it. Retail goes as well as the consumer. That is not the – that’s not what’s happening here, right. Consumer is in good health. There is a business model issue and a structural issue with retail, but more so given the fixed cost base and given the discerning mediation of both kind of fast brands and plus Amazon and omni-channel business models. And so, it’s really the liquidation value of inventory and the liquidation value of the inventory has held up great. So, we continue to hope for a decent amount of structural change. So we can provide capital and provide – be a solution provider into that space. And quite frankly, the liquidation values continue to hold up very, very, very well.

From previous call: “35% of our 2018 originations were what we call opportunistic capital deployment in areas where our platform’s ability to underwrite and navigate complexity and process risk, allow us to create excess returns across our portfolio. Examples since inception include our investments in upstream E&P, retail ABL and secondary market purchases during periods of market volatility. These also include opportunities arising from the challenging regulatory environments for banks such as our larger financings iHeart and Ferrellgas. Since inception through year-end 2018, the gross unlevered IRR in our fully realized investments that we designate as opportunistic in nature was 28%, which compares to a gross unlevered IRR of 14% across the remainder of our fully realized investments over this period of time.”

As predicted, its $25 million ABL-DIP loan to Sears was fully repaid in connections with the bankruptcy court approving the sale of its assets to ESL Investments for $5.2 billion. However, TSLX invested an additional $75 million in Q1 2019 for “a strong risk-adjusted return opportunity for our shareholders”:

“During the quarter, we also received full repayment of our Sears DIP loan in connection with the company’s exit from chapter 11. Subsequently, we participated in a $250 million asset-based loan to support Sears’ go-forward operations. We’ve been a lender to the company since late 2015. Given our relationship and familiarity with the company’s capital structure and its collateral, we believe we created a strong risk-adjusted return opportunity for our shareholders.”

“Specifically with Sears and generally with all of our asset-based loans which is quite frankly this hasn’t to anything about the prospects of any of our retail asset-based loans, but we underwrite them to liquidation value. I think our last dollar is 80% of NRLV, liquidation value of the inventory, which hold up very, very well and when most of the stores were liquidated, in the all series format. So, again, this is not commenting on Sears specific prospects. We continue to believe that all brick and mortar retail is extremely challenged. But you would expect, we underwrite these transactions to a liquidation given the secular challenges and the volatility of earnings and the fixed cost structure that exists in all brick and mortar retail. So that is actually very similar on a structure basis with the same protections and borrowing-based mechanism that you had and advance rate that you had in the last years.”

“On February 18, Payless filed voluntary petition for relief under Chapter 11 of the bankruptcy code given the continuing challenges facing brick and mortar retailers. Post quarter end, we were fully repaid on our loan which resulted in an unlevered – gross unlevered IRR of 80% on our investment.”

Similar to investing in distressed retail assets, the company is focused on increasing returns through investing opportunistically in oil/energy but only first-lien “with attractive downside protective features in the form of significant hedged collateral value at current price levels”. Management has mentioned that energy exposure would not exceed 10% of the portfolio and only first-lien using appropriate hedges. As discussed in previous reports, TSLX made “opportunistic” investments in MD America Energy during Q4 2018, Ferrellgas Partners during Q2 2018 and Northern Oil & Gas in Q4 2017 that was previously repaid.

 

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated TSLX target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

 

PennantPark Floating Rate (PFLT) Recent Credit Issues Update

The following is a quick PFLT Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • Hollander Sleep Products and LifeCare Holdings filed for bankruptcy in May 2019 and are both working to reduce costs to improve overall profitability and/or selling assets.
  • The recent credit issues were mostly idiosyncratic, not indicative of general underwriting issues and have been discussed in many of the previous reports as management was marking down.
  • Country Fresh Holdings was restructured at the end of June likely resulting in realized losses in calendar Q2 2019 of around $0.16/share but likely not impacting NAV.
  • The updated projections take into account increased leverage and reduced borrowing rates.
  • Montreign and American Teleconferencing are still considered performing investments but marked well below cost and could also be restructured and/or added to non-accrual status (taken into account with the current/previous pricing).
  • Insiders have purchased ~$1 million in shares (at higher prices).

Recent PFLT Insider Purchases:

As shown below, insiders have been actively purchasing shares at prices below the current stock price between $12.05 and $12.15:

PFLT Risk Profile Update:

I consider the recent portfolio credit issues to be idiosyncratic (as compared to systematic) implying that they are not indicative of general underwriting issues within the portfolio. These investments have been discussed in many of the previous reports as management was clearly marking their values. PFLT remains a component in the suggested ‘Risk Averse’ portfolio due to its portfolio of mostlyhigher quality, first-lien senior secured investments at floating rates.

“As a result of our focus on high quality companies’ seniority and capital structure, floating rate assets and continuing diversification, our portfolio was constructed to withstand market and economic volatility. The cash users coverage ratio, the amount by which our EBITDA or cash flow exceeds cash interest expense continued to be healthy a 2.8 times. This provide significant cushion to support stable investment income. Additionally, at cost, the ratio of debt EBITDA on the overall portfolio was 4.3 times, another indication of prudent risk.”

PFLT’s short-term target price was previously reduced to “take into account markdowns and the possibility for New Trident HoldCorp and LifeCare Holdings to be added to non-accrual status”. Also, the previous report mentioned the markdowns for New Trident HoldCorp, Country Fresh Holdings, and American Teleconferencing Services that accounted for around $6 million (or $0.15 per share) of ‘unrealized losses’ during calendar Q4 2018 and “need close attention over the coming quarters”.

“It’s been two years since we have a non-accrual of PFLT and that run had to end at some point. As of March 31, 2019, we had four non-accruals. These names represented by 3.2% of our overall portfolio at cost and 1.5% on the market value basis. The four non-accruals along with a mark-up of our credit facility and bonds contributed to most of the NAV decline in the quarter.”

During calendar Q1 2019, New Trident HoldCorp and LifeCare Holdings were added to non-accrual status along with Quick Weight Loss Centers and Hollander Sleep Products, representing 3.2% and 1.5% of the overall portfolio on a cost and fair value basis, respectively. As mentioned above and below, PFLT has not experienced non-accruals over the last two years and “it’s unfortunate that they all happened in this one quarter”:

“Non-accrual is they stopped paying us interest. So, that’s what happened. Look, we haven’t had a non-accrual and over two years, it looks lumpy here and we’re certainly disappointed, but non-accruals are part of this business. It’s unfortunate that they all happened in this one quarter. But we normally, they’d be smoothed out overtime and we had, as you said, we already had already marked them down by and large. So, this should not have been a big surprise to people to know for them were exhibiting weakness in the past. So, as part of our business, again our track record over a long period of time PFLT now eight years is really only annualized loss of 6 basis points.”

Montreign Operating Co., Country Fresh Holdings, and American Teleconferencing Services are still considered to be performing assets but could be restructured and/or added to non-accrual status over the coming quarters.

As shown below, these investments accounted for $16.1 million or $0.42 per share of unrealized losses during the quarter resulting in net asset value (“NAV”) per share decline of $0.43 or 3.1% (from $13.66 to $13.24).

 

Hollander Sleep Products and LifeCare Holdings filed for bankruptcy in May 2019 and are both working to reduce costs to improve overall profitability and/or selling assets.

If the current non-accruals were completely written off, the impact to NAV per share would be around $0.38 or 2.8%. However, management believes that these investments have been valued appropriately and with the potential for some restructurings and “getting value back for our shareholders”:

“The loans have been marked fairly by independent third-party evaluations terms. We agree with the marks and inherent in the marks gives you a sense of what we think a least value is today. We do have a really good long-term track record, working things out and getting really good recoveries overtime. We’ve, had a lot of experience, when we have to convert that equity. We’ve had a very good track record working things out, getting value back for our shareholders. In some cases, the equity security that we end up owning performed very, very well. So, the current marks are accurate, but currently may or may not reflect future value.”

During calendar Q1 2019, there was an additional markdown in its first-lien loan to Montreign Operating Company which owns and operates a resort casino in Monticello, New York. However, the company previously received $130 million of additional equity capital from its sponsor as discussed in the previous report:

“In terms of the largest investment changes, was unrealized in Montreign, I’ll point out Montreign which is the Resorts World casino up in the Catskills, which as has had a slower ramp than expected since quarter end and this was actually announced yesterday before. The sponsor has been agreed to inject more junior capital to sponsors, KT Lim, who is a global gaming entrepreneur at Malaysia. So these sponsors agreed to put in about $130 million more of equity and also that company cut a deal to do betting which it helps. So if you look at the stock of the underlying company its up quite substantially and in fact, the level of the quote on the paper is up substantially since those announcements, but Montreign was the big, at least temporarily unrealized mover in the quarter.”

Management discussed New Trident and LifeCare on the recent call:

“The two healthcare deals Trident and LifeCare have been marked down for a while. They’re both relatively small. They were on the wrong side of changes in healthcare. Those should not have been surprises and you said it was unexpected. I guess if you had no non-accruals for two years, it is unexpected to have four on one quarter. But hopefully, people understand non-accruals are part of this business. We get them from time to time and we had marked to these. The vast majority of deals already down.”

Also discussed, was Country Fresh that will be restructured at the end of June and will likely result in realized losses in calendar Q2 2019 of around $6 million or $0.16 per share but will not impact NAV unless there are additional markdowns.

Q. “As far as Country Fresh goes that was a — it’s a fairly sizable investment that had a pretty big markdown this quarter. It’s still on accrual status. Obviously, it’s still paying you guys interest income, but any sort of outlook on that investment given that is now at 66% of your cost?”

A. “You’re going to see a restructuring of that investment in this quarter end of June.”

PFLT has now had 9 out of 349 investments on non-accrual status since its IPO with a previous recovery rate of around 98%:

“Our credit quality since inception eight years ago has been excellent. Out of 349 companies in which we have invested since inception, we’ve experienced only nine non-accruals. Since inception, PFLT has made 349 investments totaling about $3 billion and an average yield of 8%. This compares to an annualized loss ratio, including both realized and unrealized losses of only about six basis points annually.”

“Although PFLT was not in existence back then, PennantPark as an organization was, and at that time was focused primarily on investing in subordinated and mezzanine debt. Prior to the onset of the global financial crisis in September 2008, we initiated investments which ultimately aggregated $480 million, again primarily in subordinated debt. During the recession, the weighted average EBITDA of those underlying portfolio companies, declined by 7.2% at the trough of the recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of down 42%. As a result, the IRR of those underlying investments was 8% even though they were done prior to the financial crisis and recession. We are proud of this downside case track record on primarily subordinated debt.”

From previous call: “We underwrite as if it is the peak of the credit cycle. We do our downside cases in our investment memos assuming a recession hits next year. On average, the equity cushions from the financial sponsors are 40%, 50%. So, we’re underwriting as if we’re at the peak of the credit cycle.”

“We can be extremely selective about what we ultimately invest in. We are only investing in about 2% of the deals that we have shown. We remain primarily focused on long term value and making investments that will perform well over several years and can withstand different business cycles. Our focus continues to be on companies and structures that are more defensive, have low leverage, strong covenants and high returns.”

The portfolio remains predominantly invested in first-lien debt at around 76% portfolio and the PSSL has grown from 9% to 18% over the last three quarters. It is important to note that its PSSL is 100% invested in first-lien debt. Also, management mentioned that it will likely not invest in second-lien assets as they “roll off”.

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated PFLT target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

Hercules Capital (HTGC) Announces Equity Offering

The following is a quick HTGC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

HTGC Update:

Hercules Capital, Inc. (HTGC) today announced a public offering of 5,000,000 shares of its common stock plus the underwriters option to purchase up to an additional 750,000 shares of its common stock. The offering is subject to customary closing conditions and is expected to close on June 17, 2019.

Subsequent to this update, HTGC priced the offering at $12.64 and the stock is trading at $12.46 in pre-hours.

The following information was included in the associated SEC filings:

  • As of June 10, 2019, we have closed debt and equity commitments of approximately $335.8 million to new and existing portfolio companies and funded approximately $244.1 million subsequent to March 31, 2019.
  • As of June 10, 2019, we have pending commitments (signed non-binding term sheets) of approximately $207.8 million.
  • In June 2019, Brigade Group Inc., a technology company focused on providing business process outsourcing services and knowledge process outsourcing service for global corporation sourcing services for global corporations, was acquired by Countable Corporation, a provider of a web and mobile-based modern civic engagement platform designed to understand summaries of upcoming and active legislation. Terms of the transaction were not disclosed.

For updated HTGC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

Prospect Capital (PSEC) Update: United Sporting Cos. Files For Bankruptcy

The following is a quick PSEC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports.

 

United Sporting Companies (“USC”) filed for bankruptcy today due to falling gun sales and tightening credit lines. The company plans to liquidate, hurt by falling sales after President Donald Trump was elected and as Dick’s Sporting Goods began moving away from firearms. In a court filing, Chief Executive Officer Bradley Johnson said USC boosted inventory before the 2016 White House race, expecting the higher sales that historically follow a Democrat’s election.

Other reasons for its Chapter 11 filing were excessive debt (including PSEC with $127 million at cost) and discounting caused by excess inventory. In its petition filed with the U.S. bankruptcy court in Wilmington, Delaware, USC said it had between $100 million and $500 million of liabilities. It plans to keep operating during the wind-down.

 

 

The amount of investments that PSEC had on non-accrual status declined from seven to six due to Ark-La-Tex Wireline Services written off during the quarter. Non-accruals remained around 8.2% of the portfolio at cost and declined to around 3.4% at fair value (previously 3.7%) mostly due to markdowns (discussed later) in calendar Q1 2019.

 

 

Similar to the previous quarter, many of the investments on non-accrual status were recently marked down including Pacific WorldUniversal Turbine Parts, LLC and United Sporting Companies. Other meaningful markdowns include its CLOs, National Property REIT Corp (“NPRC”) and CCPI Inc. However, these were offset by large markups in Valley Electric Company (similar to previous quarter) and First Tower Finance:

 

During calendar Q4 2018, PSEC added two of its loans to InterDent, Inc. and another one of its loans to Pacific World to non-accrual status. As mentioned in the previous report, some of my primary concerns include portfolio concentration issues including its “top 10 investments accounting for over 40% of the portfolio” and the amount of equity investments that continues to increase “accounting for over 16% of the portfolio”. Also mentioned was that “InterDent remains one of its largest investment and needs to be watched.” Previously, PSEC extended its loans to InterDent, which were past due as well as being marked down “but still marked near cost and likely overvalued”. During calendar Q2 2018, PSEC assumed control of InterDent and marked it down an additional $11 million and during Q3 2018 made additional investments.

As shown below, PSEC only placed around $41 million of the $244 million loans with InterDent on non-accrual. There is a chance that the other loans could be placed on non-accrual that would have a meaningful impact upcoming to dividend coverage. Also, InterDent still accounts for around $0.61 per share or 6.7% of NAV.

 

In October 2018, a $96 million loan to Pacific World was added to non-accrual status but is still marked up above cost as shown below and this investment accounts for around $0.36 per share or 3.9% of NAV.

 

I consider PSEC to have a higher risk portfolio due to the previous rotation into higher yield assets during a period of potentially higher defaults and later stage credit cycle concerns, CLO exposure of 16% combined with real-estate 14%, online consumer loans of 3%, consumer finance of 11% and energy, oil & gas exposure of 3%. As mentioned in previous reports, Moody’s and S&P Global Ratings also considers the CLO, real-estate and online lending to be riskier allocations that currently account for over 33% of the portfolio.

 

Moody’s Investors Service/Standard & Poor’s Global Ratings:

Moody’s Investors Service: Baa3/ Outlook Stable

On February 26, 2019, Moody’s Investors Service (Moody’s) assigned a rating of to Prospect Capital Corporation’s (“PSEC”) senior unsecured convertible notes due 2025. The outlook for PSEC’s ratings is stable.

Moody’s could upgrade PSEC’s ratings if the company: 1) decreases debt/tangible equity to not more than .7x, doesn’t increase its structured credit and real estate exposures as a proportion of total investments, further enhances financial flexibility by obtaining prior shareholder consent to issue shares at a price below net asset value, and generates profitability that consistently compares well with BDC peers, taking into consideration differences in investment strategies.

Moody’s could downgrade the ratings if PSEC increases the ratio of net debt to equity to more than .85x, increases structured credit and real estate equity investments without decreasing leverage, pays dividends that exceed net investment income on a regular basis, or generates profitability that is weaker than expected compared to peers.

Standard & Poor’s Global Ratings: Credit Rating: BBB-/Outlook Stable

On October 12, 2018, S&P Global Ratings affirmed its ‘BBB-‘ issuer credit rating on Prospect Capital Corp. (“PSEC”) and previously removed the ratings from CreditWatch, where they were placed on April 3, 2018, with negative implications. The negative outlook was due to “PSEC’s leverage near the upper end of our expectations for the ratings and our view that certain of its investments may have more volatile valuations than typical BDC investments.” The stable outlook reflects S&P Global Ratings’ expectation that Prospect Capital Corp. (PSEC) will maintain reported debt to equity below 0.85x and will not adopt a modified asset coverage requirement from the current 200%. We expect PSEC will maintain investment portfolio results consistent with other BDCs that we rate investment grade.

We could lower the ratings over the next 12-24 months if:

  • Reported debt to equity rises to 0.85x or higher or debt to ATE rises to 1.50x or higher
  • The investment portfolio’s risk increases or performance deteriorates, as indicated by rising realized or unrealized losses or nonaccruals

We could raise the ratings if debt to ATE declines below 1.0x on a sustained basis and if PSEC substantially reduces its exposure to investments that we view as subject to greater volatility, particularly CLO equity. The ratings reflect PSEC’s broad capabilities as the second-largest BDC, with diversified origination channels, as well as its favorable funding profile. The company’s debt to equity leverage is low, but debt to ATE is higher than other BDCs we rate. We believe certain of PSEC’s investments may have more volatile valuations than typical BDC investments, particularly its investments in collateralized loan obligation (“CLO”) residual interests, online consumer loans, and real estate, all of which we deduct from ATE.

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated PSEC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

GBDC Q1 2019 Update

The following is a quick GBDC Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • GBDC hit its base case projections covering its dividend by 100%, leverage continues to increase as shareholders recently approved the reduced asset coverage requirements.
  • The annualized quarterly return from its SLF improved from the previous quarter “but continues to be impacted by a few underperforming investments” as well as under its target leverage.
  • There was a rebound in its overall portfolio yield from 8.6% to 8.8% due to new investments at higher yields that were 90% One Stop loans.
  • NAV declined by $0.02 or 0.8% (from $15.97 to $15.95) partially due to the restructuring of its non-accrual investment in Uinta Brewing Company and markdown in its non-accrual investment in Aris Teleradiology.
  • Portfolio credit quality improved slightly due to the restructuring of its non-accrual investment in Uinta Brewing Company reducing non-accrual investments as a percentage of total investments at fair value and cost of 0.2% and 0.5%, respectively.
  • On February 1, 2019, GBDC closed on a $200 million credit facility with Morgan Stanley priced at LIBOR +2.05% and was used to repay its higher cost credit facility with Wells Fargo.

 

For the quarter ended March 31, 2019, Golub Capital BDC (GBDC) hit its base case projections covering its dividend by 100% after excluding $0.7 million reverse accrual for the capital gain incentive fee. Its portfolio yield and income from the Senior Loan Fund LLC (“SLF”) rebounded from the previous quarter. Leverage continues to increase as shareholders recently approved the reduced asset coverage requirements allowing higher leverage.

 

 

GBDC usually has predictably boring NII of $0.32 each quarter (see table below) that is mostly due to its fee structure combined with strong portfolio credit quality.

 

 

The annualized quarterly return from its Senior Loan Fund LLC (“SLF”) improved from the previous quarter “but continues to be impacted by a few underperforming investments” as well as under its target leverage due to continued declines in total investments.

 

 

On August 31, 2018, the reinvestment period on SLF’s credit facility expired. Due to a “paucity of attractive traditional senior secured opportunities”, the SLF determined not to extend the reinvestment period but instead amended the facility to reduce the interest rate on the facility from LIBOR + 2.15% to LIBOR + 2.05% and to reduce the commitment to advances outstanding. On previous calls, management has mentioned that it is currently in “shrink mode” due to having difficulties finding attractive investments for the SLF:

From previous call: “This was a decrease of $1 million from the prior quarter, primarily due to a decline in dividend income from SLF, which was partially offset by higher interest income from a growing portfolio. The Senior Loan Fund had a weak quarter as a result of unrealized losses, below target leverage and a shortage of attractive new investment opportunities appropriate for this fund. SLF investments at fair value at December 31 declined by 2.6% to $174.4 million. Guidance remains the same, as I have said in prior quarters, which is we are not actively looking to grow SLF right now, but we think it is a smart tool to keep in our arsenal if and when market conditions change and we find traditional middle market senior loans more attractive.”

There was a rebound in its overall portfolio yield from 8.6% to 8.8% due to new investments at higher yields that were 90% One Stop loans:

 

 

New investment commitments totaled $116 million with approximately 8% were senior secured loans, 90% were one stop loans, and 2% were in the SLF.

 

 

Net asset value (“NAV”) per share declined slightly by $0.02 or 0.8% (from $15.97 to $15.95) partially due to the restructuring of its non-accrual investment in Uinta Brewing Company and markdown in its non-accrual investment in Aris Teleradiology. However, NAV has increased 23 out of the last 27 quarters, after excluding the impact from previous special dividends:

 

 

Portfolio credit quality remains strong with low non-accrual investments as a percentage of total investments that declined slightly to 0.2% and 0.5% of fair value and cost, respectively. The three investments currently on non-accrual include Aris Teleradiology ($0.8 million FV, $3.1 million cost) was added to non-accrual status during the previous quarter, Uinta Brewing Company ($0.8 million FV, $0.9 million cost) and Tresys Technology Holdings ($1.8 million FV, $4.5 million cost). It is important to remember that GBDC has 211 portfolio companies, so three on non-accrual is to be expected.

 

GBDC’s liquidity and capital resources are primarily from its debt securitizations (also known as collateralized loan obligations, or CLOs), SBA debentures, and revolving credit facilities. On February 1, 2019, GBDC closed on a new $200 million credit facility with Morgan Stanley priced at LIBOR +2.05% and was used to repay its revolving credit facility with Wells Fargo. As of March 31, 2019, the company had $53 million of available SBA debenture commitments, of which $12.5 million was available to be drawn.

 

 

On September 7, 2018, GBDC received a ‘no-action letter’ from the SEC allowing the company to issue new securitizations for a lower cost alternative to its Morgan Stanley credit facility as well as longer term and more flexible. On November 16, 2018, the Company issued $408.2 million in notes through a debt securitization structured as follows:

 

 

On November 27, 2018, GBDC entered into a definitive agreement to merge with Golub Capital Investment Corporation (“GCIC”) and is expected to close “during the first half of the calendar year 2019”. Following the merger, GBDC is expected to be the fourth-largest externally managed, publicly traded BDC with $3.5 billion of assets. The combined company will remain externally managed by GC Advisors and continue to trade under the ticker GBDC. Please see the previous linked Deep Dive report for more information.

  • The transaction would be accretive to GBDC’s NAV per share by 4.5%(previously 3.6%).
  • Based on the pro forma earnings power of the combined company, GBDC’s Board intends to increase GBDC’s quarterly dividend to $0.33 per share after
  • The increased market cap of GBDC is anticipated to provide greater trading liquidity, broader research coverage and the potential for greater institutional
  • The combined portfolio is expected to be substantially similar to GBDC’s current portfolio, as over 96% of GBDC’s investments overlap with those of GCIC;
  • The transaction is expected to deliver operational synergies via the elimination of redundant expenses

 

 

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated GBDC target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.

 

TPVG Q1 2019 Update

The following is a quick TPVG Update that was previously provided to subscribers of Premium Reports along with revised target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all business development companies (“BDCs”) please see Deep Dive Reports

Summary

  • TPVG reported between its base and best case projections covering 111% of its dividend due to prepayment-related income (similar to the previous quarters).
  • NAV/share increased by 0.7% due to overearning the dividend by $0.04 per share and net unrealized appreciation on investments of $1.2 million, or $0.05 per share mostly due to FTCH.
  • Cambridge Broadband Network ($7.1 million cost; $6.5 million FV) and Munchery, Inc. ($3.2 million cost; $2.2 million FV) remain on non-accrual status.
  • TPVG has portfolio concentration risk as the top five positions account for 37% of the portfolio compared to 30% in December 2018 but down from 57% in early 2018.
  • Since March 31, 2019, TPVG closed $17 million of additional debt commitments and funded $40 million.

 

 

TriplePoint Venture Growth (TPVG) reported between its base and best case projections covering 111% of its dividend due to prepayment-related income (similar to the previous quarters) driving an effective yield of 16.5% as shown in the following chart.

“The first quarter marked the fifth anniversary of our initial public offering. Our brand, reputation, focus on venture growth stage companies and our track record continue to differentiate us in the market,” said Jim Labe, Chairman and Chief Executive Officer of TPVG. “We are pleased to grow our platform and our investment portfolio while delivering attractive returns to our stockholders.”

 

 

 

During Q1 2019, NAV per share increased by 0.7% or $0.09 per share (from $13.50 to $13.59) due to overearning the dividend by $0.04 per share and net unrealized appreciation on investments of $1.2 million, or $0.05 per share, mostly due to “market-related changes affecting fair value estimates” including Farfetch Ltd. (FTCH) as discussed in the previous report.

“The mark-to-market increase was primarily due to price appreciation in our publicly traded equity holdings in Farfetch Limited and was somewhat offset by reversals in unrealized gains associated with loans that had been marked up due to pending acquisitions or anticipated prepayments.”

During Q1 2019, the company invested $92 million to 9 companies with a 13.0% weighted average yield but remains underleveraged due to the previous equity offering and $58 million of early prepayments. As of March 31, 2019, TPVG had $42 million of cash and $129 million of available capacity under its revolving credit facility for upcoming portfolio growth. In June 2018, TPVG obtained shareholder approval to reduce its asset coverage ratio to potentially increase its leverage (debt-to-equity) to a maximum of 2.00x. However, the company continues to experience early repayments and will likely remain under 1.00x.

“In general we expect and have always given guidance of one to two prepayments per quarter and it’s going to be part of our activity and part of our yields, but we always can get down to you know specific crystal ball vision next 30, 60 days necessarily. But I would say in general, there’d be a decrease if there’s not a lot of prepays.

From previous call: “Looking back, we had at least one prepay every single quarter over the past two years and 10 in the past 12 quarters. In fact, we’ve already had two here in 2019. We expect to see that pattern of one on average per quarter in 2019, and along with our expected originations and increased leverage, is something our board is taking into consideration as we consider possible increases in our dividend policy on a go-forward basis.”

“In the guidance that we gave when we got shareholder approval on our expectation for target leverage, right, we don’t need to lever the business out more than 1 to 1, given the return profile of our assets. But having said that, we did say that, during periods where portfolio growth in between capital raises to optimize when we raise equity, we would expect to go north of 1 to 1 to take advantage of that in building the portfolio and then waiting for prepays and for the capital markets to cooperate.”

As discussed in previous reports, TPVG has historically had portfolio concentration risk and management is actively working to diversify the portfolio using the ability to co-invest across the broader platform and likely one of the reasons for the previous equity offering. The top five positions currently account for around 37% of the portfolio compared to 30% in December 2018 but down from 57% in early 2018.

Since March 31, 2019, TPVG closed $17 million of additional debt commitments and funded $40 million. On the recent call management was asked about repayments so far in Q2:

A. “No repayments. That was – it should have been in the PR or it is in the earnings with case of a yes, no repayments as or prepaying, sorry.”

 

 

Management seems confident in the ability to grow the portfolio given the current pipeline and unfunded commitments.

“To be clear, while our pipeline is quite large and our investment portfolio is growing there has been no change to our underwriting approach which we have built over the 20 years that Jim and I have worked together. I think we also want to take advantage of the lower asset coverage ability and to lever up the business. And so I would say we’re active at work managing them. I think we have the challenge as we talked about earlier in the prepared remarks of the overfunding of equity, I think I mentioned $3.3 billion has been raised by 16 of our portfolio companies in the past 15 months that have slightly under $200 million of unfunded commitment with us. We would – we would hope for those companies to utilize our debt. The challenge is when really good things happen, the large equity raises or acquisitions those goes – those go unutilized. So we’re actually thoughtful, mindful and vary on top of them.”

As of March 31, 2019, the company’s unfunded commitments totaled $379.7 million, of which $102.0 million is dependent upon portfolio companies reaching certain milestones. Of the $379.7 million of unfunded commitments, $218.7 million will expire during 2019, $131.0 million will expire during 2020 and $30.0 million will expire in 2021 if not drawn prior to expiration.

TPVG had around $4.6 million or $0.18 (was $0.19) per share of spillover/undistributed income that management “intends to distribute in 2019”:

Sajal Srivastava, President and Chief Investment Officer: “Our performance last year demonstrated our portfolio’s ability to generate substantial yields and positive net realized gains, which resulted in approximately $4.6 million, or $0.19 per share, of spillover income we intend to distribute in 2019. Our origination capabilities, combined with our existing commitments to high quality companies in our portfolio, positions us for 2019 to be another year of growth.”

As discussed in the previous report, Cambridge Broadband Network ($7.1 million cost; $6.5 million FV) was added to non-accrual status during Q4 2018 and Munchery, Inc. ($3.2 million cost; $2.2 million FV) remains on non-accrual status and previously downgraded to Category 5 indicating “serious concern/trouble due to pending or actual default”. Mind Candy ($11.7 million cost; $6.9 million FV) is a video game developer for kids and remains its only investment that is considered a ‘Category 4’ investment “needing close attention”.

 

 

To be a successful BDC investor:

  • As companies report results, closely monitor dividend coverage potential and portfolio credit quality.
  • Identify BDCs that fit your risk profile.
  • Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends).
  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

For updated TPVG target prices, dividend coverage and risk profile rankings, credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions on all BDCs please see Premium Reports.