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.

 

FSK Q1 2019 Update

The following is a quick FSK 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

  • This is the first full quarter of reported results after combining the CCT portfolio. FSK reported just below its base case projections covering 95% of its dividend.
  • As mentioned in the previous report, Sungard Availability is filing for Chapter 11 and was marked down by around $2.7 million and added to non-accrual status in Q1 2019.
  • Z Gallerie filed for Chapter 11 bankruptcy in March 2019 and marked down an additional $6.5 million during Q1 2019.
  • Its non-accrual investment Charlotte Russe Inc. recently announced that it had sold the Charlotte Russe brand and related IP that will drive realized losses of around $20 million.
  • The company is repurchasing shares. Non-accruals decreased from 1.0% to 0.4% of the portfolio and include many of the energy and retail-related investments discussed in the previous report.

 

 

FS KKR Capital Corp. (FSK) reported just below its base case projections covering 95% of its dividend. This was the first full quarter of reported results after combining the CCT portfolio and management is working to reduce the amount of non-income producing equity investments. FSK remains above its target debt-to-equity ratio of 0.75 due to the previous NAV declines. During Q1 2019, the company repurchased 7.4 million shares (~1.4% of available shares) at an average price of $6.33 (19% discount to NAV).

Michael Forman, Chairman and CEO. “During the first quarter, we made further progress on our long-term strategic initiatives, and continued improving upon our portfolio. We feel well positioned with our significant scale and quality deal flow, and believe our continued execution of our share repurchase program demonstrates our confidence and our commitment to aligning ourselves with our shareholders.”

Previously, I downgraded FSK due to continued credit issues as discussed in the previously linked Deep Dive report. FSK’s Board has declared a regular cash distribution for Q2 2019 of $0.19 per share, paid on or about July 2, 2019 to stockholders of record as of the close of business on June 19, 2019.

 

 

Total non-accruals decreased from 1.0% to 0.4% of the portfolio based on fair value partially due to ThermaSys Corp, MB Precision Holdings, and Aspect Software Inc. added back to accrual status. As mentioned in the previous report, Sungard Availability Services Capital (cost and fair value of $14.7 million and $4.8 million, respectively) is filing for Chapter 11 and was marked down by around $2.7 million and added to non-accrual status in Q1 2019. The other non-accruals include many of the energy and retail-related investments discussed in the previous report including AltEn, LLC, Hilding Anders, Rockport (Relay), Advanced Lighting Technologies Inc., Charlotte Russe Inc., CTI Foods Holding Co., Z Gallerie, Petroplex Acidizing Inc., and HM Dunn Co.

Z Gallerie filed for Chapter 11 bankruptcy in March 2019 and marked down an additional $6.5 million during Q1 2019. The company blames the filing on self-imposed problems namely a failure to invest enough in e-commerce, the addition of a costly distribution center and an expansion that didn’t meet performance targets. On March 20, 2019 Nine West Holdings announced its exit from Chapter 11 that will not impact upcoming NAV but will likely result in realized losses of around $6.5 million in Q2 2019. Its non-accrual investment Charlotte Russe Inc. recently announced that it had sold the Charlotte Russe brand and related intellectual property to YM Inc. that will drive additional realized losses of around $20 million.

During Q1 2019, net asset value (“NAV”) per share increased by $0.02 or 0.3% (from $7.84 to $7.86) due to share repurchases as the net unrealized gains were offset by under-earning the dividend.

 

There was a $90 million increase in the amount of investments in ‘Investment Rating 3’ implying “Underperforming investment some loss of interest or dividend possible, but still expecting a positive return on investment” and needs to be watched.

 

In December 2018, FSK’s board of directors authorized a $200 million stock repurchase program. During the three months ended March 31, 2019, the Company repurchased 7,396,048 shares of common stock pursuant to the share repurchase program at an average price per share (inclusive of commissions paid) of $6.33 (totaling $47 million). During the period from April 1, 2019 to May 7, 2019, the Company repurchased 1,429,956 shares of common stock pursuant to the share repurchase program at an average price per share (inclusive of commissions paid) of $6.27 (totaling $9 million). Additional repurchases could be limited due to being above target leverage but funded through rotating out of portfolio assets.

As mentioned earlier, management has been working to reduce the amount of non-income producing equity investments that is now 8.1% of the portfolio (partially due to markdowns in equity investments). However, the amount of first-lien declined from 70% to 54% due to combining the portfolios of FSIC and CCT:

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 FSK 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.

GSBD Q1 2019 Update

The following is a quick GSBD 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

  • GSBD beat best-case projections (again) mostly due to lower incentive fees paid during the quarter covering its dividend by 123% (average coverage of 117% over the last 8 quarters).
  • NAV/share declined by 2.3% due to the restructuring of ASC Acquisition Holdings, discussed in the previous report and Country Fresh Holdings which was placed on non-accrual status.
  • Country Fresh is also an investment held by PFLT that contributed to its recent NAV decline.
  • Effective May 8, 2019, GSBD commenced the dissolution of its SCF and will receive around $216 million of assets financed directly on its balance sheet. This will instantly increase leverage and returns to shareholders as well as increase the amount of first-lien and overall diversification of the portfolio.
  • NTS Communications remains on non-accrual representing 3.5% of the total investments and is expected to be repaid in Q2 2019. Excluding NTS, non-accruals represented less than 0.1% of the portfolio.

 

Goldman Sachs BDC (GSBD) beat best-case projections (again) covering its dividend by 123% mostly due to lower incentive fees paid during the quarter. The company has covered its dividend by an average of 117% over the last 8 quarters. The company is in the process of dissolving its Senior Credit Fund(“SCF”) and will receive around half of the assets financed directly on its balance sheet. Effective May 8, 2019, GSBD commenced the dissolution of the joint venture partnership and GSBD received its pro rata portion of the SCF investments on balance sheet. This will instantly increase leverage and returns to shareholders as well as increase the amount of first-lien and overall diversification of the portfolio.

Net asset value (“NAV”) per share declined by $0.40 per share or 2.3% (from $17.65 to $17.25) due to the restructuring of ASC Acquisition Holdings, LLC(“ASC”) discussed in the previous report and Country Fresh Holdings which was placed on non-accrual status due to financial underperformance. Country Fresh is also an investment held by PennantPark Floating Rate Capital (PFLT) that contributed to its recent NAV decline.

In June 2018, shareholders approved the reduced asset coverage ratio of at least 150% (potentially allowing a debt-to-equity of 2.00) and management reduced the base management fee from 1.50% to 1.00%, lowering expenses and improving dividend coverage as shown below. GSBD is now well above its previous targeted leverage of 0.75 and has obtained all of the necessary approvals and is positioned to benefit from the reduced asset coverage requirement.

 

ASC Acquisition Holdings, LLC (“ASC”) was discussed on the previous call with management:

“Animal Supply is a more fluid situation but there are recent developments that we would like to share. Animal Supply is a nationwide distributor of pet food and supplies. Our investment thesis centered on the Company’s leading industry position and positive industry tailwinds driven by long-term trends driving demand for pet food supplies. During 2018 the Company’s performance and profitability declined. We determined that the best course of action was to deleverage the capital structure to better position the company to perform. As of last Friday, we successfully closed restructuring by swapping our debt for equity and providing additional working capital to enable the company to increase fill rates, revenue and EBITDA. We believe that with a clean balance sheet and a more focused management the Company is well positioned to benefit from stable industry trends and consolidation opportunities.”

During the previous quarter,  Its first lien, last-out unitranche debt investment in NTS Communications, Inc. (“NTS”) was added to non-accrual status and represents 3.5% and 3.8% of the total investment portfolio at fair value and amortized cost, respectively. This investment is expected to be repaid in Q2 2019 in connection with the sale of NTS.

“However, the exact timing is dependent on the satisfaction of certain closing conditions to the sale transaction, including receipt of Federal Communications Commission approval.”

Excluding its investment in NTS, non-accruals represented less than 0.1% and 0.7% of the total investment portfolio at fair value and amortized cost, respectively.

 

 

New investments during Q1 2019 were mostly first-lien and the portfolio remains heavily invested in first-lien debt including its SCF as shown below. Over the past four quarters, GSBD’s proportion of its first lien debt investments within its investment portfolio increased by 74% and second lien debt investments decreased by 44%.

 

 

Senior Credit Fund (“SCF”) Portfolio

The SCF was GSBD’s largest investment and is a joint venture with the Regents of the University of California (“Cal Regents”) that invests primarily in senior secured loans to middle-market companies. GSBD and Cal Regents have both subscribed/invested $100 million and using off-balance sheet leverage have invested in 32 companies with a total fair value of almost $452 million. GSBD will directly invest in around 50% of the portfolio using its own leverage and likely selected the higher-yielding assets. The SCF portfolio is 95% first lien and 100% floating rate diversified by sector:

 

 

“On May 8, 2019, the Company and Cal Regents each contributed $125,555 to the Senior Credit Fund, which was used by the Senior Credit Fund to repay in full all outstanding indebtedness, including all accrued and unpaid interest and fees, under the Asset Based Facility and to fund certain other related expenses that the Senior Credit Fund expects to incur in connection with its dissolution. The Asset Based Facility was then terminated and all liens securing the collateral under the Asset Based Facility were released. The Company funded its portion of the contributed amount through additional borrowings under its Revolving Credit Facility.”

“Following the repayment and termination, the Senior Credit Fund distributed each member’s pro rata share of all of its assets (other than cash and cash equivalents), primarily consisting of senior secured loans, to the members. The Company also assumed the obligation to fund outstanding unfunded commitments of the Senior Credit Fund that totaled $7,795 as of March 31, 2019, representing 50% of the Senior Credit Fund’s aggregate unfunded commitments. The pro rata portion of the assets received by the Company will become the Company’s assets and will be directly included in the Company’s consolidated financial statements and notes thereto, and will also be included for purposes of determining the Company’s asset coverage ratio. Based on March 31, 2019 balances, the assets to be received by the Company are approximately $221,769 and $215,728 at amortized cost and at fair value, respectively. In connection with the repayment of the Asset Based Facility and the distribution of all of its loan assets, the Senior Credit Fund declared a $2,000 cash distribution to its members, representing estimated quarter-to-date net investment income, 50% of which will be paid to the Company.”

 

 

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 GSBD 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.

 

SUNS Q1 2019 Update

The following is a quick SUNS 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

  • SUNS hit its base case projections covering its dividend only due to continued fee waivers with realized gains of $0.1 million mostly due to the exit from Genmark Diagnostics.
  • NAV/share increased by 0.6% primarily due to appreciation on its investments in North Mill Capital, Gemino Healthcare and TwentyEighty Investors, partially offset by depreciation in Trident USA Health Services.
  • Trident was added to non-accrual status and accounts for 0.2% of the portfolio and is the only portfolio company with an “Internal Investment Rating 4”.
  • SUNS remain underleveraged with plenty of growth capital and debt-to-equity of 0.80 compared to its target a range of 1.25 to 1.50.
  • North Mill Capital remains around 15% of the total portfolio and the weighted average yield decreased from 17.4% to 13.1% (closer to previous levels).

 

Solar Senior Capital (SUNS) hit its base case projections covering its dividend only due to continued fee waivers. As predicted, its total portfolio declined closer to previous levels and there was a meaningful increase in leverage with a debt-to-equity ratio of 0.80 (previously 0.65). North Mill Capital (“NMC”) remains around 15% of the total portfolio and the weighted average yield from NMC decreased from 17.4% to 13.1%. Net asset value (“NAV”) increased by $0.10 to $16.40 per share and the Board declared a monthly distribution for May of $0.1175 per share payable on June 4, 2019, to stockholders of record on May 23, 2019.

Michael Gross, SUNS Chairman/CEO: “We are pleased with Solar Senior Capital’s first quarter operating performance. Overall, the financial health of our portfolio companies remains sound and over 98% of our portfolio is invested in first lien senior secured loans. With our continued focus on asset-based specialty lending and cash flow investments in defensive, non-cyclical industries, we believe SUNS is positioned to perform well through economic cycles. The Company has ample capital to expand our specialty finance platform while continuing to be highly selective in cash flow lending.”

 

Risk Profile Update

SUNS continues to have mostly “true first-lien” positions, historically stable NAV and low non-accruals. Management has a history of doing the right thing including waiving fees to cover the dividend without the need to “reach for yield” and deploying capital in a prudent manner.

NAV per share increased by 0.6% from $16.30 to $16.40 primarily due to appreciation on its investments in North Mill Capital LLC, Gemino Healthcare Finance LLC and TwentyEighty Investors, LLC, partially offset by depreciation in Trident USA Health Services (cost of $7.0 million, fair value of $0.9 million) that was added to non-accrual status. Trident accounts for 0.2% of portfolio fair value and is the only portfolio company with an “Internal Investment Rating 4” implying that the investment is “performing well below expectations and is no anticipated to be repaid in full.” During Q1 2019, SUNS had net realized gains of $0.1 million primarily related to the exit from its investment in Genmark Diagnostics, Inc.

Liquidity and Capital Resources

As mentioned in previous reports, shareholders approved the reduced asset coverage ratio allowing for higher leverage and the immediate integration of its First Lien Loan Program (“FLLP”). SUNS will target a range of 1.25 to 1.50 debt-to-equity and took on additional debt associated with the FLLP but its debt-to-equity is still only 0.80.

Previously, SUNS announced that it had amended its credit facilities’ leverage covenants to allow for the asset coverage ratio minimum of 150%. At March 31, 2019, SUNS had $88 million of unused borrowing capacity under its revolving credit facilities. However, including NMC and Gemino non-recourse credit facilities, the company had approximately $225 million of unused borrowing capacity under its revolving credit facilities as of March 31, 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 SUNS 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.

 

 

Quick BDC Market Update: April 2019

Previous Quick Market Update:

The following is a quick update that was previously provided to subscribers of Premium Reports along with 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 BDC Market Update:

  • BDCs will begin reporting Q1 2019 results later this month. Please see reporting schedule below.
  • As predicted in previous updates, BDC prices rebounded strongly in Q1 2019.
  • I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B). I consider BDCs oversold when the yield spread is 4.0% higher and overbought when it is 3.0% lower.
  • The average BDC dividend yield is now over 10.2% and 3.7% higher than Corp B implying that the BDC sector is heading into oversold territory.
  • BDC fundamentals remain strong including a healthy U.S. economy, low market defaults and most BDCs focused on protecting shareholder capital with first-lien assets with protective covenants as discussed in many Deep Dive reports.

Estimated BDC Reporting Schedule

 

Are BDCs Overbought or Oversold?

Business Development Company (“BDC”) pricing is closely correlated to yield spreads including other non-investment grade debt and ‘BofA Merrill Lynch US Corporate B Index’ (Corp B). As shown in the chart below, I typically make multiple purchases when Corp B effective yields rise including January/February 2016, when the markets experienced similar concerns of slowing Chinese growth and increased energy sector defaults driving higher yield expectations, especially for non-investment grade debt (Junk bonds suffer a rare negative return in January).

Also shown in the chart below, is the recent pullback in Corp B yields which is/was driving higher BDC pricing this year.

 

 

Yield spreads are important to monitor as they can indicate when a basket of investments is overbought or oversold compared to other yield-related investments. However, general market yields can change at any time. Also, spreads change depending on the perception of risk and these are only averages that then need to be assigned a range for assessing individual investments/BDCs. BDCs can be volatile and timing is everything for investors that want to get the “biggest bang for their buck” but still have a higher quality portfolio that will deliver consistent returns over the long-term.

I closely watch the yield spreads between BDCs and other investments including the ‘BofA Merrill Lynch US Corporate B Index’ (Corp B) that recently increased from 6.36% on October 1, 2018, to 8.45% on December 26, 2018. However, as discussed earlier, these yields have been declining in 2019 and are currently around 6.53% (compared to the historical average of 6.50%). This is meaningful for many reasons but mostly due to indicating higher (or lower) yields expected by investors for non-investment grade debt.

The following chart uses the information from the previous chart showing the average yield spread between BDCs and Corp B. I consider BDCs oversold when the yield spread is 4.0% higher and overbought when it is 3.0% lower.

As shown in the chart below, the BDC sector is heading into oversold territory as the current yield spread is slightly over 3.7% (the difference between 10.2% for BDCs and 6.5% for Corp B). Please see the table at the end of this update for a list of current BDC yields.

Establishing a Range of Yields for BDCs:

Initially, I start with a baseline average yield that is driven by various comparable investment spreads. As shown in the first chart, the average historical yield of the ‘BofA Merrill Lynch US Corporate B’ index is around 6.5% with an average BDC yield spread of 3.5% implying an expected average BDC yield of 10.0%. I use the “standard deviation” or [σ] of the current BDC yields to develop an appropriate range. The following diagram shows a typical “bell curve” or normal distribution of results, with 95% represented within 2 standard deviations of the mean. The current standard deviation [σ] is around 1.4%. I use 2.0 σ to come up with a range that should accommodate around 95% of all BDCs which calculates to yields between 7.2% and 12.8% as shown in the diagram below.

 

 

Once I have established an appropriate yield range for BDCs, I assign a corresponding yield to each BDC using rankings of risk and dividend coverage. It is important for subscribers to understand that much more analysis goes into the pricing for each company.

For BDC 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.

Analyzing BDCs: 

 

Hercules Capital (HTGC): CEO Steps Down, What Comes Next?

 

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

Summary

  • On March 12, 2019, federal authorities arrested dozens of people involved in the largest college admissions fraud scam in U.S. history. Prosecutors have named 33 parents including Manuel Henriquez, Chairman/CEO of HTGC.
  • Mr. Henriquez has voluntarily stepped aside but will continue as a member of the Company’s Board and an adviser to the Company.
  • I sold shares in May 2017 due to Mr. Henriquez seeking externalization which was bad for the company/shareholders but excellent for Mr. Henriquez and fully supported by the Board.

As mentioned at the bottom of each of my articles, to be a successful BDC investor:

  • Diversify your BDC portfolio with at least five companies. There are around 50 publicly traded BDCs; please be selective.

This is a good example of why you need to diversify your BDC holdings.

On March 12, 2019, federal authorities arrested dozens of people involved in the largest college admissions fraud scam in U.S. history. Prosecutors have named 33 parents (including Manuel Henriquez, Chairman and CEO of HTGC) and 13 coaches but said the investigation continues and more parents and coaches could be charged.

Federal prosecutors allege that Mr. Henriquez, along with his wife, participated in the cheating scheme on four occasions for their two daughters and were charged with conspiracy to commit mail and wire fraud. Mr. Henriquez surrendered to the FBI on Tuesday and was released on a $500,000 bond following a court appearance.

On March 13, 2019, HTGC announced that effective immediately, Manuel Henriquez has voluntarily stepped aside as Chairman and Chief Executive Officer. The Board has elected Robert P. Badavas, currently Lead Independent Director to be Interim Chairman of the Board and elected Scott Bluestein, the Company’s Chief Investment Officer as Interim Chief Executive Officer.

Mr. Henriquez will continue as a member of the Company’s Board and an adviser to the Company.

Mr. Bluestein has nearly 20 years of financial services, direct investment and credit experience. He joined the Company in 2010 as Chief Credit Officer and was appointed Chief Investment Officer in 2014. Before joining Hercules, Mr. Bluestein served as Founder and Partner of Century Tree Capital Management, a fund established to make senior secured debt investments with warrants and equity co-investments in small and micro-cap public and private companies.

Mr. Badavas stated, “The Company has a strong and deep management and investment team and a preeminent position as a provider of financing for innovative, venture backed companies. We are fortunate that Hercules has Scott, who leads our investment and origination team and was previously our Chief Credit Officer, to assume the role of Interim Chief Executive Officer. Scott has deep knowledge of our investments and has played a key role in defining our underwriting strategies. We are confident that our market leading role in providing financial solutions to innovators and their venture capital partners will continue uninterrupted.”

As mentioned in previous articles and the BDC Risk Profiles, the ‘Quality of Management’ is likely the most important part of BDC analysis as management is responsible for building a portfolio to deliver returns to shareholders while protecting the capital invested. BDC management controls all the levers including the quality of the origination/credit platform, managing the capital structure with appropriate leverage, meaningful share repurchases, accretive equity offerings and dividend policy, creating an efficient operating cost structure and willingness to “do the right thing” by waiving management fees or having a best in class fee structure that protects returns to shareholders.

Also mentioned in previous public HTGC articles, including “Hercules Capital: External Management Analysis”, in May 2017 Mr. Henriquez attempted “externalization” which would have increased the overall cost structure as well as making it less scalable for future dividend increases. This likely has weighed on the stock (for fear of another attempt to externalize) and shareholder’s trust in management.

The recent events did not appear to have any relation to activities at the company but will be a distraction for HTGC management and will likely impact the near term stock price. I have taken into account lower expected portfolio growth starting in Q2 2019 as well as lower core portfolio yields. However, HTGC had a $1.5 billion pipeline of potential opportunities and had been actively hiring additional personnel driving higher operating expenses in 2018. Please see the discussions below.

From recent earnings call: Now, let me take a brief opportunity to discuss our views of the marketplace and activities as we enter the first quarter 2019. We remain very optimistic about what we’re seeing so far in Q1 of 2019. As we continue to be hyperly selective in evaluating and reviewing the potential pipeline that now stands at over $1.5 billion of new investment opportunities that we’re evaluating. This is above and beyond the already $345 billion of close or pending to close commitments that we already have in-house today as outlined in our earnings release this afternoon.

From a previous call: In an effort to address the increasing loan demand, we’re actively expanding our offices in Boston and Palo Alto. We’re adding additional new headcounts across all levels of the company, which we expect to continue throughout the remainder 2018 and early part of 2019. We see tremendous opportunities continue to grow our loan portfolio rolling into 2019 and we want to make sure that we’re properly capitalized as well as staffed to continue to address the strong demand that we are seeing for our capital.

What Comes Next?

As many readers know, I am typically a ‘Buy and Hold’ investor making additional purchases during general market/sector pullbacks and only selling if there are serious issues. I have been investing (on and off) in HTGC over the last 10 years and writing public articles on Seeking Alpha discussing the stock for over 6 years.

Previously, I sold my shares of HTGC at an average price of $15.17 on May 4, 2017, due to the company seeking “externalization”. However, I have been slowly repurchasing shares including most recently on December 26, 2018, at $10.95. As shown below, HTGC’s stock price never recovered from its pre-externalization highs likely for the reasons discussed earlier.

I also own shares in another internally managed BDCs, Main Street Capital (MAIN), which is one of the best-managed companies in the sector as discussed last month in “Dividend Increases For The High-Yield BDC Sector Part 4“. Shortly after the HTGC externalization announcement, MAIN’s management was asked if they would ever seek to be externally managed and Vince Foster (the CEO at the time) responded with:

Yeah. If I went to the Board and expressed an intent to externalize, I would — I think I would become externalized, I expect to be terminated. And if the Board let me, I would hope that the shareholders would terminate them.

Source: Main Street Capital’ (MAIN) CEO Vince Foster on Q1 2017 Results – Earnings Call Transcript

I sold my shares in May 2017 because the externalization was a bad deal for the company and shareholders but excellent for Mr. Henriquez and fully supported by the Board. My previous articles discussed why I thought it was a ‘bad deal’ including:

  • Optics for investors and changes in trust of management.
  • Increased conflicts of interest.
  • Reaching for yield due to a higher cost structure.
  • 2% base management fee – the highest in the sector and much more important than the incentive fee structure.
  • 7% hurdle rate for incentive fees – too low and not shareholder-friendly.
  • Lack of total return hurdle to protect shareholders from capital losses – as most BDCs are headed toward shareholder-friendly fee structures, HTGC has decided to take the opposite approach.
  • Changes to stock valuation based on lower expected dividend coverage/growth and likely higher risk profile (from increased conflicts of interest and potentially reaching for yield).

It should be noted that Mr. Henriquez has around 2 million shares currently valued at almost $25 million which is much more than the interim CEO and Board of Directors as shown below.

 

Source: GuruFocus

What Can The Board Do From Here?

The following is from the Retention Agreement, dated as of October 26, 2017, between Hercules Capital, Inc. and Manuel A. Henriquez:

The Executive’s employment may be terminated by the Company prior to the occurrence of a Change in Control at any time and the Executive will be entitled to the benefits provided by Section 4, provided the Executive has incurred a “separation from service” as defined in Section 409A, unless such termination is the result of the occurrence of one or more of the following events: “Cause” shall mean, with respect to the Executive: (II) the Executive’s conviction (or entry of a plea bargain admitting criminal guilt) of any felony or a misdemeanor involving moral turpitude.

If anyone has any doubt of whether Mr. Henriquez will be found guilty “of any felony or a misdemeanor involving moral turpitude”, please read the charging documents including pages 44 through 57:

The following is from “How Silicon Valley became epicenter of college-entry cheating scandal“:

The Henriquezes of Atherton, however, seemed to have few qualms of drawing in their daughters’ participation. In 2015, after paying upward of $25,000 to arrange for a proctor to sit next to one of their daughters during her SAT exam at a private Belmont high school and feed her the answers, the young man “gloated with” Elizabeth Henriquez and her daughter “about the fact that they had cheated and gotten away with it,” according to the indictment.

Clearly, Manny (Mr. Henriquez) is still important to the company and needed for the transition as he is very influential in the VC community. But it would be nice if the Board would do the right thing this time for shareholders including adjusting/canceling current and future stock option awards or even a potential clawback of shares and restricted stock units.

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 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.