Author: BDC Buzz

TSLX Preliminary Estimates

• NAV increase of almost 2%
• NII of $0.48 compared to its dividend of $0.41
• Stable portfolio credit quality with 0.9% non-accruals

As of January 25, 2021, Sixth Street Specialty Lending, Inc. (TSLX) estimates that its net asset value per share as of December 31, 2020 was approximately $17.16 per share, up from $16.87 as of September 30, 2020 (or $16.77 after adjusting for the impact of the Company’s Q3 2020 supplemental dividend that was paid on December 31, 2020). As of December 31, 2020, the Company’s total portfolio was approximately $2.3 billion in aggregate fair value, up from $2.1 billion as of September 30, 2020.

Estimated net income per share for the quarter ended December 31, 2020 is $0.79. Estimated net investment income per share for the quarter ended December 31, 2020 is $0.48. Both these amounts include approximately $0.02 per share of incentive fee expenses that were accrued, but not paid, related to the Company’s cumulative inception-to-date unrealized gains exceeding its cumulative inception-to-date realized gains and losses and unrealized losses as of December 31, 2020. Excluding the impact of the accrued capital gains-related incentive fee expenses, the Company’s estimated net income per share and net investment income per share for the quarter ended December 31, 2020 were $0.81 and $0.50, respectively.

As of December 31, 2020, the Company had approximately $865 million of liquidity in undrawn debt capacity and unrestricted cash. During the fourth quarter, the Company added $20 million of commitments to its senior secured revolver, bringing total capacity to $1.335 billion as of December 31, 2020. Estimated debt to equity as of December 31, 2020 was approximately 0.95x, up from 0.81x as of September 30, 2020. The Company’s debt funding mix at quarter end was comprised of approximately 58% unsecured debt, and the Company had approximately $863 million of undrawn capacity under its revolving credit facility.

There has been no material change to the Company’s weighted average portfolio performance ratings from September 30, 2020, to December 31, 2020. As of December 31, 2020, investments on non-accrual status was approximately 0.9% of the portfolio at fair value, flat from the prior quarter. During the quarter ended December 31, 2020, one additional portfolio company was placed on non-accrual status, American Achievement Corporation. The Company’s investments in MD America Energy, LLC and J.C. Penney Company, Inc. were removed from non-accrual status.

BlackRock TCP Capital (TCPC) announced preliminary financial estimates for the fourth quarter ended December 31, 2020.

• NAV increase of 4%
• NII of $0.34 to $0.35 compared to its dividend of $0.30

Full BDC Reports

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

GAIN Dividend Coverage Update

GAIN has recently announced two transactions accounting for $43.8 million of portfolio investments or 7.3% of the overall portfolio fair value which will result in significant realized gains and additional income. Around $34.3 million was invested in non-income-producing equity positions potentially driving ~$0.76 per share of realized gains (if exited at recent fair values) and will likely be reinvested mostly into income-producing assets.

On January 4, 2021, GAIN announced the exit of its investment in Frontier Packaging, Inc. resulting in the repayment of its $9.5 million debt investment at par and “realized a significant gain on its equity investment”. Its equity investment in Frontier was valued at $13.4 million as of September 30, 2020, and if exited at the same value would result in realized gains of around $0.36 per share. Also, the proceeds will likely be reinvested into income-producing assets.

“With our sale of Frontier Packaging and from our inception in 2005, Gladstone Investment has exited over 20 of its management supported buy-outs, generating significant net realized gains on these investments in the aggregate. Our strategy as a buyout fund, realizing gains on equity, while also generating strong current income during the investment period from debt investments alongside our equity investments, provides meaningful value to our shareholders through stock appreciation and dividend growth. Significant winners like Frontier prove out our focus on buying high quality businesses, backing outstanding management teams and being able to have investments with long hold periods.”

On December 21, 2020, GAIN announced the recapitalization of its portfolio company Old World Christmas, Inc. with the origination of a new secured term loan. GAIN received “significant equity proceeds and realized a capital gain and other income”. Its equity investment in Old World was valued at $20.9 million as of September 30, 2020, and if exited at the same value would result in realized gains of around $0.40 per share.

GAIN will not be covering its upcoming dividends due to remaining underleveraged, additional non-accruals, lower portfolio yield, and continued lower dividend income. However, dividend coverage should improve due to th recent increase in portfolio yield, higher use of leverage, and likely lower non-accruals.

Also, the upcoming realized gains will more than cover its $0.07 per share monthly dividend as the company reinvests the proceeds.

Also, as of September 30, 2020, GAIN had around $5 million or $0.16 per share of undistributed income “available for distribution to shareholders in future periods”:

“In addition, distributable income to shareholders remained solid. On a book basis undistributed net investment income combined with net realized gains totaled over $5 million or about $0.16 per common share. This amount is reduced by the book accrual of the capital gains based incentive fee that’s required under U.S. GAAP and that number is roughly $7 million which is not contractually due yet. All else equal, the $0.16 per common share would be available for distribution to shareholders in future periods even if the entire capital gains-based incentive fee accrual were to be contractually due which it is not.”

Similar to BDCs such as MAIN and CSWC, the company supports supplemental/semiannual dividends through realized gains typically from equity positions:

GAIN has increased its dividend three times over the last two years while growing its NAV per share by 7.5% over the last three years. Also, GAIN has relatively low amounts of leverage with the potential for improved coverage through portfolio growth and rotating out of equity investments. On October 13, 2020, GAIN reaffirmed its monthly dividend of $0.07 per share.

Previously, the Board approved the modified asset coverage ratio from 200% to 150%, effective April 10, 2019. However, the company is subject to a minimum asset coverage requirement of 200% with respect to its Series D Term Preferred Stock.

The amount of preferred/common equity accounted for around 25% of the portfolio fair value which is being monetized and eventually reinvested into income-producing secured debt.

Full BDC Reports

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

ARCC Issues An Additional $650 Million 2.150% Unsecured Notes Due 2026

• The following information was previously covered in a public on Seeking Alpha “Ares Capital: 9.4% Yield, Provides Preliminary Results“.

On January 13, 2021, ARCC closed an offering of $650 million of its 2.150% unsecured notes due 2026 at a slight discount of 99.593% of their principal amount, resulting in estimated net proceeds, after estimated offering expenses, of approximately $641.2 million. It should be noted that issuing notes at a discount drives a slightly higher yield-to-maturity of 2.229%.

This is an extremely low fixed rate for an unsecured note due 2026. Many BDCs have been issuing unsecured notes which adds tremendous flexibility to their balance sheets not to mention maintaining net interest margins with the potential to invest at higher rates later this year. This means that we will likely see maintained or even improved earnings over the coming quarters resulting in sustainable dividends.

Source: SEC Filing

Included in the SEC filings related to the offering were the following preliminary results through December 28, 2020:

• Sold 0.2 million shares for ~$4 million.
• Funded $2.5 billion of new investments at a weighted average yield of 7.7%.
• Exited $2.8 billion of investments at a weighted average yield of 7.2%.
• Net realized losses of $177 million or around $0.42 per share.
• These realized losses were offset by $199 million of reversed unrealized losses.

ARCC’s portfolio is/was over $14 billion so there will only be a slightly positive impact on the overall portfolio yield. The realized losses were due to exiting or restructuring quite a few of its non-accrual investments but there should be a slightly positive impact to NAV per share as they were completely offset by the reversal of previous unrealized losses. This would imply that the company exited/sold these investments at a higher price (on average) than the fair value as of September 30, 2020.

From October 1, 2020 through December 28, 2020, we sold an aggregate of approximately 0.2 million shares of common stock for total net proceeds of approximately $4 million under our equity distribution agreements with Truist Securities Inc. and Regions Securities LLC.”

“From October 1, 2020 through December 28, 2020, we made new investment commitments of approximately $3.2 billion, of which $2.5 billion were funded. Of these new commitments, 78% were in first lien senior secured loans, 16% were in second lien senior secured loans, 4% were in preferred equity securities and 2% were in other equity securities. Of the approximately $3.2 billion of new investment commitments, 94% were floating rate, 4% were fixed rate and 2% were non-interest bearing. The weighted average yield of debt and other income producing securities funded during the period at amortized cost was 7.7%.”

“From October 1, 2020 through December 28, 2020, we exited approximately $2.8 billion of investment commitments. Of the total investment commitments, 79% were first lien senior secured loans, 15% were second lien senior secured loans, 2% were subordinated certificates of the SDLP, 2% were senior subordinated loans, 1% were other equity securities and 1% were collateralized loan obligations. Of the approximately $2.8 billion of exited investment commitments, 89% were floating rate, 8% were on non-accrual status, 2% were non-income producing and 1% were fixed rate. The weighted average yield of debt and other income producing securities exited or repaid during the period at amortized cost was 8.0% and the weighted average yield on total investments exited or repaid during the period at amortized cost was 7.2%. On the approximately $2.8 billion of investment commitments exited from October 1, 2020 through December 28, 2020, we recognized total net realized losses of approximately $177 million. As a result of the investment commitments exited, we reversed previously recorded net unrealized depreciation related to such net realized losses of approximately $199 million.”

“In addition, as of December 28, 2020, we had an investment backlog and pipeline of approximately $1.1 billion and $15 million, respectively.”

ARCC Portfolio Credit/Non-Accruals Update

During Q3 2020, non-accrual investments increased from 2.6% to 3.2% of fair value (from 4.4% to 5.1% of cost) of the total portfolio due to adding OTG Management, Sundance Energy, and InterVision Systems with the weighted average grade of the investments in the portfolio at fair value remains around 2.9. As mentioned in the previous report, OTG Management is an airport restaurant operator that was partially added to non-accrual status during Q3 2020 and continues to be marked down currently at 69% of cost and accounts for around 1.0% of the portfolio and $0.36 per share or 2.2% of NAV.

Source: SEC Filing

As mentioned earlier, the company will likely have around $177 million or around $0.42 per share of realized losses in Q4 2020 mostly related to the exiting or restructuring of its non-accrual investments. But there should be a slightly positive impact to NAV per share as they were completely offset by the reversal of previous unrealized losses. This would imply that the company exited/sold these investments at a higher price (on average) than the fair value as of September 30, 2020. Also, it’s important to note that there will likely be a meaningful reduction in the amount of investments on non-accrual as well as additional income related to investments that were restructured during the quarter.

We believe that in future quarters, non-accrual levels may stabilize or could improve from these third quarter levels. Of the existing non-accruals we think, for the most part, they’re all pretty darn good businesses, that tier-point are operating in cities impacted by COVID. And through a combination of equity coming into those companies and potentially providing some concessions in the near term, they figured out how to operate. But, yes, I think there will be a path to recovery for most, if not all of them. So, I think it’s being reasonably optimistic on the existing non-accruals. But I think I’m optimistic too around the portfolio, because when you when you look at our non-accrual list, it’s pretty small list, right? And we’ve talked about the grade ones and twos being, I think in my mind, ring fenced at this point, and that we understand where the issues are. And we think that we have them under control, as I mentioned in the prepared remarks, so definitely a lot more optimistic than I was in April.”

Please note that ARCC has a very large portfolio with investments in 347 companies valued at almost $14.4 billion so there will always be a certain amount of non-accruals.

In terms of risk management, we remain focused on maintaining a highly diversified portfolio, which today includes 347 different companies with an average hold position at fair value of only 0.3%. We believe this diversity is a differentiator as it underscores the performance of any single investment and is unlikely to have a material impact on the aggregate performance of our company.”

My primary concern is 18.1% (previously 18.8%) of the portfolio considered “Investment Grade 2” which indicates that the “risk to our ability to recoup the initial cost basis of such investment has increased materially since origination or acquisition, including as a result of factors such as declining performance and non-compliance with debt covenants, however, payments are generally not more than 120 days past due.” However, ARCC has higher quality management that takes a conservative approach to assess portfolio credit quality and there will likely be a material improvement during Q4 2020 for the reasons discussed earlier.

Regarding the health of our portfolio, our weighted average portfolio grade of 2.9 remain stable versus last quarter, and less than 5% of our portfolio companies changed grades. The ratio of upgrades to downgrades was greater than three to one, which we believe highlights the steady to improving cash flows of our portfolio companies that is followed with partial or complete reopening of many businesses. For the more COVID impacted names, which we largely see in our grade one and grade two names, we believe we have an informed view of their path to recovery but we do think this recovery will take time and likely be quite uneven with the ever-evolving COVID health crisis. Many of these companies are generally strong franchises with every reason to perform as they did pre-COVID and that they will recover during more certain economic times.”

Full BDC Reports

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

Capital Southwest 5.95% Notes due 12/15/2022 (CSWCL)

On November 5, 2020, CSWC announced the partial redemption (another $20 million) of its 5.95% Notes due 2022 (CUSIP No. 140501206; NASDAQ: CSWCL) on December 10, 2020.

The “Bond Risk” tab of the BDC Google Sheets includes a summary of metrics used to analyze the safety of a debt position such as the “Interest Expense Coverage” ratio which is used to see how well a firm can pay the interest on outstanding debt. Also called the times-interest-earned ratio, this ratio is used by creditors and prospective lenders to assess the risk of lending capital to a firm. A higher coverage ratio is better, although the ideal ratio may vary by industry. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio.

Previous CSWC Insider Purchases

From previous call: “As a further demonstration of our confidence and shareholder alignment, our directors and officers purchased approximately 107,000 shares of CSWC stock during the quarter, bringing the group’s total ownership in Capital Southwest to approximately 10% of the outstanding common stock.”

CSWC Dividend Coverage Update

“I think we do have an eye on growing the regular dividend over time, based on origination to date and sort of this transition to the five points — getting away from those unsecured bonds, we think our run rate in the next quarter or two is going to be in the $0.42 to $0.43 in terms of NII. When we feel comfortable there, we’ll probably inch up the dividend in turn. When we make the full transition out of those notes, and we start drawing on the revolver next year, we see quite a bit of an increase in NII. To quantify it long term, I think I’ve said this on the last call and once we have fully immersed in the FDIC, fully deployed, we see that’s a 20% to 25% increase relative to using bonds in the next two to three years. So we’re definitely looking ahead towards increasing that dividend slowly and steadily.”

CSWC’s Board declared a total dividend of $0.51 per share for the quarter ended December 31, 2020, including the regular quarterly dividend of $0.41 per share and a supplemental dividend of $0.10 per share.

“Total dividends for the quarter of $0.51 per share represented an annualized dividend yield on the quarter stock price per share of 14.5% and an annualized yield on net asset value per share of 13.3%. I’m also pleased to announce that our board has declared total dividends of $0.51 per share again for the quarter ended December 31, 2020, consisting of a regular dividend of $0.41 per share and a supplemental dividend of $0.10 per share.”

CSWC’s target pricing and dividend yield in the BDC Google Sheets takes into account $0.10 per share of quarterly supplemental/special distributions that will likely continue beyond 2021. Similar to MAIN, the supplemental dividends are typically covered by realized capital gains and over-earning the regular dividend. CSWC had net realized gains of $44 million during calendar Q4 2019 related to the exit of Media Recovery. As of September 30, 2020, CSWC had $1.19 per share of undistributed taxable income and gains. Management is likely going to maintain its dividends going forward as they need to distribute this over the coming quarters:

“We also continued our supplemental dividend program paying out an additional $0.10 per share, funded by our sizable undistributed taxable income balance. As a reminder, the supplemental dividend program allows our shareholders to meaningfully participate in the successful exits of our investment portfolio through distributions from our UTI balance. As of September 30, 2020, our estimated UTI balance was $1.19 per share.”

From previous call: “Due to the successful sale of Media Recovery in late 2019, we were able to replenish our UTI balance to the maximum allowable level as of the end of the 2019 tax year, providing visibility on the longevity of the program well into the future. The program will continue to be funded from UTI earned from realized gains on both debt and equity, as well as undistributed net investment income earned each quarter in excess of our regular dividends. The good news is the UTI balance that you have is not affected by having realized losses. What it does create is sort of an amount that you have to overcome with realized gains before you’re able to book additional pennies into the UTI bucket. We feel like we’ve got two to three years of runway to create those gains to apply against those losses to continue this program without any interruption.”

For calendar Q3 2020, CSWC reported just above its best-case projections with higher-than-expected portfolio growth, interest and fee income covering its regular quarterly dividend by 109%. The company is now above its upper targeted leverage (1.20) with a debt-to-equity ratio of 1.29 but recently submitted its application to form a new SBIC subsidiary with access to an additional $175 million of low-cost capital with potential approval by the end of this year as discussed later.

“This quarter, we had probably about $400,000-ish of one-time fees that are above our normal expectation or run rate. Then in terms of this quarter repayments — right now I think of the one to three prepayments, one of them does not have a [indiscernible], and I think that there’s maybe one small one between the other two. So I would tell you, it’s like $50,000-ish but having said that, there’s always something that comes up so that number could be elevated by the end of the quarter.”

As predicted in the previous report, dividend coverage improved partly due to adding Delphi Intermediate Healthco back on accrual status. Over the coming quarters, dividend coverage should continue to improve due to additional investments added back to accrual status (discussed later) and reduced borrowing expenses including the previously discussed redemption of $20 million of its Baby Bond “CSWCL” and SBIC license, and new investments at a relatively higher yield. An SBIC license will provide CSWC an incremental source of long-term capital by permitting it to issue up to $175 million of SBA-guaranteed debentures. These debentures have maturities of ten years with fixed interest rates currently around 3%.

“During the quarter, we raised an additional $50 million on our 5.375% unsecured notes due 2024 and subsequently paid down $20 million on our 5.95% baby bond due 2022. We will continue to be opportunistic in paying down higher price debt to optimize net investment income while also being mindful of maintaining appropriate flexibility in our liability structure. So we will be ramping up our revolver, in fact, to both pay down some of the 5.95% bonds, as well as to accommodate originations that are not in the SBIC going forward. Finally, as we mentioned last quarter, we continue to work with the U.S. Small Business Administration towards becoming officially licensed as an SBIC. We are pleased to report that we completed our final license submittal during the quarter, and look forward to reporting developments on the status of our pending license application to our shareholders as warranted. As a reminder, final approval, and issuance to Capital southwest of an SBIC license would provide a 10-year commitment to provide Capital Southwest with up to $175 million in debt financing to be drawn to fund investment in our lower middle market strategy.”

Also, management is actively growing the portfolio including $66 million of new originations in Q3 2020: “On the new origination front, we remained active, committing $66.3 million in originations to both new and existing portfolio companies.”

On July 30, 2020, CSWC announced that the U.S. Small Business Administration (the “SBA”) has issued a “green light” letter inviting the company to file its application to obtain a license to operate a Small Business Investment Company (“SBIC”) subsidiary. During Q3 2020, the CSWC submitted its final application and is expecting to receive its first license by the end of the year with qualifying investments that could be funded as early as Q1 2021:

“We estimate that the vast majority of the deals we have reviewed over the past five years would qualify for SBIC financing, giving us a high level of competence that we will be able to invest this capital in our existing strategy and continue to support growth and employment in small businesses across the country. As a reminder, each draw from the SBIC debenture program separately represents a new debt security in our capital structure with a 10-year maturity from the date of draw, making this capital truly long term in nature. From a cost perspective, if treasury rates remain close to today’s level, the all-in cost of the SBIC debentures would be less than 3%. This program is clearly a perfect fit for our lower middle market focus and we look forward to continuing to work with the SBA in completing the application process and in successfully executing the SBA’s mission of supporting growth and employment in U.S. Small businesses. We believe we’re in the final stages of the licensing process and are hopeful of receiving our license by the end of the calendar year. We are excited to integrate the SBIC license into our capitalization strategy as the flexibility and low cost of SBIC debentures should be highly accretive to our net investment income per share, while also allowing us to continue to provide important growth and acquisition capital to U.S. Small businesses.”

“We actually expect that we’re weeks away from actually having that application. We don’t want to be presumptive, but that’s the kind of the guidance we’ve been given. So we’re going to just wait until probably December and likely start allocating those assets to the SBIC, probably in January.”

On September 29, 2020, CSWC redeemed $20 million of its 5.95% Notes due December 2022 and recognized realized losses on the extinguishment of debt of $0.3 million. In August 2020, the company issued an additional $50 million of the 5.375% Notes due October 2024. As of September 30, 2020, CSWC had almost $16 million in unrestricted cash and almost $135 million in available borrowings under its credit facility for upcoming portfolio growth. In April 2018, the Board 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%. Previously, management was targeting a debt-to-equity ratio between 1.00 and 1.20 but is expecting around $30 million of prepayments in Q4 2020 and is taken into account with the updated projections along with additional prepayment fees:

“If you think about leverage up to 1.28, the answer is, yes, we’re comfortable with where we are. It is higher than our 1.1 to 1.2 target range we gave pre-COVID. If you look at — if you just take a high level, look at the depreciation in the portfolio during COVID, retracing that COVID effect on the portfolio, we’re basically back to the top end of our leverage range and so, you have to keep in mind that as the portfolio re-appreciate that leverage, all else equal will come down. So that’s one point and why I can say we’re comfortable with where we are. The next thing is we’ve got visibility on $30 million to $35 million of pre-payments coming in from portfolio companies that are performing very well and are being sold or refinanced or what have you. So if you of think about leverage, we have visibility on cash coming in. So we’ll obviously be redeploying that cash in originations.”

In March 2019, CSWC established its equity “At-The-Market” (“ATM”) program of slowly issuing small amounts of shares at a premium to book value/NAV and accretive to shareholders. As CSWC’s stock price continues higher, management will likely 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. During Q3 2020, the company sold only 35,112 shares of its common stock at a weighted-average price of $14.99 per share, raising $0.5 million.

“But that’s another point. And the third thing I would say is, if you think about — we traded well above book for almost two years pre-COVID. So I believe that we’ve proven that our business model and our strategy in a more normal market should trade above NAV. So if it trades above NAV, as you know, we’ve got an ATM program that we’re diligent about accessing at very low spreads to trade. So that’s obviously a function and our yield on NAV today is 13.5% or so. And on the stock price, it’s north of 14%. The market will figure out the risk premium on our stock over time. So we’re comfortable and just letting the market play out. But those yield levels, based on our strategy and track record, really are not where we believe those yield levels will normalize out over time, which we believe will trade above NAV and we’ll be able to raise equity. So, those are all the points that are in my head, as I look at the leverage of 1.28 and go, am I comfortable with that or not?”

As expected, its I-45 Senior Loan Fund was marked up again, remains around 10% of the total portfolio and is a joint venture with MAIN created in September 2015. The portfolio is 96% invested in first-lien assets with CSWC receiving over 75% of the profits providing 11.0% annualized yield (previously 12.5%) paying a quarterly dividend of $1.7 million compared to $1.8 million during the previous quarter.

“Turning to Slide 16, the I-45 portfolio shows meaningful improvement during the quarter as our investment in I-45 appreciated by $4.7 million or 8%. Leverage at the I-45 fund level is now 1.39x debt to equity at fair value, which is substantially improved from the March 31, quarter average of 2.51x.”

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

CSWC Risk Profile Update

There were no additional investments added to non-accrual status during the quarter. American Addiction Centers (“AAC”), AG Kings Holdings, and California Pizza Kitchen (“CPK”) remain on non-accrual status with a total fair value of $10.9 million or 1.7% of the total portfolio. If completely written off would impact NAV per share by around 3.8% as shown in the following table.

These investments were discussed on the recent call and management is expecting some positive results including either being restructured back on accrual status (AAC and CPK) or outright sales (AG Kings is being purchased by Albertsons) and then reinvested into income-producing assets:

Q. “I wanted to touch on the non-performing loans, if I’m not mistaken, they’re all in certain stages of bankruptcy. And I think there’s been some movements since our last call. So starting with American Addiction, from what I’ve read, the information is a little sparse, it looks like you’re going to be repaid in cash on that from asset sales. Is that correct? And when will that be?”

A. “So based on what’s public, it’s going to emerge from bankruptcy relatively soon. It’ll be restructured. So the lender group, which we are a part of, will end up holding a debt security, first lien debt security in the new restructured company, and then ownership of the equity in the company. So it’ll be restructured, it will emerge from bankruptcy and Capital Southwest actually will have a board seat. And so, that’s that, it will all be resolved relatively soon. I mean, it’s not in our control, but it’s basically got to work through taxes and various things, structuring the recap, the restructuring, so that’s AC. Anyway, you want to talk about Kings and CPK, as well?”

Q. “So CPK, it looks like similarly you’re going to get equity and debt. Is that correct? And when is that going to happen?”

A. “Similar story as AC as far as what will happen from the bankruptcy perspective. So we’ll end up with a performing, firs lien note and equity in the company, we will not have a board seat in that instance. We think that’s going to happen — I think it may be announced, but it’ll be relatively soon. This manager team seems to be doing a really good job with the business. And it’s one thing, and then the other thing is that the restaurants that have opened, people come eat there, and so it tells me that the brand is relevant, and it’s desired, and there’s a demand for that brand and that concept in the market. So that’s encouraging. Clearly COVID is a bunch of noise out there. It’s affecting all the restaurants, the management team is doing some interesting creative things around that, with respect to CPK. The election and any kind of unrest that may result — unrest in an area affects all the retailers, all the places, restaurants included in those areas. So there’s clearly noise out there. But the thing I grab on to is manager team is seem to be doing a great job, we have weekly calls, and the restaurants that are open, people want to eat there. And so, based on those two things, that gives me a lot of encouragement as to the future of that concept once all the market noise, COVID pandemic noise sort of fades away, which will, this too shall pass. And so, still challenges, but good team, and there’s some definitely some signs of relevance of that concept and brand.”

Q. “And on AG Kings, obviously there was a stalking-horse bid. I haven’t seen another bid come through unless I’m mistaken. Is that correct? Or are there other folks snooping around and potentially going to offer?”

A. “Yes, so that’s actually been announced, and they signed a purchase agreement to sell the Albertsons. That’s in a process of closing/documentation process. And it’s pretty much all I should really say about it, but our evaluation is the best guess on waterfall analysis around the proceeds on a sale.”

Similar to other BDCs, I am expecting additional increases in its net asset value (“NAV”) per share over the coming quarters:

“So as far as NAV I think a big uplift in NAV for many BDCs including us will be just re-appreciation of the noise that’s been created by the current market environment. I think we certainly expect to see that. Then we have a nice equity portfolio with some companies that are growing, a couple of companies that we’ve had to decrease the appreciation to write it down based on COVID, which we certainly expect that to re-appreciate. So I think that clearly there are — from where we sit today, there are definitely tailwinds that should support NAV growth going forward.”

“Our investment strategy has remained consistent since its launch in January of 2015. We continue to focus on our core lower middle market, while also maintaining the ability to invest in the upper-middle market when attractive risk-adjusted returns exist. In a lower middle market, we directly originate opportunities consisting of debt investments and equity co-investments. Building out a well-performing and granular portfolio of equity co-investments is important to driving NAV per share growth as well as aiding in the mitigation of any credit losses over time.”

For Q3 2020, CSWC’s NAV per share increased by $0.18 or 2.7% (from $14.95 to $15.36) “primarily due to net unrealized appreciation on the investment portfolio”,

“Turning to Slide 20, the company’s NAV per share as of September 30, 2020, was $15.36 as compared to $14.95 at June 30, 2020. The main driver of the NAV per share increase was $8.4 million of appreciation in the investment portfolio, much of which was in the upper-middle market portfolio.”

There was an improvement in overall credit quality including two upgrades to ‘Investment Rating 1’ and no downgrades. Similar to other BDCs, my primary concern is the 10.0% (previously 12.5% in Q1 2020) of the portfolio considered ‘Investment Rating 3’ which implies that the “investment may be out of compliance with financial covenants and interest payments may be impaired, however, principal payments are generally not past due.”

“Turning to Slide 14, we have laid out the rating migration within our portfolio for the quarter. During the quarter we had two loans upgraded while having no loans downgraded. As a reminder, all loans upon origination are initially assigned an investment rating of two on a four-point scale, with 1 being the highest rating and 4 being the lowest rating. The upgrades consisted of two loans to one portfolio company previously rated at 3, which were upgraded to a 2 rating based on much-improved performance. As of the end of the quarter, 80% of our investment portfolio at fair value was rated in one of the top two categories a one or two. We had seven loans representing 10% of the portfolio at fair value rated a three and only two loans representing 2% of the portfolio at fair value rated a four.”

Investment Rating 3 involves an investment performing below underwriting expectations and the trends and risk factors are generally neutral to negative. The portfolio company or investment may be out of compliance with financial covenants and interest payments may be impaired, however principal payments are generally not past due.

Investment Rating 4 indicates that the investment is performing materially below underwriting expectations, the trends and risk factors are generally negative and the risk of the investment has increased substantially. Interest and principal payments on our investment are likely to be impaired.

“Turning to Slide 12, as I previously alluded to, we had two lower than the market exits this quarter, Danforth Advisors and Trinity 3. Our debt at Danforth was refinanced by a traditional bank, repaying our loan in full, generating proceeds of $6.7 million and an IRR of 12.4%. We continue to hold equity in Danforth alongside the sponsor and we are excited to watch this management team and sponsor continue its stellar performance.”

“In the case of Trinity 3, which also appears on the New Deal funding’s for the quarter, we were able to participate in a much larger club deal which refinanced our original loan and finance a large strategic acquisition for Trinity 3. We also hold an equity interest in this company and are very excited about its continued growth prospects going forward. This continues our track record of successful exits. To date, we have generated a cumulative weighted average IRR of 14.7% on 33 portfolio exits, generating approximately $308 million in proceeds.”

New portfolio company investment transactions that occurred during the quarter ended September 30, 2020, are summarized as follows:

• Electronic Transaction Consultants LLC, $10.0 million 1st Lien Senior Secured Debt, $3.7 million Revolving Loan, $1.0 million Common Equity: Electronic Transaction Consultants Corporation designs, implements, supports and maintains software systems used to facilitate electronic toll collections for toll road authorities and operators.
• Ian, Evan, & Alexander Corporation (d/b/a EverWatch), $10.0 million 1st Lien Senior Secured Debt, $2.0 million Revolving Loan: EverWatch is a technology solutions company providing advanced defense, intelligence, and deployed support to mission critical missions in the national security and intelligence space.
• RTIC Subsidiary Holdings, LLC, $6.9 million 1st Lien Senior Secured Debt, $1.1 million Revolving Loan: RTIC Holdings, LLC is the largest pure-play direct-to-consumer eCommerce provider of high-quality outdoor products that are priced for value-conscious outdoor enthusiasts.
• Sonobi, Inc., $8.5 million 1st Lien Senior Secured Debt, $0.5 million Common Equity: Sonobi, Inc. is a digital media technology platform that directly connects advertisers in order to efficiently connect brands with their desired consumers.
• “We had 39 lower middle market portfolio companies with a weighted average leverage ratio measured as debt to EBITDA through our security of 3.9x down from 4.1x weighted average leverage in the prior quarter. This reduction in leverage was primarily driven by EBITDA performance across the lower middle market portfolio during the quarter. Within our lower middle market portfolio, as of the end of the quarter, we held equity ownership in approximately two-thirds of our portfolio companies.”
• “Our own balance sheet upper middle market portfolio excluding I-45 consisted of 12 companies with an average leverage ratio through our security of 3.7x down meaningfully from the 4.4x weighted average leverage for the prior quarter. This decrease was also driven primarily by EBITDA improvement quarter-over-quarter across the portfolio.”

Volatility is your friend!

BDC pricing 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 higher-than-average returns over the long term. One of my goals is to help subscribers take advantage of “oversold” conditions.

Full BDC Reports

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

Previous TCPC Insider Purchases

• Last month, Howard Levkowitz, TCPC Chairman and CEO, purchased 20,000 shares at $10.95 per share for a total of $219,000.

TCPC Dividend Coverage Update

Previous reports correctly predicted the reduction of TCPC’s quarterly dividend from $0.36 to $0.30 which was at the top of my estimated range of $0.28 to $0.30. At the time, the company had spillover or undistributed taxable income (“UTI”) of almost $45 million or $0.78 per share. However, this is typically used for temporary dividend coverage issues. The previously projected lower dividend coverage was mostly due to lower LIBOR and portfolio yield combined with management keeping lower leverage to retain its investment-grade rating.

Howard Levkowitz, TCPC Chairman and CEO: “The board’s decision to adjust the dividend rate was a prudent response to substantial declines in LIBOR over the last year and a half. We are confident in the sustainability of our dividend at this level. We also strengthened our diversified and low-cost leverage program by extending and expanding our SVCP credit facility and replacing our TCPC Funding credit facility with a new facility with improved terms. We appreciate the ongoing support of our lenders.”

The rapid decline in interest rates (LIBOR) has mostly been responsible for the decline in portfolio yield with “limited exposure to any further declines”. During Q3 2020 there was an increase in the overall portfolio yield due to “amendments made on several loans coupled with the higher yield on originations versus exits”:

“Investments in new portfolio of companies during the quarter had a weighted average effective yield of 9.5%. Investments we exited had a weighted average effective yield of 8.8%. The overall effective yield on our debt portfolio increased to 10%, primarily reflecting amendments made on several loans coupled with the higher yield on originations versus exits. Since the end of 2018, LIBOR declined 257 basis points or by 92%, which put pressure on our portfolio yield over this period. However, our portfolio is largely protected from any further declines in interest rates as over 80% of our floating rate loans are currently operating with LIBOR floors as demonstrated on slide nine.”

Historically, the company has consistently over-earned its dividend with undistributed taxable income. Management previously indicated that the company will likely retain the spillover income and use it for reinvestment and growing NAV per share and quarterly NII rather than special dividends.

“Today, we declared a fourth quarter dividend of $0.30 per share payable on December 31, 2020 to shareholders of record as of December 17 and in line with the third quarter dividend of $0.30 per share paid on September 30th. We are committed to paying sustainable dividends and continuing our track record of having covered our dividend every quarter as a public company. In the third quarter, our dividend coverage ratio was 117%.”

For Q3 2020, TCPC beat its best-case projections mostly due to much higher-than-expected dividend and other income as well as improved portfolio yield and $0.03 per share of income related to prepayment premiums and accelerated original issue discount amortization. Its net interest margin improved due to the higher yield combined with lower borrowing rates.

“Investment income for the third quarter was $0.74 per share. This included recurring cash interest of $0.54, recurring discount and fee amortization of $0.06 and PIK income of $0.06. We had modest prepayments in the quarter that contributed $0.03 per share including both prepayment fees and unamortized OID. Investment income also included $0.03 of other income and $0.02 of dividend income. Our income recognition follows our conservative policy of generally amortizing upfront economics over the life of an investment rather than recognizing all of it at the time the investment is made. Combined, our outstanding liabilities had a weighted average interest rate of 3.3%, down from 3.8% or 51 basis points since the end of 2019.”

On October 29, 2020, the Board re-approved its stock repurchase plan to acquire up to $50 million of common stock “at prices at certain thresholds below our net asset value per share”. There were no additional shares repurchased during Q3 2020. From October 1, 2020 through October 30, 2020, TCPC has invested approximately $18 million primarily in three senior secured loan with a combined effective yield of approximately 10.9%.

Howard Levkowitz, TCPC Chairman and CEO: “We are pleased with the continuing strength of our highly diversified portfolio even in this challenging environment, which led to a 4.1% increase in NAV. We also further strengthened our leverage structure by increasing our unsecured debt, adding an accordion commitment to our operating facility, and replacing our funding facility on even better terms. While we remain highly selective in this lending environment, our pipeline of investment opportunities is growing, and we are prudently deploying capital to achieve strong risk-adjusted returns for our shareholders.”

Payment-in-kind (“PIK”) income declined from 7.6% in Q2 2020 to 7.4% in Q3 2020 and needs to be watched. As shown below, TCPC’s portfolio is highly diversified by borrower and sector with only 5 portfolio companies that contribute 3% or more to dividend coverage:

TCPC Risk Profile Update

During Q3 2020, TCPC’s net asset value (“NAV”) per share increased by another $0.50 or 4.1% (from $12.21 to $12.51) “primarily driven by continued spread tightening”:

“Our net asset value increased 4.1% from the prior quarter, reflecting a 1.8% net market value gain on our investments, driven by spread narrowing on middle market private credit transactions as well as improved financial results for several portfolio companies. Importantly, the overall credit quality of our portfolio remains strong.”

Some of the largest markups during the quarter were Edmentum and One Sky Flight:

“Unrealized gains included $6.9 million of appreciation in the value of our investment in Edmentum and $4.4 million of appreciation on our investment in OneSky. The strong performance at One Sky as charter flight activity has outpaced expectations and Edmentum continues to benefit from a shift toward online learning that has accelerated in the current environment.”

However, there were net realized losses of $18 million or $0.31 per share mostly due to the restructuring of its non-accrual investment in AGY Holding Corp that was discussed on the call:

“Net realized losses during the quarter were comprised primarily of the restructuring of our investment in AGY. AGY is fundamentally good business, but it has struggled with the cost of one of its major inputs rhodium. And we reached the conclusion that it was more appropriate to let a third party come into the business and pay down our position and sell down significant part of our economics and retain small preferred upside.”

CIBT Solutions, Inc. was added to non-accrual status during Q3 2020 and is a provider of expedited travel document processing services serving multinational corporations, global travel management companies, tour and cruise operators, government agencies and Do-It-Yourself travelers. GlassPoint Solar, Inc. and Avanti Communications remain on non-accrual. As of June 30, 2020, loans on non-accrual status represented 0.6% of the portfolio at fair value and 1.2% at cost. If these investments were completely written off the impact to NAV per share would be around $0.17 or 1.3%.

“As of September 30, total non-accruals were only 0.6% of the portfolio at fair value. This is a testament to our disciplined approach to underwriting, our more than 20 years of experience lending to middle market companies and the strength and breadth of the BlackRock platform.”

“We have loans to just three portfolio companies on non-accrual, GlassPoint, CIBT, and Avanti, which together represented only 0.6% of the portfolio at fair value and 1.2% of costs. CIBT, which is new this quarter is a leading global provider of immigration and visa services for corporations and individuals and the company has been challenged, given the current slowdown in international travel.”

TCPC will likely finally exit its investment in Kawa Solar Holdings “in the near future”:

“Kawa Solar Holdings is part of a larger series of securities and some of the loans in certain regions were paid off via loans [ph]. The Kawa loans, I believe, were also paid off and then what’s remaining is, some of the equity that was converted in the APAC region, which is the outstanding position. So the loans that were paid off are no longer on the balance sheet and there were a number that were successfully completed. What remains is simply the equity position as part of a conversion in Asia. That’s in a run-off mode that we’ve talked about a few times in the past. The primary asset is also an operating facility that we expect to exit at some point in the near future as we’re going through a process there.”

“91% of our investments are senior secured debt and are spread across a wide variety of industries. We have a diverse portfolio of companies with an emphasis on less cyclical businesses with limited direct exposure to sectors that have been more severely affected by the pandemic. Furthermore, our loans to companies in more impacted industries including retail and airlines are generally supported by strong collateral protections and most of our investments in these industries continue to perform well. As an example, the value of our investment in OneSky, the second largest provider of private jet aviation services in the country appreciated during the quarter based on strong performance, resulting from increased charter flight activity. At the end of the third quarter, our diverse portfolio included 101 companies. Our largest position, which represented only 4.5% of the portfolio is an equipment leasing company that itself has a highly diversified underlying portfolio of lease assets. As the chart on the left side of slide seven illustrates, our recurring income is not reliant on income from any one portfolio company. In fact, over half of our individual portfolio companies contribute less than 1% to our recurring income.”

“Our investment activity in the fourth quarter to-date has been selective and focused on companies that are minimally impacted by the pandemic or beneficiaries of the COVID impacted operating environment. Dispositions in the third quarter included payoffs of our $29 million loan to InMobi, our $16 million loan to American Broadband and the refinancing of our $11 million loan to Pulse Secure.”

Volatility is your friend!

BDC pricing 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 higher-than-average returns over the long term. One of my goals is to help subscribers take advantage of “oversold” conditions.

Full BDC Reports

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

This update discusses Sixth Street Specialty Lending (TSLX) which has been an excellent investment. Over the last 5 years, TSLX has provided me with annualized returns of 14% to 15% and likely headed higher as the stock rebounds and the company continues to pay supplemental dividends.

TSLX Distribution & Q3 2020 Update

On November 4, 2020, TSLX reaffirmed its regular quarterly dividend of $0.41and announced a supplemental dividend of $0.10 per share to shareholders of record as of November 30, 2020, payable on December 31, 2020.

“Based on a net asset value rebound and the overearning of our base dividend this quarter, our board declared a supplemental dividend and dividend in accordance with our formulaic dividend approach, a supplemental dividend of $0.10 per share, which is half of the quarter’s overearning was declared yesterday to shareholders of record as of November 30 payable on December 31.”

During Q3 2020, the company had realized gains of $11 million or $0.16 per share (to support continued supplemental dividends) due to the sale of its equity position in AFS Technologies, Inc. Also, TSLX still holds its Series A preferred shares of Validity, Inc. valued at $9.2 million over cost and will likely result in upcoming realized gains of $0.13 per share to support additional supplemental dividends:

TSLX is clearly one of the highest quality BDCs that actually performs well in distressed environments such as this. The management team is very skilled at finding value in the worst-case scenarios including previous retail and energy investments. TSLX often lends to companies with an exit strategy of being paid back through bankruptcy/restructuring so they are proficient at stress testing every investment with proper coverage and covenants. Please see the “Previous TSLX Portfolio Credit Track Record” section at the end of this report for some historical examples. Management has prepared for the worst as a general philosophy and historically used it to make superior returns.

Previously, the company paid $0.06 per share of supplemental in Q1 2020 and $0.50 per share of supplemental dividends paid in Q2 2020. When calculating supplemental dividends, management takes into account a “NAV constraint test” to preserve NAV per share. This is one of the reasons that management prefers not to pay large supplemental dividend payments even though the amount of undistributed/spillover income continues to grow. However, management also likes to avoid paying excessive amounts of excise tax through “cleaning out” the spillover as it “creates a drag on earnings”. This was discussed on the recent call:

“We’ve tried to avoid doing large specials, when we put in the recurring supplemental dividend framework, two, 2.5 years ago. And then given that the level set earlier at $0.50, we ended up having friction costs and kind of growing the spillover income and growing unfortunately on a per share basis, the excise tax. And so we wanted to clean it out. I think we’re basically back pre-cleanout. At the beginning of this year, when we went to the board with the proposal, we were at $1.61 per share of undistributed income and at the end of Q3 we were at $1.55. So we’re pretty much back there. The plan is to look at where we sit on tax basis and looking at the 90% rule and look at how much of excise tax is a drag on earnings. And we’ll go through the same work we did at the end of the year – at the end of this year.”

For Q3 2020, TSLX beat its best-case projections (again) covering its regular quarterly dividend by 156% due to higher than expected dividend and fee income as well as higher portfolio yield.

“Other fees, which consists of prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs continued to be relatively strong at $9.3 million led by our fees related to Dye & Durham and now Neiman ABL FILO. Other income increased from $6.5 million to $8.1 million quarter-over-quarter, primarily due to the receipt of a one-time termination fee for a commitment we made in Q1 of 2019, but it was never eligible to be funded given the required milestones in the underlying loan agreement we’re not satisfied.”

Leverage (debt-to-equity) remained mostly flat and similar to many other BDCs this quarter, TSLX improved its net interest margin with higher portfolio yield and lower borrowing rates likely driving improved dividend coverage over the coming quarters:

“Looking ahead into Q4 based on our current asset level yields and assuming average leverage in line with Q3, we would expect further net interest margin expansion of approximately 10 basis points based on this quarter’s movement in LIBOR.”

Annualized return on equity (ROE) on net investment income and net income of 15.1% and 30.1%, respectively, and an annualized year-to-date ROE on net investment income and net income of 13.5% and 14.7%, respectively.

“On a year-to-date basis, we’ve generated an annualized return on equity on net investment income of 13.5% and net income of 14.7% based on the beginning year pro forma net asset value per share of $16.77, which is adjusted for the impact of our Q4 2019 supplemental dividend of $0.06 per share. Of note, these annualized year-to-date return on ROEs both exceed our average annualized performance since our IPO through the end of 2019, which we think is notable given the difficult operating conditions experienced during the first three quarters of 2020.”

As shown in the following chart there was another increase in its portfolio yield (from 10.0% to 10.2%) and there was another decline in its borrowing rates for improved net interest margins:

“The weighted average total yield on our debt and income producing securities at amortized cost increased by approximately 20 basis points to 10.2% this quarter, primarily driven by the favorable impact of this quarter’s funding activity. The yield at amortized cost of new investments in Q3 was 11.5% compared to 10.8% for exited investments. Note that LIBOR move into Q3 had minimal impact on this quarter’s portfolio yield given that LIBOR had already fallen below the effective average LIBO floor across our portfolio in the prior quarter. Net expenses this decreased by $1.6 million to $28.2 million, primarily driven by lower interest expense from a lower effective LIBOR on our entirely floating rate liability structure; this quota, our weighted average cost of debt decreased by a notable 90 basis points. This was primarily a function of movement in LIBOR during Q2, which flowed through our cost of debt in Q3 due to the one-quarter timing lag on the libel reset dates on our interest rates swaps. We benefit from net interest margin expansion, given a decrease in the cost of that floating rate liabilities, while the earnings power of our contractual floating rate assets is protected by the LIBOR floors that we’ve structured into our loan agreements. The combination of these two forces has been the primary driver of the 100 basis points of net interest margin expansion we’ve experienced year-to-date; equating to incremental earnings of approximately $2.4 million or $0.04 per share.”

As of September 30, 2020, TSLX had $16 million in cash and cash equivalents and over $1 billion of undrawn capacity on its revolving credit facility:

“Our financial leverage of 0.81 times remained well below the regulatory limit of two times. And we had ample liquidity at quarter end with $1.02 billion of undrawn revolver commitments. At quarter end, our funding mix was comprised of 69% unsecured and 31% secured debt. And our nearest maturity was approximately two years away and only $143 million principal amount. We continue to be matched funded with a weighted average remaining life of our investments funded with debt of two years, compared to a weighted average remaining maturity of four years on our liabilities from revolver commitments.”

During Q3 2020, MD America was added to non-accrual status but TSLX received its regularly scheduled cash interest payment during the quarter and applied those proceeds to the amortized cost of the position due to the “imminent reorganization of the company’s capital structure”. In October 2020, MD America made a voluntary paydown of $1.4 million and subsequently filed for protection under Chapter 11. In Q4 2020, TSLX expects to put $9 million of its loan, or ~70% of its remaining prepetition loan at 9/30/20 fair value, back on accrual status upon MD America’s emergence from Chapter 11 and the remaining investment will be restructured into an equity position. This was discussed on the recent call:

“On MD America, we received a roughly scheduled cash – our regularly scheduled cash interest payment during the quarter, but applied those proceeds to the amortized cost of our position given our view of an imminent reorg of the company’s capital structure that result in a reduction of the value of our loan. Post quarter end, the company made a voluntary pay down of $1.4 million on our position and are subsequently filed for protection under Chapter 11 that implements prepackaged plan of reorganization. For Q4, we expect to put $9 million of our loan or approximately 70% of our remaining pre-petition loan at 9/30 fair value, back on accrual status upon the company’s emergence from Chapter 11. Our remaining investment will be restructured into an equity position. Note that the quarter-end, our total energy exposure was 2.4% of the portfolio at fair value.”

J.C. Penney was added to non-accrual status during Q2 2020 but there was a partial roll-up of its first-lien term loan into the DIP term loan and the rest remains on non-accrual. Mississippi Resources was added to non-accrual status in Q1 2020 and was previously written off with no further impact to NAV per share. The total current fair value of non-accrual investments is $19.7 million or 0.9% of the portfolio but will likely decline in Q4 2020 as MD America is restricted.

“There was a slight increase in our non-accruals this quarter from 40 basis points to 90 basis points on a fair value basis. This was primarily driven to the addition of first lien loan in MD America, an upstream E&P company, which is partially offset by removal of our pre-petition Neiman Marcus term loan and a partial roll up of our JCP’s pre-petition first lien term loan into the debt term loan.”

In September 2020, Neiman Marcus Group was removed from non-accrual status as it completed its Chapter 11 bankruptcy protection process eliminating more than $4 billion of debt and $200 million of annual interest expense. The new owners, which include PIMCO, Davidson Kempner Capital Management and Sixth Street Partners LLC funded a $750 million exit financing package that fully refinances its debtor-in-possession (“DIP”) loan.

“In September, upon the full repayment of the Neiman ABL FILO and debt loans, we subsequently funded a new $17 million par value first lien loan related to our exit financing backstop commitment. And our schedule of investments roughly $4 million difference between the par value and the cost basis of the new Neiman loan reflects our fees on the backstop, which were payable and common stock of the reorg company. Our loan today is trading at a price of approximately 104.75. This again was another way that we created value during the volatile market environment earlier this year. We believe our attractive cost base along with the company’s high quality assets and improved perspective cash flow profile post restructuring provide considerable downside protection on our investments.”

“Retail and consumer products was our third highest industrial exposure increasing from 11.3% to 13.9% quarter-over-quarter; this was primarily driven by new fundings for designer brands and centric brands, which was partially offset by the repayment of the Neiman ABL FILO Term Loan. Post quarter end, we fully exited our investment in Centric Brands in connection with a new financing obtained by the company as it emerged from bankruptcy. Pro forma the pay down of Centric Brands, our retail and consumer exposure would have been 10.5% at quarter-end and retail names – with retail names comprising 9.5% of the portfolio and 77% of this exposure consisting of ABL investments. 99 Cents is doing well and there’s going to be a significant refi risk.”

First-lien debt accounts for around 95% 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%.

“While none of our portfolio companies have been immune to the economic impact of COVID, only 11% of our portfolio by fair value at quarter end has experienced meaningful performance issues directly related to it. We believe the relative resilience of our portfolio is mostly a result of a deliberate shift we made in late 2014 towards a more defensive portfolio construction. Today, 95% of our portfolio by fair value is first lien and nearly 75% of our portfolio by fair value is comprised of mission critical software businesses with sticky predictable revenue characteristics. These businesses also tend to have variable cost structures that it can be fluxed down to support debt service and protect liquidity in cases of challenging operating environments.”

“A portfolio weighted average performance rating was 1.21 compared to 1.23 in Q2, on a scale of one to five with one being the strongest. There were no material changes in the overall credit metrics of our portfolio companies. Interest covers this quarter remain flat at 3.3X, net attachment point was unchanged at 0.4X, and that leverage increased slightly from 4.3X to 4.4X, which is on par with our trailing two-year historical quarterly average.”

Volatility is your friend!

BDC pricing 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 higher-than-average returns over the long term. One of my goals is to help subscribers take advantage of “oversold” conditions.

Full BDC Reports

BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means investors need to do their due diligence before buying.

The following information is from the MRCC Projections Update that was previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).

Quick Update:

As mentioned in “8% To 10% Balanced Portfolio Yield Investing In America: Part 2” on Seeking Alpha, I will be using this blog for additional public updates on individual BDCs.

Quick BDC Market Update

As mentioned in previous articles, I was expecting Business Development Company (“BDC”) pricing to pull back from the recent highs for various reasons including profit-taking and a partial return to “risk-off” mode. Please note that most BDC charts look similar to the one below with a peak on June 8 and then mostly down.

I am expecting volatility through July until BDCs start to report Q2 2020 results (see dates at the end). However, I am expecting many BDCs to report stronger-than-expected results including net asset value “NAV” increases, adequate dividend coverage, and reaffirming current dividends. Many of the NAV increases will be due to:

• Tightening of yield spreads (will impact each BDC differently depending on loan mix)
• Likely improved valuations related to COVID-19 as many BDCs made large general write-downs due to the uncertainty of the impact as of March 31
• PPP aid which reduced liquidity and leverage issues for many portfolio companies

It is important to understand that the values BDC management applied to their assets on March 31, 2020, were conservative as we did understand which companies/sectors would be the most impacted. Of course, there will be some increased non-accruals but for most BDCs, this will more than offset by improved valuations on other investments. As these results are reported (mostly in early August), it will drive some positive headlines and another rally in BDC pricing as investors are looking to improve portfolio yield/returns in this low yield environment.

Clearly, the potential for additional or renewed lockdowns related to COVID-19 is a concern driving markets lower, including BDCs that are now yielding around 14% (see list below).

This article discusses Monroe Capital (MRCC) that is trading at a 37% discount to book value/NAV for the reasons discussed in “Why Investors Are Selling 12% Yielding Monroe Capital” that also predicted the recent dividend cut almost 6 months ago:

From January 26, 2020: “the quarterly dividend will likely be reduced to between $0.25 and $0.30. This also is shown in the worst-case projections that take into account continued credit issues likely from the investments discussed later in this report”

Issuing Shares Below NAV:

I am often asked about concerns that most BDCs have the ability to issue shares below NAV and hopefully, the following will help.

Most BDCs have the ability to issue shares below NAV typically related to lending facility covenants and/or extreme worst and best-case scenarios. During market volatility, BDCs could temporarily break a bank covenant and be forced to stop paying dividends until the company is back in compliance. The ability to issue even small amounts of equity can easily bring the BDC back into compliance. Also, having this option likely improves lending rates or other terms. I only invest in BDCs with higher quality management that would not issue shares below NAV unless it was an extreme case that could be either bad or good (opportunistic) such as using to make an acquisition at extremely low prices as ARCC did with Allied Capital and was a huge win for investors and NAV down the road:

The Company has also received stockholder approval to issue shares of its common stock under NAV for each of the last eight years (the “Annual Under NAV Approval”), and despite the Company trading below NAV for periods during such time frame, including for most of 2016, it has only used the flexibility provided by the Annual Under NAV Approval one time. In 2009, during a period of significant credit market volatility when credit spreads increased materially, the Company, acting pursuant to the Annual Under NAV Approval, prudently issued shares of its common stock at a price below NAV and invested the proceeds from such issuance at attractive returns to stockholders. These proceeds were also used to create liquidity and financial flexibility in an uncertain time of extreme volatility. While such issuance was at a price below NAV, it resulted in less than a 2.5% dilution in the aggregate net asset value of the Company. Additionally, the Company believes that this financial flexibility was a key component of the Company’s ability to opportunistically acquire Allied Capital Corporation, which transaction was agreed to on October 26, 2009 and closed on April 1, 2010 (the “Allied Acquisition”). The Company’s NAV increased during the one-year period following the date of the Company’s most recently determined NAV prior to such issuance, increasing from $11.21 (as of June 30, 2009) to $14.11 (as of June 30, 2010). The increase in the Company’s NAV from June 30, 2009 to June 30, 2010 includes a $1.11 per share increase related to the gain on the Allied Acquisition. Furthermore, for the one-year period following the date of such issuance, the Company’s total stockholder return outperformed that of every other BDC with a market capitalization of greater than $500 million. Therefore, periods of market volatility and dislocation have created, and may create again, favorable opportunities for the Company to make investments at attractive risk-adjusted returns, including opportunities that may increase NAV over the longer term, even if financed with the issuance of common stock below NAV.

Source: ARCC SEC Filing

MRCC is overleveraged and currently issuing shares through its “at the market” equity program at prices 30% to 40% below book value/NAV and will have a negative impact on upcoming results including NAV per share.

The following information was included in a recent SEC filing:

“this prospectus supplement and the accompanying prospectus. The equity distribution agreements provide that we may offer and sell up to $50,000,000 of our common stock from time to time through the Sales Agents in negotiated transactions or transactions that are deemed to be “at the market offerings,” as defined in Rule 415 under the Securities Act of 1933, as amended. As of the date of this prospectus supplement, we have sold $8.7 million of our common stock under the equity distribution agreements. Our common stock is listed on The Nasdaq Global Select Market under the symbol “MRCC.” On June 23, 2020, the last reported sale price of our stock on The Nasdaq Global Select Market was $7.12 per share. Our net asset value as of March 31, 2020 was $10.04 per share.”

“The table below assumes that we will sell all of the remaining common stock available under the program as of June 23, 2020 of $41.3 million at a price of $7.12 per share (the last reported sale price of our common stock on The Nasdaq Global Select Market on June 23, 2020)…The following table sets forth our capitalization as of March 31, 2020, and on an as adjusted basis giving effect to the $6.2 million of common stock sold from March 31, 2020 to June 23, 2020 at an average price of $7.86 per share and to the assumed sale of $41.3 million of our common stock at a price of $7.12 per share (the last reported sale price of our common stock on The Nasdaq Global Select Market on June 23, 2020) less commissions and expenses.”

It should be noted that as of the writing of this article, the stock was trading at $6.33 (not $7.12) which is a 37% discount to NAV and would have a larger impact if the company is actively issuing shares. Please keep in mind that any shares issued after June 30, 2020, will impact Q3 2020 results (not Q2 2020).

Source: MRCC SEC Filing

Previous Insider Purchases & Ownership:

• It should be noted that the most recent insider purchases were at prices below $7.00:

Source: Gurufocus

Monroe Capital 5.75% Notes (MRCCL) due 10/31/2023:

I have previously invested in MRCC’s Baby Bond “MRCCL” but sold due to the amount of leverage, lower-quality assets, and declining interest expense coverage all of which increase its risk ranking. As mentioned in previous articles, I rank each Baby Bond using portfolio credit quality and many metrics including the ones listed below.

Please see the following links from Investopedia for more information:

• Interest Expense Coverage
• Asset Coverage Ratio

MRCC Dividend Update

One of the methods that I use to assess BDC dividend coverage is my Optimal Leverage Analysis based on portfolio growth using available cash and borrowings (leverage) as well as changes in portfolio yield and potential credit issues. This is a longer-term run rate analysis of coverage that includes “stable” and “lower” portfolio yields with minimal amounts of non-recurring income and is an apples-to-apples comparison using similar amounts of leverage. In May 2020, MRCC announced a quarterly dividend reduction from $0.35/share to $0.25/share.

My Current BDC Investment Plan

My last two major purchases of multiple BDC common stocks were March 12 and March 19 and included 14 higher-quality BDCs. I was lucky and bought at or very near the previous lows and now collecting dividends and:

• Waiting for BDCs to report Q2 results (see dates below),
• Watching for preliminary result announcements (similar to NMFC discussed last week),
• Gathering information (portfolio and capital structure updates),
• Updating projected changes to NAV and dividend coverage for each BDC,
• Planning for future purchases.

Full BDC Reports:

This information was previously made available to subscribers of Premium BDC Reports, along with:

• MRCC target prices and buying points
• MRCC risk profile, potential credit issues, and overall rankings
• MRCC dividend coverage projections and worst-case scenarios
• Real-time changes to my personal portfolio

To be a successful BDC investor:

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

The following information is from the GSBD Projections Update that was previously provided to subscribers of Premium BDC Reports along with target prices, dividend coverage and risk profile rankings, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all Business Development Companies (“BDCs”).

Quick Update:

As mentioned in “8% To 10% Balanced Portfolio Yield Investing In America: Part 2” on Seeking Alpha, I will be using this blog for additional public updates on individual BDCs.

GSBD Merger With MMLC Update

On June 11, 2020, GSBD and MMLC announced that they had amended and restated the Original Merger Agreement (the “Amended Merger Agreement”). The Amended Merger Agreement has been unanimously approved by the Boards of Directors of both companies. GSBD and MMLC previously announced that they had entered into an Agreement and Plan of Merger dated as of December 9, 2019 (the “Original Merger Agreement”).

Why are the terms of the Merger being amended?

In order to comply with provisions of the Investment Company Act of 1940 which require that a merger of affiliated business development companies not result in dilution to either party, the Original Merger Agreement contained a closing condition whose satisfaction was dependent on the trading price of GSBD’s common stock. Heightened volatility in the current market precipitated by the COVID-19 pandemic has created uncertainty as to whether this condition can be met. The Amended Merger Agreement eliminates this closing condition while still ensuring that the transaction would not result in dilution to either party.

What are the key changes from the original merger terms?

The consideration has been changed from a fixed exchange ratio to a “net asset value for net asset value” exchange. Based on this change, the exchange ratio will be determined at closing such that shares issued by GSBD to MMLC shareholders will result in an ownership split of the combined company based on each of GSBD’s and MMLC’s respective net asset values. Based on March 31, 2020 net asset values and pro forma for the MMLC distributions, transaction costs and the repayment of MMLC’s revolving credit facility described below, GSBD would issue approximately 1.0656 shares for each MMLC share outstanding. The total share consideration to MMLC shareholders would represent a 17% premium to the pro forma MMLC net asset value, based on the closing market price of GSBD as of June 10, 2020.

The variable cap on GSAM’s incentive fees has been extended for an additional year, through the end of 2021. The Variable Incentive Fee Cap provides that incentive fees payable to GSAM will be reduced if net investment income (”NII”) would be less than $0.48 per share without implementation of the incentive fee cap.

Upon closing the transaction, GSAM has agreed to reimburse GSBD and MMLC for all fees and expenses incurred and payable by GSBD or MMLC or on their behalf in connection with the transaction, subject to a cap of $4 million with respect to each of GSBD and MMLC.

Prior to closing the Merger, MMLC’s board of directors will declare a $75 million distribution to MMLC shareholders relating to the pre-closing period. This distribution is an amount equal to approximately 8.1% of MMLC’s March 31, 2020 net asset value.

What impact will a change in the market price of GSBD stock price have on the Merger Consideration to be received by MMLC stockholders?

Under the “NAV for NAV” exchange mechanism, the shares issued by GSBD to MMLC shareholders will result in an ownership split of the combined company based on each of GSBD’s and MMLC’s respective net asset values. Changes in the market price of the GSBD stock price will therefore have no impact on the exchange ratio. However, the total value of the consideration received by MMLC stockholders will be the product of the shares received in the exchange, and the price of GSBD stock.

What are the benefits of the Merger to GSBD stockholders?

The GSBD Board and the GSBD Special Committee weighed various benefits and risks, both with respect to the immediate effects of the Merger on GSBD and its stockholders and with respect to the potential benefits that could be experienced by the combined company after the Merger. These potential benefits include, among others:

Expected to be Accretive to Short and Long-Term NII: GSAM expects the merger to be accretive to GSBD’s net investment income per share both in the short and long-term, reflecting a variable incentive fee cap through 2021, as well as anticipated optimization of the combined company’s capitalization following the close of the transaction. On June 11, 2020, GSAM announced that it will waive a portion of its incentive fee for the four quarters of 2021 (Q1 2021 through and including Q4 2021) payable pursuant to the Investment Advisory Agreement for each such quarter in an amount sufficient to ensure that GSBD’s net investment income per weighted average share outstanding for such quarter is at least $0.48 per share. This waiver helps to ensure that the distributions paid to GSBD’s stockholders are not a return of capital for tax purposes. This waiver is an addition to the existing waiver with the same terms that applies through the end of 2020.

Benefits of Scale: The combination more than doubles the size of GSBD, and is expected to result in benefits of scale, including improved access to diversified funding sources, cost synergies and greater trading liquidity.

Improved Balance Sheet: GSBD’s debt to equity ratio is expected to decline, creating more capacity to deploy capital into today’s attractive investment environment while adding a greater margin of safety to maintain investment grade (“IG”) credit rating and comply with regulatory and contractual leverage ratios.

What approvals are required for the Merger to be completed, and what is the expected timing of such approvals?

Consummation of the Merger is subject to certain closing conditions, including receipt of approval from each of the MMLC and GSBD stockholders, regulatory approval and other closing conditions. The Merger is currently anticipated to close during Q4 2020, subject to the satisfaction of certain closing conditions.

GSBD Dividend Update

The Board has approved special distributions of $0.15 per share, and “payable post-closing in three $0.05 per share quarterly installments currently expected to begin Q1 2021”:

GSBD has covered its dividend by an average of 112% over the last 8 quarters growing spillover/undistributed income to $46.6 million or around $1.15 per share. GSBD’s dividend coverage is not reliant on fee and dividend income, some of which is amortized over the life of the investment, reducing the potential for “lumpy” earnings results.

“Loan origination fees, original issue discount and market discount or premiums are capitalized, and the Company then amortizes such amounts using the effective interest method as interest income over the life of the investment. Consistent with prior years, we spilled over all of the undistributed NII into 2020 as we believe the cost of the spillover in the form of the excise tax is a small price to pay relative to the much higher cost of issuing new equity if we had to replace that amount.”

As a part of the merger agreement, Goldman Sachs Asset Management (“GSAM”) has agreed to waive a portion of its incentive fees and was discussed on the recent call:

Q, “And just a reminder on the fee waivers that you proposed for GSBD related to this transaction, are those still independent on schedule? Or is there any time…”

A, “Yes, all of those are — all of those kind of are part of the merger agreement, and there’s been — yes, there’s been no change to that merger agreement. So all those fee waivers would continue to apply through the course of 2020.”

Q. “But if the merger doesn’t happen, do they reverse?”

A. “Well, so again, we’re looking at the way the merger document is structured today. There’s basically a concept called the outside date by which something has to happen or termination provisions start to kick in. That’s really not until December of 2020. And so we have no expectation or no reason to think that in the short term, anything would change to that dynamic, which would cause us to change the fee waivers.”

On June 11, 2020, GSAM announced that it will waive a portion of its incentive fee for the four quarters of 2021 (Q1 2021 through and including Q4 2021) payable pursuant to the Investment Advisory Agreement for each such quarter in an amount sufficient to ensure that GSBD’s net investment income per weighted average share outstanding for such quarter is at least $0.48 per share. This waiver helps to ensure that the distributions paid to GSBD’s stockholders are not a return of capital for tax purposes.

For Q1 2020, there were no incentive fees paid and the portfolio yield continues to decline due to lower LIBOR and investments at lower yields.

On February 6, 2020, GSBD issued $360 million of unsecured notes due 2025 at a very low rate of 3.750% trading under CUSIP: 38147UAC1. Also, on February 27, 2020, the company reduced the borrowing rate on its credit facility to LIBOR +1.875% from LIBOR + 2.00% and extended to February 25, 2025 which is taken into account with updated projections.

“We favorably amended our senior secured revolving credit facility agreement to reduce the stated interest rate from LIBOR plus 2% to LIBOR plus 1.875% and to extend the final maturity date from February 2023 to February 2025. On February 10, 2020, we closed a public offering of $360 million aggregate principal amount of unsecured notes due 2025 and bearing interest at a fixed rate of 3.75%. We used the proceeds from the sale of notes to partially repay our senior secured revolving credit facility. This action left us with no near-term maturities until our convert comes due in 2022, while preserving almost $400 million in availability under our revolving credit facility.”

Previously, 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 in the following table. However, the merger with MMLC will result in lower leverage and is taken into account with the updated projections. Also, management is acutely aware of needing lower leverage to retain its investment-grade rating and will likely be using repayments to deleverage as well prudently making new investments:

“When we endeavor to get a rating and issue the bonds, we articulated a leverage strategy where we’re now operating at the high end of what we articulated by virtue of adding a couple of assets in the quarter and, of course, marking down the NAV. And so we do think it’s smart to be thoughtful and prudent. The bar is certainly high for any new investments. And of course, we want to make sure that there’s capital available, if necessary, to support some of our portfolio companies. And so in that context, we think we’re overall in a very good position with the agencies, with our capitalization overall, and we wouldn’t expect just to take up leverage, to take on new opportunistic, higher-yielding opportunities because they’re available. Our hope is that they’ll be more organic deleveraging. That would give us that opportunity here.”

Updated Slides Related to the Merger With MMLC:

Previous GSBD Insider Purchases:

Full BDC Reports:

This information was previously made available to subscribers of Premium BDC Reports, along with:

• GSBD target prices and buying points
• GSBD risk profile, potential credit issues, and overall rankings
• GSBD dividend coverage projections and worst-case scenarios
• Real-time changes to my personal portfolio

To be a successful BDC investor:

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