BDC Baby Bonds/Preferreds Update: Upcoming Coverage And Balancing Your Portfolio

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

Over the coming weeks, I will be spending more time discussing Baby Bonds that currently yield around 6% and much less volatile than stocks even during extreme scenarios experienced in December 2018 where I made multiple purchases of BDC stocks, bonds, and preferred shares. My personal portfolio includes various other bonds some of which are tax-related and likely not applicable to most but included in “Other” along BDC Baby Bonds shown below. Together these investments account for around 37% of my portfolio and this report will discuss all of my recent purchase and returns.

Subscribers of Premium Reports will receive real-time announcements of all upcoming purchases of BDC Baby Bonds and preferred shares but please be aware that these have lower returns and are not expected to outperform the S&P 500 or upcoming BDC stock purchases. However, these investments will easily outperform during volatility and/or downturn while continuing to provide a relatively safe and stable yield as they are senior to the common stocks. Also, I am constantly monitoring the balance sheets of BDCs which provide insight for bond risk measures including portfolio credit quality, changes to leverage, interest coverage ratios and redemption risk such as GAINM as discussed in the GAIN Deep Dive report.

Bond pricing is closely correlated to expected investment yields including other non-investment grade debt and ‘BofA Merrill Lynch US Corporate B Index’ (Corp B) that previously increased to 8.45% on December 26, 2018.

As discussed in previous updates, these yields have been declining in 2019 and are currently around 5.89%. This is meaningful for many reasons but mostly due to indicating higher (or lower) yields expected by investors for non-investment grade debt.

 

Baby Bonds Basics:

  • BDC Baby Bonds trade “dirty” which means that there is a certain amount of accrued interest in the market price. I have included the amount of accrued interest that updates daily.
  • The ‘effective yield’ is based on the current price less accrued interest.
  • Investors should use limit orders when purchasing exchange-traded debt such as Baby Bonds.
  • You need to own the Baby Bond one trading day before the ex-dividend date to be eligible for the full quarter of interest.
  • It is important to take into account which BDCs are “callable” and the potential for capital losses during the worst-case scenario.
  • I do not actively cover some of the BDCs with baby bonds, especially if they are thinly traded.

I will discuss various details related to investing in Baby Bonds and preferred shares over the coming weeks including redemption risks and the timing of purchases as well as my upcoming purchases and limit orders. One of the metrics used to analyze the safety of a debt position is “Interest Expense Coverage” ratio which measures the ability to pay current borrowing expenses. From Investopdia:

“The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. The ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the company’s interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company’s interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable.

“The ratio measures how many times over a company could pay its outstanding debts using its earnings. This can be thought of as a margin of safety for the company’s creditors should the company run into financial difficulty down the road. The ability to service its debt obligations is a key factor in determining a company’s solvency and is an important statistic for shareholders and prospective investors.”

I have included the “Interest Expense Coverage” ratio in the Leverage Analysis and financial projections for GLAD and GAIN using net investment income before interest expense divided by interest and debt expenses for each quarter. GLAD has a historical ratio between 3.2 and 3.8 and projected to be between 3.1 and 3.4 in the coming quarters. It should be noted that this is higher than GAIN historically between 2.0 and 3.3 and projected to be between 2.4 and 3.0 in the coming quarters.

Over the coming weeks, I will include this ratio for all BDCs that have Baby Bonds so that subscriber can compare.

BDC Baby Bonds and Preferred Stocks are currently averaging 6.07% yield as shown in the following table including some that are considered investment grade. Please read “Baby Bonds For BDCs: Price Stability” for previous discussions and information about these investments.

The following is from the BDC Google Sheets and is what I use to make purchases when increasing allocations:

 

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

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

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

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

The previous table uses 120 as I believe interest rates will remain low given the changes to various policies from central banks and investors will continue to have equity investments for an adequate yield from their portfolios.

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

General Bond Funds

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

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

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

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.

PFLT Earnings & Risk Profile Update: Resolving Credit Issues

 

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, potential credit issues, earnings/dividend projections, quality of management, fee agreements, and my personal positions for all business development companies (“BDCs”).

Recent PFLT Insider Purchases

As shown below, Art Penn (Chairman and CEO) was actively purchasing shares last month at prices between $11.55 and $11.73:

 

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 has not experienced non-accruals over the last two years and “it’s unfortunate that they all happened in this one quarter”:

From previous call: “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.”

“Our credit quality since inception eight years ago has been excellent. Out of 357 companies in which we have invested since inception, we’ve experienced only nine non-accruals. Since inception, PFLT has made investments totaling about $3 billion at an average yield of 8.1%. This compares with an annualized loss ratio, including both realized and unrealized losses of only about 8 basis points annually.”

PFLT remains a component in the suggested ‘Risk Averse’ portfolio due to its portfolio of mostly higher quality, first-lien senior secured investments at floating rates.

“The cash interest coverage ratio, the amount by which EBITDA or cash flow exceeds cash interest expense continue to be healthy 2.8 times. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt-to-EBITDA on the overall portfolio was 4.8 times, another indication of prudent risk. In our core market of companies with 15 million to 50 million of EBITDA, our capital is generally important to the borrowers and sponsors. We are still seeing attractive risk reward, and we are receiving covenants, which help protect our capital.”

During calendar Q2 2019, its net asset value (“NAV”) per share declined by $0.17 or 1.3% (from $13.24 to $13.07) due to the previously discussed investments shown in the following table. Country Fresh Holdings is still not considered a ‘non-accrual’ but was restructured during the quarter resulting in realized losses of $7.2 million. PFLT now has $2.3 million of first-lien, $5.2 million of second-lien and $10.5 million of non-income producing common equity fair valued at $8.6 million. The other meaningful realized loss came from exiting its non-accrual investment in New Trident HoldCorp resulting in another $7.0 million of realized loss for the quarter.

“New Trident was certainly a big driver. The other ones were [Hollander], which remains a problem, that was one of the non-accruals; and Country Fresh, which got restructured into our quarter. Those were the negative drivers. We do have some very nice co-invest like By Light, DecoPac, Cano Health and Walker Edison, which have been performing well, which, you know, the theme here of course is we are going to make mistakes from time to time; we are going to have non-accruals; and these equity co-invest investments are meant to have some upside that could, you know, in part or in full, you know, fill some of those gaps. So, New Trident certainly was a negative outcome for sure.”

 

Hollander Sleep Products, Quick Weight Loss Centers, and LifeCare Holdings remain on non-accrual status and were marked down again during the recent quarter but still account for $10.1 million in fair value or 0.9% of the portfolio. If the current non-accruals were completely written off, the impact to NAV per share would be around $0.26 or 2.0% (previously $0.38 or 2.8%). However, management mentioned that there were only two companies on non-accrual as of the earnings call on August 8, 2019:

“Credit quality has improved since last quarter. Today, we only have two non-accruals on the books, representing only 1.4% of the portfolio at cost, and 0.5% end market. As of June 30, we had three non-accruals, which represented about 2.3% of our overall portfolio cost and 0.8% at market. We are pleased with the progress we are making on this front.”

That would imply that Quick Weight Loss Centers was likely restructured or exited during calendar Q3 2019. American Teleconferencing Services was marked down again but is still considered to be performing asset that could be restructured and/or added to non-accrual status over the coming quarters.

As discussed in the previous report,Hollander and LifeCare filed for bankruptcy in May 2019 and are both working to reduce costs to improve overall profitability and/or selling assets. Hollander cited “across-the-board increase in costs, including new tariffs, rising material, labor and shipping costs and the costs of integrating a competitor it acquired last year had left it in a severe liquidity squeeze”. In June 2019, Hollander announced that it could be closing its plant in Thompson, Georgia. In addition, Hollander has been spending money to integrate Pacific Coast Feather Co., which it acquired in 2017.

On September 4, 2019, a New York bankruptcy judge approved the $102 million sale of Hollander to private equity firm Centre Lane Partners. In the motion asking for approval of the new plan, Hollander said negotiations since the filing produced a global creditor settlement that was approved by the court on August 15, 2019. Under the terms of the settlement, Hollander and the plan sponsors will put up $1.25 million to be paid to the company’s unsecured creditors, it said. While the settlement negotiations were happening, the company said it was also soliciting bids for its assets. Ten initial expressions of interest were narrowed down to the one acceptable bid from Bedding Acquisition, it said.

A revised plan with a “toggle” feature to allow switching to an asset sale was put to a vote by the impaired creditors and received approval from the holders of all of the company’s $173.9 million in term loan debt and the holders of more than 95% of its $38.5 million in unsecured debt, it said. Hollander noted that additional changes to the plan include that the providers of the company’s $90 million in debtor-in-possession funding have agreed to accept less than full repayment and to cede repayment priority to Hollander’s prepetition term loan creditors, as well as the establishment of a $1 million wind-down reserve fund.

CEO Marc Pfefferle said “Upon emergence [from bankruptcy], we will have a stronger balance sheet and the financial flexibility needed to compete in today’s dynamic business environment now and over the long-term.”

Montreign Operating Co. is owned by Empire Resorts (NYNY) and operates a resort casino in Monticello, New York that previously received $130 million of additional equity capital from its sponsor as discussed in the previous report. On August 19, 2019, NYNY announced that it was being acquired by Kien Huat Realty and Genting Malaysia Berhad. Kien Huat has agreed to provide incremental credit support to Empire Resorts, “which will enable the company to meet its debt obligations as we continue to execute on our business strategy”.

Ryan Eller, President and CEO of Empire Resorts, said, “With the resources and support of Kien Huat and Genting Malaysia, Empire Resorts will be better positioned financially and operationally, which will help us advance our mission of delivering a winning combination of luxury facilities, quality entertainment and exceptional customer service. This transaction is a win-win for all our stakeholders, including our stockholders, customers, employees, creditors and the communities in which we operate.”

The transaction is expected to close in the fourth quarter of 2019 and I am expecting PFLT’s investment in Montreign to be marked back up to 100% over the coming quarters which would positively impact NAV per share by around $0.13 or 1.0%. Management discussed Montreign on the recent call:

Q. “I believe on the last call you mentioned activity from the sponsor up at Montreign, the casino in the Catskills, and with the announcement over the last few days about the sponsor possibly taking out the minority shareholders, I’m wondering how does that all flows through to your holding in it and the value you assign to that holding?”

A. “Montreign is – the equity there is controlled by an entrepreneur, and KT Lim, is well-known in the gaming sector. He controls Genting, which is a large gaming company. Montreign is owned in a public company called the New York-New York, NYNY is the ticker. KT Lim has made an announcement that he wants to take NYNY private. He already owns 80% plus of it. At the enterprise value that he’s proposed to take the company private; it values the equity around $300 million. That $300 million of equity of course is junior to $500 million of debt. We own a piece of the Montreign debt, which, today is marked in the mid-80s or so. We still think this is par. Obviously, if the entrepreneur behind it is valuing the equity of $300 million beneath the debt, we think the debt is par, the entrepreneur is indicating that he thinks the debt is par, you know, we’ll see. We think we have a fairly full position right now in PFLT, so we’re not going to add any more debt, but for all those of you in the market who want to buy what we think is very attractive piece of paper, that is broker dealer quoted in the mid-80s, Montreign first lien debt is and we think it’s going to end up being a par piece of paper.”

The portfolio remains predominantly invested in first-lien debt at around 76% portfolio and the PSSL has grown from 9% to 16% (previously 18%) over the last four quarters. It is important to note that its PSSL is 100% invested in first-lien debt.

“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.”

PFLT Dividend Coverage Update

PFLT continues to increase leverage, growing its portfolio and overall yield through ramping of its PennantPark Senior Secured Loan Fund (“PSSL”).

Art Penn, Chairman and CEO. “Due to our activity level and the maturation of PSSL, we are pleased that our current run rate net investment income covers our dividend. Our earnings stream should have a nice tailwind based on gradual increase in our debt to equity ratio, while still maintaining a prudent debt profile. As of September 30, our spillover was $0.31 per share.”

On August 26, 2019, PFLT announced that it had priced its $301.4 million debt securitization in the form of a collateralized loan obligation (“CLO”) which is a lower-cost alternative to its credit facility as well as longer-term and more flexible. The company will retain all of the Class D Notes and Subordinated Notes through a consolidated subsidiary.

“You know CLO financing, you know, has a nice long term and longer than our credit facility. So, we’re actively assessing that option, and as we, you know, think about gradually and prudently increasing leverage of that, that could be a key element of doing that really doing CLO financing, contributing assets to that, and then fraying up the revolver to finance future growth.”

On April 5, 2018, the Board approved the application of the modified asset coverage requirements reduced from 200% to 150%, effective as of April 5, 2019. Management is targeting a debt-to-equity ratio of 1.40 to 1.70 that will “take several quarters”:

“Over time, we are targeting a debt to equity ratio 1.4 to 1.7 times. We will not reach this target overnight. We will continue to carefully invest and it may take us several quarters to reach the new target. Given the seniority of our assets, in the near-term we’re actively considering utilizing CLO financing to help achieve the target.”

For the quarter ended June 30, 2019, PFLT reported just above base case projections with much higher-than-expected portfolio growth partially offset by continued lower portfolio yield. During the quarter, the company invested $183 million of in 14 existing portfolio companies with a weighted average yield of 9.3% with sales and repayments of $67 million. As expected, the company continues to increase leverage with a debt-to-equity of 1.09 utilizing its Board approved reduced asset coverage ratio, effective as of April 5, 2019. It should be pointed out that the company had $36.5 million of ‘payables for investments purchased’ that is not included in the current borrowing.

 

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

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

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.

MRCC Earnings & Risk Profile Update: Continued Downgrades

 

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

MRCC Risk Profile Update:

As mentioned in the BDC Risk Profiles report, MRCC was downgraded last year due to potential/continued credit issues including adding Education Corporation of America (“ECA”) to non-accrual status, previous markdowns of Rockdale Blackhawk and realized losses from TPP Operating, Inc. During Q2 2019, its net asset value (“NAV”) decreased by $0.15 or 1.2% (from $12.67 to $12.52) mostly due to additional markdowns in previously discussed investments including American Community Homes, Inc. (“ACH”) as well as its retail-related investment in The Worth Collection, Ltd.

 

 

My primary concern is the potential for additional non-accruals and markdowns of the investments listed in the previous table that currently account for around 15% of the portfolio and 36% of NAV per share. The worst-case projections take into account additional credit issues that could result in a dividend reduction of around 25% as discussed later.

“We’re in an uncertain market and things are happening very often beyond our control as investors. And some of the things that happen from time to time that are beyond our control very really affect industries, in particular, companies in those industries, and it’s very hard to predict. So, we’re going to continue to do that, and we’ll be back to you next quarter with a report. Hopefully, we’ll see more stability in world affairs and other things that are happening that are the more uncontrollable factors.”

The total fair value of investments on non-accrual declined to $14.0 million (previously $16.7 million) and account for around 2.2% of the portfolio fair value and $0.69 per share or around 5.5% of NAV. ECA was added to non-accrual status during Q4 2018 and are ‘junior secured loans’ and preferred stock as compared to first-lien positions. Other non-accruals include its Curion Holdings promissory notes, Incipio, LLC third lien tranches, Millennial Brands LLC (previously Rocket Dog Brands LLC), and Rockdale. The Curion promissory notes and the Incipio third lien tranches were obtained in restructurings during 2018 for no cost.

“The other non-accruals just as a reminder, because this is a constant source of confusion. We have a couple of names where a portion of the holding is on non-accrual because there are situations in which we took over a piece of debt or a piece of paper that we didn’t pay for as part of a restructuring. That includes the promissory note at Curion and a third lien piece at Incipio, and those are the only parts of those that are on non-accrual. There was really no cost associated with those two. And so I don’t know. The only time those would ever really go in accrual would be, if there was a massive recovery in the business. But because those are no cost, I mean, it doesn’t make any sense to put them on accrual status. And then there’s a small piece of preferred Millennial Brands that we don’t really expect to ever see value from. Those are all the non-accruals.”

During Q2 2019, MRCC participated in a credit bid to acquire the assets of New England College of Business (“NECB”), which was a subsidiary of ECA resulting in a 20.8% equity stake in NECB in exchange for a $1.5 reduction of secured loan position in ECA. Management mentioned “the ECA situation is going to be ongoing for an [extended] period of time”:

Q. “A quick on Education Corporation of America, can you give like just some color on what drove the write-down there this quarter and then the outlook for just the rest of your non-accruals in general and the timing of the resolution?”

A. “So, yeah, I think what you have to look at there is ECA has basically been split into two investments now. So that’s the confusion here. ECA had an asset that’s called NECB, New England College of Business, which is a performing school that’s was – that’s doing okay and was a good ongoing asset. And so basically, through the receivership situation there, we’ve credited a bit some of the debt and taken over NECB. So when you look at the marks, you sort of have to look at it by combining ECA and NECB. And more or less, when you look at it that way, the valuation hasn’t really changed quarter-to-quarter. The ECA situation is going to be ongoing for a period of time, that’s going to be extended”

As discussed in previous reports, American Community Homes, Inc. (“ACH”) is still on accrual status (discussed later) and needs to be watched as it still accounts for around $0.73 per share or 5.9% of NAV. In October 2014, MRCC funded a senior credit facility to support the recapitalization of Towne Mortgage Corporation by ACH. Based in Troy, Michigan, Towne originates and services mortgage loans on residential properties located primarily in Michigan, Minnesota and Wisconsin. ACH has been marked down in previous quarters and during Q1 2019, MRCC invested another $3.3 million. Also mentioned in the previous report, MRCC has put in place new management and was discussed on a previous call:

“American Community Homes just to be more clear is that was a compliance in the mortgage servicing business and general the mortgage servicing rights on a fair value from dollar in the industry and so what we did and our third-party valuation firm did more importantly is they looked at industry norms for valuation of mortgage servicing rights there. You know I don’t believe that there is any deterioration in the overall enterprise value or the value of the Company, but when you value particular companies based on underlying rights or commodity items its right to do what they did. So we took the adjustment on that, but at the end of day as you mentioned, we have no additional non-accrual and I believe our portfolio is stable. There has been a change in management, we have put a new management, there is some things that could be done on the operating basis to make a company more profitable and better, we feel we have done all that and from here it looks really good in terms of the company’s valuation. We feel solid in the future should be very strong, because we have done a lot to change the management team there and how they approach the business and it looks good in the future even if we have a protracted slowdown in mortgage originations, which appears to be the case right now. We still think there is value being created in the business.”

Previously, management discussed its investment in ACH including having “significant downside protection” and “our expectation is that the company can be improved and that we will enjoy a full recovery”:

From previous call: “Our expectation is that we have significant downside protection through this fairly large portfolio of mortgage servicing rights, the only trouble of the business is because the mortgage origination business is slow and liquidity became a little tight it’s harder for the company to retain as many new mortgage servicing rights as they would have liked, which would have created a more value for us. But long-term, we expect the recovery here, sponsor here has made significant changes to management and as advisors in who have made fairly large cost cuts to the business, which we don’t think will impact the business profitability going forward negatively, but only positively. And our expectation is that the company can be improved and that we will enjoy a full recovery. And we also have some equity in this business as well, which has some potential upside in the future as well, but for now this is the fair market value on the loans. There were some additional funding I mentioned on the term loan during the period, which is what you are seeing with regards to the increase in funding.”

The fair value of its investment in Rockdale Blackhawk, LLC (“Rockdale”) remained stable but previously filed for bankruptcy as part of a restructuring process. MRCC’s total investment in Rockdale accounts for almost $18 million (around 2.8% of the portfolio) and $0.88 (or 7.0%) of NAV per share. Management

Q. “The fair value in Rockdale went up a little quarter-over-quarter, was that simply change in the discount rate?”

A. “It’s really in the margin, I think. It’s not a particularly material change. So, I wouldn’t read much into it. It’s just as you go through sort of a waterfall analysis and look at how things sort of play out on the valuation side, they have small shifts up and down. So there was some, I think, in the estate some realization of certain assets in the estate, so that has something to do with it as well. The Rockdale situation ought to have some resolution in the next quarter or two. It’s – the arbitration there is happening as we speak, and we’ll see – it’ll take some time for that case to get through all the arguments, and then the arbitrator has some time to make a decision on what he wants to do. So I would expect to see that resolve itself, if not in the third quarter, maybe into the early part of the fourth quarter.

 

 

Previously, management mentioned that its Rockdale investment was valued appropriately but that “there is a range of outcome some of which are considerably higher and some of which are lower”:

From previous call: “We are required to mark every assets to what we believe is a fair market value in every quarter, based on the available information. And we use independent third-parties to assist us in that and we have done nothing different this period than any other period and nothing different with this investment than other investments. We have given all the information we have to an independent third-party evaluation firm who has done What Ted has described, which is try to put reasonable probability of outcomes on the assets and the liquidation of assets and the recovery of assets and sales of business units and things of that nature. And I will just say probably there is a range of outcome some of which are considerably higher and some of which are lower. So, this is the best expectation of what we think the fair value of the loan is today based on the view of the independent third-party and all the contingencies.”

MRCC’s portfolio remains primarily of first lien loans, representing around 90% of the portfolio and its investment in the SLF (discussed next) remains around 6% of the portfolio:

“Our portfolio is heavily concentrated in senior secured loans, and specifically first lien secured loans. 92.9% of our portfolio consists of secured loans, and approximately 90% is first lien secured. We are pleased with the construction, diversity and the senior secured nature of our investment portfolio at this point in the credit cycle.”

Grade 4: Includes an issuer performing materially below expectations and indicates that the issuer’s risk has increased materially since origination. In addition to the issuer being generally out of compliance with debt covenants, scheduled loan payments may be past due (but generally not more than six months past due). For grade 4 investments, we intend to increase monitoring of the issuer.

Grade 5: Indicates that the issuer is performing substantially below expectations and the investment risk has substantially increased since origination. Most or all of the debt covenants are out of compliance or payments are substantially delinquent. Investments graded 5 are not anticipated to be repaid in full and we will reduce the fair market value of the loan to the amount we expect to recover.

MRCC Dividend Coverage Update:

MRCC was previously downgraded in the Dividend Coverage Levels report due to continued credit issues driving increased reliance on fee waivers to cover its dividend. Over the last three quarters, the company has covered its dividend only due to the ability to use higher leverage through its SBIC license and management willing to waive incentive fees to ensure dividend coverage. Previously, MRCC had higher dividend coverage only due to the ‘total return requirement’ driving no incentives fees paid. The following was from a previous earnings call:

It has everything to do with where the NAV of the portfolio is in any given quarter and the performance on NII and dividends paid to shareholders. So it just depends on what happens each quarter going forward. And it’s a formulaic, as you said it’s formulaic. And so it’s difficult for me to predict today with any certainty where incentive fees would be on. And as you probably know it’s not a binary trigger either. They could be on it partially, or they could be on fully. It just depends on where we are with regards to NAV. It’s possible, there could be some incentive fee earned in the first quarter, if NAV was flat. I wouldn’t expect we’d be in a position to earn an entire incentive fee. And I would think that everything else was equal than probably in the second quarter is when you could start seeing an incentive fee payable.”

The last two quarters of higher-than-expected portfolio growth have driven its debt-to-equity ratio from 1.24 to 1.61 and its regulatory debt-to-equity ratio (excluding SBA debentures) has increased from 0.79 to 1.16. However, dividend coverage has not improved due to additional non-accruals and restricted cash which was discussed on the recent call:

“I think, if you look at where we are in NII coverage today and if all things being equal, if we could get the cash to work in the SBIC subsidiary, which we’re working hard to do, and if we could try to get some of the money that’s locked up in non-accruals out and reinvest it in accrual assets, our visibility for coverage looks really good.”

“What we’re trying to work on doing is getting some of the cash that’s sitting in the SBIC today to work over the next couple of three quarters. Obviously, it’s difficult to find deals in a competitive environment that are SBIC eligible. But we’re hopeful that we can find some good deals in the pipeline, and there are a couple now that look like they could qualify, and so getting that cash to work is really going to be a good help in driving NII performance, because right now, we’re just sitting on cash.”

Management also mentioned increasing its regulatory debt-to-equity ratio to 1.25 to 1.30:

“We’ve said for a while since the change in the rules that we intended to go above 1:1. So that shouldn’t be a big surprise. Maybe the velocity with which we were able to do it is surprising to you, but it’s not surprising to me because Monroe has always had a very, very active pipeline. We are, I believe, taking on deals that are maybe on the margin less risky than what we had done in the past. And we continue to expect to grow our regulatory leverage over the next couple of quarters, I’d say. I don’t know where we’ll wind up. It really depends on how the portfolio shakes out in the new origination shakeout, but I’d say think of it as maybe up to 1.25 to 1.3 times kind of regulatory leverage as a next target.”

As mentioned earlier, my primary concern is the potential for additional non-accruals and markdowns of certain investments that currently account for around 15% of the portfolio and 36% of NAV per share. The worst-case projections take into account additional credit issues and could result in a dividend reduction of around 25% as “the Board will revisit it in the future, and we’ll continue to think about it and look at it”:

From previous call: “We continue to believe that our adjusted NII can cover our dividend assuming no other material changes in our portfolio.”

“A lot of BDCs have cut dividends over the last several years. We never cut a dividend. We’ve only increased it once and have never cut. If we can cover the dividend and continue to cover it with room, over a long period of time, I feel like we’re doing a pretty good job for shareholders. But we’ll watch it, we’ll monitor it. And the Board will revisit it in the future, and we’ll continue to think about it and look at it. But to-date, we haven’t made a determination.”

It should also be noted that there has been a meaningful increase in the amount of non-cash payment-in-kind (“PIK”) interest income from around 2.2% to 7.5% and included many of the “watchlist” investments discussed earlier including American Community Homes, The Worth Collection, Luxury Optical Holdings, and Curion Holdings:

 

Management was asked about potentially lowering the fees paid to management based on higher leverage and the response was mixed:

Q. “with the increased leverage, you’re talking 1.25 and maybe, obviously, you can go up to 2, but I know you wouldn’t take it there. But obviously, it drives more assets, and I know other BDCs have reduced some of their management fees for assets above the 1:1 ratio. I mean have you given that kind of any thought of reducing the base management fee on any level of assets?”

A. “Yes. So we’re really focused on delivering returns to shareholders in the form of NII-covering dividend. And so, what we have chosen to do to date is to look at waiving fees voluntarily to make sure we’re covering. And we’re going to continue to monitor, sort of, our performance level, and we’ll make decisions about that in the future if we think that it’s warranted based on our ability to cover. You got to remember that we have a business model, as Ted just went through, that includes a lot of people. We’ve really invested in infrastructure of people here to generate the unique deal flow. And I think if you look at a lot of other BDCs our size, you’ll find that their employee base is considerably smaller than ours.”

The company still has around $0.48 per share of undistributed net investment income for temporary dividend coverage shortfalls. For the quarter ended June 30, 2019, MRCC reported slightly below base-case projections with continued portfolio growth and expected slightly lower portfolio yield mostly covering its dividend for the 21st consecutive quarter.

Theodore L. Koenig, CEO: “We are pleased to report another quarter of consistent net investment income, with Adjusted Net Investment Income of $0.35 per share, representing the 21st straight quarter where per share Adjusted Net Investment Income met or exceeded our quarterly per share dividend. We have also made our 27th consecutive quarterly dividend payment to our shareholders. As of quarter end, our portfolio totaled $630.8 million in investments at fair value, which represented a $33.9 million increase in the portfolio during the second quarter, or about a 6% increase. Portfolio growth during the quarter was funded primarily utilizing the available capital under our revolving credit facility. We would expect to continue to selectively grow our portfolio, including utilizing additional leverage capacity available to us under our revolving credit facility. We would expect recent and continued portfolio growth to positively contribute to our earnings in future quarters.

 

 

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:

  • 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.

 

TCPC Earnings & Risk Profile Update: September 2019

 

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

TCPC Dividend Coverage Update:

BlackRock TCP Capital (TCPC) continues to consistently over-earn its dividend growing its undistributed taxable income to almost $39 million spillover or $0.66 per share.

“We generated net investment income in the second quarter of $0.41 per share again exceeding our dividend of $0.36 per share. This extends our more than seven-year record of covering our regular dividend every quarter since we went public. Over this period on a cumulative basis, we’ve out-earned our dividends by an aggregate $39 million, or $0.66 per share based on total shares outstanding at quarter end.”

Dividend coverage for TCPC 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.

“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.”

Previously, management indicated that the company will likely retain the spillover income and use for reinvestment and growing NAV per share and quarterly NII rather than special dividends:

“As we talked with shareholders we reached the conclusion although opinions weren’t universal on this that most people didn’t seem to value them that much and we thought that retaining the spill-over income seem to be better received.”

“So while we do look at our dividend from time-to-time and want to make sure it’s an appropriate level, our primary focus is on continuing to make sure that we keep up that record of covering our dividend each quarter.”

However, management indicated that the recent shareholder approval to increase leverage will likely drive higher earnings and “will continue to assess our dividend policy going forward”:

“As you’re aware, our shareholders just voted overwhelmingly to give us the ability to increase leverage, and we’ve been earning our dividend very comfortably without that. So as we talk about our board we will continue to assess our dividend policy going forward. As our balance sheet and income statement may change over time, we will continue to analyze that have discussions with our board reflect the views of other important constituents and continue to reassess our dividend policy. ”

For the quarter ended June 30, 2019, TCPC reported between base and best case projections covering its dividend by 113% that included $0.05 per share of income related to prepayment premiums and accelerated original issue discount amortization. However, there was a meaningful increase in the amount payment-in-kind (PIK) income (from 5% to 10% of total income) and needs to be watched.

Howard Levkowitz, TCPC Chairman/CEO: “We out-earned our dividend for the 29th consecutive quarter, generating strong investment income and robust originations in the second quarter. Originations totaled $232 million for the quarter. We leveraged our existing relationships with borrowers and deal sources as well as the BlackRock platform’s resources to deepen relationships with existing clients and to engage new borrowers.”

“New investments during the quarter had a weighted average effective yield of 9.7% and the investments we exited had a weighted average effective yield of 12.3%. While our average new investments were lower-yielding than the investments we exited this quarter, we would caution against viewing any one quarter as a trend. The overall effective yield on our debt portfolio at quarter end was 11% compared to 11.4% at the end of the last quarter. If you look at the overall change in yields about half of that is just decreases in LIBOR. And some of the rest of it particularly the pronounced difference on the exits include a couple of higher-yielding things like Envigo that we mentioned earlier.”

The non-accrual loans to Fidelis Acquisitions, LLC (discussed later) were partially taken out of investment income during Q2 2019 and was easily offset by higher-than-expected portfolio growth and dividend income during the quarter.

Q. “Is a full quarter taken out of the second quarter earnings, or is only a partial quarter of Fidelis taking out of quarterly earnings?”

A. “We stopped accrual at the end of May. So there’s two months of Fidelis. But I would note, when we computed the incentive fees it was excluding, anything that we accrued.”

 

 

As shown below, TCPC’s portfolio is highly diversified by borrower and sector with only three portfolio companies that contribute 3% or more to dividend coverage:

 

 

On August 6, 2019, the Board re-approved its stock repurchase plan to acquire up to $50 million of common stock at prices below NAV per share, “in accordance with the guidelines specified in Rule 10b-18 and Rule 10b5-1”. During Q1 2019, there were only 9,000 shares repurchased and in 2018, the company repurchased only 73,416 shares for a total cost of $1.0 million. There is a good chance that the company will repurchase additional shares if the stock price declines below NAV again which is now $13.64 (reduced asset coverage ratio and higher leverage can be used for accretive stock repurchases).

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

TCPC continues to lower its cost of capital and in May 2019, expanded its credit facilities by $50 million each for a total increase in capacity of $100 million as well as reducing the rate on its SVCP Facility by 0.25% to LIBOR + 2.0% and extended its maturity to May 6, 2023.

“During the second quarter we also reduced the interest rate on our SVCP facility by 25 basis points to LIBOR plus 200, and extended the maturity of both facilities to May 2023. The increased capacity reduced cost and extended maturities of our credit facilities further expand our diverse leverage program which includes two low-cost credit facilities, two convertible note issuances, a straight unsecured note issuance and an SBA program.”

As of June 30, 2019, available liquidity was $237 million, including $227 million in available leverage capacity and $22 million in cash and cash equivalents, reduced by approximately $12 million in net outstanding settlements of investments purchased. However, effective August 6, 2019, the company expanded the total capacity of its SVCP Facility by $50.0 million to $270.0 million. On November 7, 2018, Moody’s Investors Service initiated an investment grade rating of Baa3, with stable outlook. On November 8, 2018, S&P Global Ratings reaffirmed its investment grade rating of BBB-, with negative outlook. Both ratings include consideration of the Company’s reduced asset coverage requirement.

“We had total liquidity of $237 million at quarter end. This included available leverage of $227 million and cash of $22 million reduced by net pending settlements of $12 million. Since the beginning of the second quarter, we have expanded our credit facility capacity by a total of $150 million, which includes an incremental $50 million on our SVCP facility that we added earlier this week.”

“Outstanding draws on our $150 million SBA program increased to $118 million at June 30 as we added two new portfolio companies to the SBIC. The increased leverage flexibility following shareholder approval of our reduced regulatory coverage ratio allowed us to take advantage of attractive investment opportunities during the quarter.“Regulatory leverage at quarter end which is net of SBIC debt was 0.99 times common equity on a gross basis and 0.98 times net of cash and outstanding trades. Our investment-grade rating was reaffirmed by Moody’s in June and we’re proud to continue to be one of only three BDCs with both 2:1 leverage flexibility and an investment-grade rating from both Moody’s and S&P.”

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

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

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

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

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

TCPC Risk Profile Update:

TCPC’s net asset value (“NAV”) per share declined by $0.54 or 3.8% (from $14.18 to $13.64) mostly due to unrealized losses related to adding Fidelis Acquisitions, LLC (“Fidelis”) to non-accrual resulting in $28.6 million or $0.49 per share of losses. Previously discussed Green Biologics was marked down an additional $3.2 million or $0.05 per share. Fidelis still accounts for around 1.3% of the portfolio and $0.37 per share of NAV.

Howard Levkowitz, TCPC Chairman and CEO: “While our overall portfolio is strong, our net asset value declined 3.8% in the quarter, almost entirely due to one underperforming investment. Looking ahead, we have a solid pipeline of new investment opportunities and believe we are well-positioned to continue to deliver attractive risk-adjusted returns to our shareholders.”

“Net unrealized losses of $34.6 million or $0.59 per share were primarily attributed to the write-down of our investment in Fidelis, most of which we placed on non-accrual during the quarter and which comprised 1.1% of our portfolio at fair value at June 30. No other loans were on non-accrual at quarter end and the credit quality of our portfolio is strong.”

Management discussed Fidelis on the recent call including making changes to management:

“While our investment portfolio remained strong overall, our net asset value declined 3.8% during the second quarter. This decline was almost entirely due to a write-down of our investment in Fidelis, a cyber security solutions provider that has significantly underperformed our expectations. Our initial investment in Fidelis, which we made in 2015 was at a relatively low loan-to-value and was made alongside a well-regarded private equity firm whose cash equity investment was nearly three times our debt. Fidelis initially performed to plan, but subsequently struggled in an increasingly competitive sector. After implementing several growth initiatives, customers are reacting favorably and sales have increased. However, liquidity is challenging, as revenue growth has yet to outpace costs. During the second quarter, it became clear, that notwithstanding several add-on investments from the sponsor, the company’s liquidity position no longer support its valuation. As a result, we recorded a $28.6 million unrealized loss and place the loans on non-accrual. We are disappointed by this result and are continuing to work closely with management and the sponsor to maximize value. The credit quality of the remainder of our portfolio is strong. Across the middle market, we are seeing mostly isolated credit events that appear to be more idiosyncratic and not indicative of widespread issues.”

“The company faced some challenges. Partly this was the marketplace, but to be honest a lot of it was self-inflicted issues from management. And leveraging our sort of experience and working with companies from our such a situation heritage and the owners we really worked to improve those shortfalls. And that included a change in management. That included several additional fundings on the business. And what we have seen since that time over the last several quarters is the impact — the positive impact on that from improvements in revenue bookings all the things you want to see happen on the income statement. The challenge and really to answer your question is the balance sheet challenges and the impact of that shortfall on continuing this recovery was notable and perhaps during the quarter became more evident and more pronounced where one impacts the other. And this isn’t a valuation that hasn’t changed over time.”

“It has changed over the last several years, but really where you saw the impact — where it’s less evident was in the equity of the junior tranches. And this quarter with the mitigation of our coverage and actually reduction of our coverage in the junior tranche — the C tranche you’re seeing a more pronounced and disproportionate effect in our piece, but the valuation has declined over time partly due to performance and partly due to just the market multiples which have also come down. So I think it’s harder to see that in any one quarter because of what we disclosed and what the overall valuation decrease has been. But you are seeing in this quarter a more notable impact where we’re affected in a straight waterfall to your point that over time where the equity has eaten more of the valuation deterioration. The term loan C; the increase is a function of PIK interest. Part of our — one of our latest efforts with the company and a restructuring of our position had us have a PIK position that is accretive into the C. So we did fund some additional money into the business but that is in the term loan A. So but specifically to your question on the amount of the C that was written down, that was not new funding. That was accretion. ”

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

“Our largest position represented only 3.2% of the portfolio and taken together our five largest positions represented only 14.9% of the portfolio. Furthermore, as the chart on the left side of slide 6 illustrates, our recurring income is distributed across a diverse set of portfolio companies. We are not reliant on income from any one portfolio company. In fact, on an individual company basis well over half of our portfolio companies, each contribute less than 1% to our recurring income. We have been pleased and surprised, in fact, with how little we’re hearing from companies about the impact of tariffs. In fact, there’s only one company that was directly citing it as being a material issue for their business. Now having said that, it’s still early in this next round and it’s not always immediately clear to people. And sometimes the impacts may be two or three layers away, and so it may take a while to filter through. But so far our emphasis on non-cyclical companies with a more domestic focus, I think, has benefited us pretty significantly with respect to tariffs.”

 

 

As mentioned in the previous report, its debt investments in Green Biologics were restructured into common equity and discussed on a previous call: “Green Bio missed projections, but received an equity infusion from its strategic owner during the quarter.” Kawa Solar Holdings was previously on non-accrual but restructured in Q3 2018 and is now in the process of “winding down”. Other investments that need to be watched include Securus Technologies, Inc., Conergy, Utilidata, Inc. and Avanti Communications Group.

 

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

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

 

“TCPC has outperformed the Wells Fargo BDC Index by 33% over the same period. Over the past few years we have seen many new entrants into direct lending and substantially more capital seeking investment opportunities in the middle market. Against this backdrop being part of the world’s largest global asset manager greatly enhances our ability to source deals and build upon TCP’s successful 20 year track record in direct lending.”

Quality of Management & Fee Agreement:

The primary advantages for TCPC investors are its investor-friendly fee structure protecting total returns to shareholders on a cumulative basis by taking into account capital losses when calculating the income incentive fees (“total return hurdle”) and lower cost of capital, which have resulted in superior dividend coverage, previous special dividends and growing undistributed ordinary income.

As mentioned earlier, on August 6, 2019, the Board re-approved its stock repurchase plan to acquire up to $50 million of common stock at prices below NAV per share, “in accordance with the guidelines specified in Rule 10b-18 and Rule 10b5-1”. During Q1 2019, there were only 9,000 shares repurchased and in 2018, the company repurchased only 73,416 shares for a total cost of $1.0 million. There is a good chance that the company will repurchase additional shares if the stock price declines below NAV again which is now $13.64 (reduced asset coverage ratio and higher leverage can be used for accretive stock repurchases).

From previous call: “With our stock trading at a small discount to NAV during the quarter we made modest share repurchases under our algorithm based share repurchase program.”

The company has the ability to issue shares below NAV but I do not see this as a “red flag” given the quality of management.

“Consistent with prior years and in line with many of our BDC peers, we have included in our proxy a proposal for shareholder approval to issue up to 25% of our common shares on any given date over the next 12 months at a price below net asset value. The purpose of the below NAV issuance proposal in our proxy is to provide flexibility. To be clear, at this point, we do not intend to issue equity below NAV, and certainly not unless it is accretive to our shareholders. This is basically an insurance policy, which our shareholders have approved every year since we went public.”

I consider TCPC to have higher quality management for many reasons including its updated fee agreement, conservative dividend and accounting practices (recognizing fee income over the life of the investment), insider ownership, strong underwriting standards and measured approach when raising and deploying capital.

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

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

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.

 

How to Get Institutional Investors into a BDC

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

Business development companies got a little more institutional with the initial public offering of Owl Rock Capital Corp. (ORCC), a business development company that lends to a broad range of middle-market companies.

Owl Rock Capital Partners, which operates the BDC, was started in 2016 by three well-known private credit veterans:

  • Doug Ostrover, co-founder of Blackstone Group’s GSO Capital Partners;
  • Marc Lipschultz, KKR’s former global head of energy and infrastructure; and
  • Craig Packer, who was co-head of leveraged finance for the Americas at Goldman Sachs.

Owl Rock initially raised $5.5 billion — more than 80 percent of which was institutional — from investors including New Jersey’s state pension fund, Brown University, and MSD Private Capital, Michael Dell’s family office.

ORCC priced the IPO at $15.30 and issued ten million shares on the New York Stock Exchange. The shares opened at $15.50. BDCs are vehicles like mutual funds, real estate investment trusts, and master limited partnerships, but which make loans, many of which support private equity deals.

BDCs, like REITs almost two decades ago, want institutional investors and the scale that comes with them. In recent years, the largest asset managers — including Blackstone, KKR, Carlyle, Ares, TPG, and Franklin Templeton — have been building initiatives to offer the still-arcane product, which has historically been geared to retail investors. But Packer, president of ORCC, said in an interview that the founders built the entire business with institutions in mind.

“If you raise money in the retail channel, it takes a long time to scale,” said Packer. “And while you do that, you have to invest in smaller deals. Because we raised $5.5 billion in equity, and with leverage scaled that to $10 billion, we could invest in larger companies from the very beginning.”

Packer said these kinds of companies are “materially better” than ones Owl Rock would have access to if it had to operate with a smaller pool of capital. “Our investors want the returns you get from illiquid securities, but they also want safety,” he added.

Although the BDC market is still a small part of private credit, Ostrover expects that to grow, stressing the benefits that BDCs offer over other traditional institutional funds that invest in private credit. For one, investors are putting money into a portfolio that is already invested.

“A GP/LP fund is a blind pool. You invest over four years, say, and then you get your money back. But you don’t know your return until the last loan is paid off, and that could be in year nine,” said Ostrover. “With us you know exactly what you are buying and you can analyze the loans. And then you go into the market, and put $100 million to work right away.”

Ostrover added that with BDCs, shareholders get dividends the following quarter, rather than having to wait until a manager puts money to work through a traditional fund, and can sell shares at any time.

As for fears about the flood of money going into private credit from institutional investors in recent years, Packer pointed out that private debt has grown, but nearly as quickly as its primary driver: private equity. The proportion of private equity that private lending represents has actually gone down.

“We think there are tremendous growth opportunities ahead,” he said. “It’s still a small fraction of the private equity market. Every dollar of PE needs five dollars of debt.” Many BDCs trade at discounts to their net asset values, but a more institutional client base could straighten that out, Owl Rock’s principals said. “The market is becoming bifurcated,” said Ostrover. “There are firms that have invested in energy, retailers, and others, and they’ve had losses and trade at a discount. But there are others that trade at a large premium because they’ve delivered a steady stream of income and avoided troubled sectors.”

To be a successful BDC investor:

As discussed in “Building a retirement portfolio with BDCs“, please consider the following suggestions:

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

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

Capital Southwest (CSWC): BDC Buzz Initiates Active Coverage

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

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

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

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

Summary

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

 

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

 

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

 

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

CSWC Dividend Coverage Discussion:

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

CSWC Risk Profile Discussion:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

 

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

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

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

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

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

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

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

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

 

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

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

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.

 

 

Building A Retirement Portfolio With BDCs

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

Summary

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

Typical Steps to Creating a Retirement Portfolio

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

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

  • Please see below for discussions of yield and allocations.

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

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

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

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

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

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

Bond Funds & Baby Bonds

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

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

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

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

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

 

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

 

What is a BDC?

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

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

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

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

Why do I like BDCs?

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

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

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

The following is from a previous call with ARCC management:

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

To be a successful BDC investor:

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

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

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

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

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

Quick Update:

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

 

Upcoming ORCC IPO:

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

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

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

Upcoming ORCC Distributions

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

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

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

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

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

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

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

Preliminary Estimates of Results as of June 30, 2019

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

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

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

ORCC Management Fees

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

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

ORCC Risk Profile

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

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

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

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

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

Select ORCC Historical Financial Information

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

Stock Repurchase Plan, Use of Leverage & Capital Structure

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

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

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

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

To be a successful BDC investor:

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

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

 

BlackRock TCP Capital (TCPC) Q1 2019 Update

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

 

Summary

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

 

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

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

 

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

 

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

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

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

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

 

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

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

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

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

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

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

Risk Profile Update:

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

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

 

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

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

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

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

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

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

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

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

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

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

To be a successful BDC investor:

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

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

 

TPG Specialty Lending (TSLX) Q1 2019 Update

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

Summary

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

TSLX Dividend Coverage Update:

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

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

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

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

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

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

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

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

TSLX Risk Profile Update:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

To be a successful BDC investor:

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

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