CSWC Quick Update: Continued Excellent Returns

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • CSWC target prices/buying points
  • CSWC risk profile, potential credit issues, and overall rankings
  • CSWC dividend coverage projections (base, best, worst-case scenarios)


Previous CSWC Articles Follow-Up

This article is a follow-up to “Growing Dividends During A Pandemic: Capital Southwest” and “BDCs Continue To Affirm Dividends: Capital Southwest At 15%” which predicted additional increases to CSWC’s regular dividend as well as continued supplemental dividends driving higher returns to shareholders.

CSWC Dividend History

Source: CSWC Investor Presentation

Hopefully, readers purchased shares as the stock is up 103% since the article, and the company has increased its regular quarterly dividend four times as well as paying additional supplemental dividends including the $0.50 “final supplemental” for Q4 2021 announced earlier this month.

As you can see, CSWC has easily outperformed the S&P 500 and as discussed later I was actively purchasing shares just before the article came out.

CWSC outperformed S&P 500

Capital Southwest is an internally-managed BDC with an ~$800 million portfolio of mostly first-lien debt and equity positions historically providing realized gains especially in its lower middle market investments. CSWC remains a “Level 1” dividend coverage BDC implying the potential for increased regular quarterly dividends and/or additional supplemental dividends mostly due to the ability to leverage its internally managed cost structure and history of realized capital gains.

In the lower middle market, we directly originate and lead opportunities, consisting primarily of first lien senior secured loans with smaller equity co-investments made alongside our loans. We believe that this combination is powerful for a BDC as it provides strong security for the vast majority of our invested capital, while also providing NAV upside from equity investments in these growing businesses. Within our lower middle market portfolio as of the end of the quarter, we held equity ownership in approximately 57% of our portfolio companies.”

Source: CSWC Investor Call Transcript


CSWC Q2 2021 Dividend Coverage Update

For calendar Q2 2021, CSWC beat its base case projections mostly due to higher dividend income with much higher-than-expected portfolio growth partially offset by higher “Other G & A” and borrowing expenses (due to higher leverage). The company is now slightly above its lower targeted leverage (1.20) with a debt-to-equity ratio of 1.21 (net of available cash). As of June 30, 2021, CSWC had almost $17 million in unrestricted cash and almost $147 million in available borrowings under its credit facility for upcoming portfolio growth.

 CSWC Q2 2021 Dividend Coverage

There was a meaningful decrease in the amount of payment-in-kind (“PIK”) income during the quarter from $2.8 million to $1.0 million due to a one-time reversal of previous cash interest income for a portfolio company recovering from “operating challenges.”

Q. “Over the last four quarters, PIK income both nominally and as a percentage of total investment income has fallen pretty materially. Is that a kind of a concentrated effort to steer away from PIK income?”

A. “I would tell you it’s actually kind of concentrated. The lower middle market company we put on non-accrual it had essentially converted from cash to PIK and then we obviously inevitably put it in non-accrual this quarter. So there was sort of a write-up of PIK for that company over the last two quarters and then it was reserved against this quarter. So therefore what you’re seeing now is actually the normal run rate of PIK.”

Source: CSWC Investor Call Transcript

Capital Southwest Key Metrics

Source: CSWC Investor Presentation


CSWC Continued Improvement in Earnings

CSWC’s total quarterly interest income has increased by almost 40% over the last two years to its highest level (over $15 million) driving continued dividend increases as the company leverages its internal operating cost structure.

I’m expecting additional regular quarterly dividend increases mostly due to increased returns from its I-45 Senior Loan Fund, reduced borrowing rates (discussed next), and continued portfolio growth combined with leveraging its lower cost operating structure:

Capital Southwest Operating Leverage

Source: CSWC Investor Presentation


On August 27, 2021, CSWC closed its offering of $100 million of 3.375% unsecured notes due Oct. 1, 2026, priced at 99.418% resulting in a yield-to-maturity of 3.5%. The proceeds were used (along with $25 million additional borrowings on its lower rate credit facility) to redeem its $125 million of 5.375% notes due 2024. This will have a meaningful impact on its overall borrowing rate and I have taken into account with the updated projections.

We are pleased with our execution in raising $100 million in long-term unsecured capital. This transaction allows us to redeem the outstanding 2024 Notes, reducing our cost of debt by 2%. We expect that, on an adjusted basis reflecting the issuance of the 2026 Notes, our quarterly interest expense will be reduced by approximately $0.02 per share, which will be beneficial to shareholders in future quarters. Additionally, this capital raise and redemption pushes out our next debt maturity to 2026, providing significant capital flexibility going forward.”

Source: CSWC Investor Call Transcript

Capital Southwest October 2024 notes

Source: CSWC Investor Presentation

In April 2021, CSWC announced that it received a license from the U.S. Small Business Administration (the “SBA”) to operate a Small Business Investment Company (“SBIC”) subsidiary. An SBIC license provides CSWC an incremental source of long-term capital by permitting it to issue up to $175 million of SBA-guaranteed debentures. These debentures have maturities of 10 years with fixed interest rates currently around 3%.

As we’ve discussed on prior calls, we have now begun operations with our SBIC subsidiary, which we’ll see going forward denoted as CSWC SBIC I. As a reminder, our initial equity commitment to the fund is $40 million and we have received an initial commitment from the SBA for $40 million of fund leverage, which is also referred to as one tier of leverage. We expect to invest this initial $80 million of capital over the next six to nine months, at which point we will apply for a second tier of leverage. Over the life of the fund, we plan to draw the full $175 million in SBIC debentures, alongside $87.5 million in capital from Capital Southwest. We are excited to be part of this program and believe it will be a natural fit with our investment strategy.”

Source: CSWC Investor Call Transcript

It should be noted that CSWC already has started utilizing its SBIC license including $7.5 million of SBA debentures through Aug. 23, 2021, as disclosed in the following SEC filing associated with the recently issued notes here.

Management is now targeting a debt-to-equity ratio between 1.20 and 1.30 including upcoming SBA borrowings.

Q. “With the receipt of the first SBIC license can you remind us whether or not you have a target leverage range both in an economic sense and on a regulatory level?”

A. “Our economic leverage is going to be somewhere in the 1.20 to 1.30 range and our regulatory leverage will be between 0.90 and 1.10. We actually think that with the pace of originations and the draws of SBIC we should be near 1 times in the next six months.”

Source: CSWC Investor Call Transcript

Management is expecting continued higher portfolio activity including prepayments (driving additional fee income) partially offset by new investments which are taken into account the updated projections:

Based on dialogue with our portfolio companies, we also believe that the active market will result in elevated prepayments for Capital Southwest over the remainder of this year. We’re looking probably at maybe somewhere in the $30 million to $60 million in potential prepayments between now and the end of the year. Now some of those have make-wholes so the newer companies that maybe have been with us a year or two, they’ll have either 102 or 101. But there’s, others that potentially come back and don’t have a make-whole. So I’m not sure that it’s (“other income”) going to be elevated beyond somewhere in the $500,000 range.”

Source: CSWC Investor Call Transcript

Also taken into account is the following guidance from management for additional dividend income and lower operating expenses (G&A) relative to the previous quarter:

Q. “Can you provide some color on the source of that dividend? And then also confirm whether that should be considered recurring or nonrecurring?”

A. “A portion of that is recurring or received from our shareholders – from our portfolio companies held in our blocker. On a quarterly basis, I think the level is around $300,000 to $350,000 is what we’re receiving. And then some of those tend to be one-time in nature from dividend income coming from portfolio companies of distributions.”

Q. “Looking at the expense side, G&A tracked a bit higher this quarter than last quarter. Is that increase driven by one-time expenses, or is that reflective of higher G&A due to increased scale of the business?”

A. “So some of this is related just to the seasonality, our annual meeting is in July. So we incurred some audit costs and 10-K. So that’s a few hundred — that’s about $200,000. And you’ll see that on — every year in the 6/30 quarter. We also noted we had $100,000 one-time costs for a headhunter for a new principle that we hired, which obviously is one-time in nature. And then, we did increase — we had one new board member and that’s increased professional expenses by $100,000. And so that will be recurring going forward.”

Source: CSWC Investor Call Transcript

Its I-45 Senior Loan Fund accounts for around 10% (previously 8%) of the total portfolio and is a joint venture with MAIN created in September 2015. The portfolio is 96% invested in first-lien assets with CSWC receiving over 75% of the profits paying a quarterly dividend of $1.6 million (previously $1.5 million) but should improve over the coming quarters due to the lower cost on its credit facility and increased leverage.

The I-45 senior loan fund showed solid performance for the quarter with asset growth and unrealized appreciation. Leverage at the I-45 fund level is now 1.4 times debt to equity. As of the end of the quarter, 96% of the I-45 portfolio was invested in first lien senior secured debt. Weighted average EBITDA and leverage across the companies in the I-45 portfolio was $77.9 million and 4.8 times respectively. The portfolio continues to have diversity among industries and an average hold size of 2.6% of the portfolio.”

Source: CSWC Investor Call Transcript

Capital Southwest I-45 loan portfolio

Source: CSWC Investor Presentation


CSWC Equity Positions and Realized Gains

Most dividend coverage measures for BDCs use net investment income (“NII”) which is basically a measure of earnings. However, some BDCs achieve incremental returns typically with equity investments that are sold for realized gains often used to pay supplemental/special dividends.

In the lower middle market, we directly originate and lead opportunities consisting primarily of first lien senior secured loans with smaller equity co-investments made alongside our loans. We believe that this combination is powerful for a BDC as it provides strong security for the vast majority of our invested capital, while also providing NAV upside from equity investments in many of these growing businesses. Building out a well-performing and granular portfolio of equity co-investments is important to driving growth in NAV per share, while aiding in the mitigation of any credit losses over time. As of the end of the quarter, our equity co-investment portfolio consisted of 31 equity investments, totaling $66.1 million representing 8% of our portfolio at fair value. Within our lower middle market portfolio as of the end of the quarter, we held equity ownership in approximately 57% of our portfolio companies.”

Source: CSWC Investor Call Transcript

As shown below, CSWC had realized gains of $18.6 million during calendar Q2 2018 related to the exit of TitanLiner and realized gains of $44.3 million during calendar Q4 2019 related to the exit of Media Recovery. These gains were primarily responsible for previous supplemental dividends and the “final supplemental dividend” is likely the accelerated completion of the commitment to share net realized gains with their shareholders.

Please keep in mind that CSWC has a March fiscal year-end so the quarters shown below are fiscal not calendar.

Capital Southwest Portfolio exits

Source: CSWC Investor Presentation

I am expecting additional supplemental dividends in late 2022 as the company continues to exit equity positions:

…shareholders will continue to participate in the successful exits of our investment portfolio through special distributions as we monetize the unrealized appreciation in our portfolio.”

We continued our track record of successful exits with one this quarter. We exited our equity investment in Tax Advisors Group, generating a realized gain of $1.1 million and an IRR of 34%. To date, we have generated a cumulative weighted average IRR of 15.2% on 39 portfolio exits, representing approximately $385.1 million in proceeds.”

Source: CSWC Investor Call Transcript

capital southwest exits

Source: CSWC Investor Presentation


Summary

On Sept. 2, 2021, CSWC increased its quarterly regular dividend from $0.44 to $0.47 per share for Q4 2021 and decided to accelerate expected future payments under the supplemental dividend program declaring a “final supplemental dividend” of $0.50 per share.

Bowen Diehl, President/CEO: “We are pleased to announce today that our Board has declared a $0.47 regular dividend for the quarter ended December 31, 2021, an increase of 6.8% compared to the $0.44 regular dividend already declared for the quarter ended September 30, 2021. Our recent successful capital markets activities, combined with strong credit portfolio growth and performance, give us confidence that we can continue to steadily grow our regular dividend going forward. In addition, we believe the accelerated distribution of $0.50 per share from our undistributed taxable income (“UTI”) maximizes value for our shareholders, while still maintaining an adequate UTI balance going forward. We have significantly strengthened our balance sheet capitalization since we established the supplemental dividend program in June 2018, and thus feel confident in our ability to accelerate the supplemental dividend payment at this time. Going forward, shareholders will continue to participate in the successful exits of our investment portfolio through special distributions as we monetize the unrealized appreciation in our portfolio.”

Source: CSWC Press Release

It’s interesting to note that this announcement was 10 weeks early as the company typically announces Q4 dividends during the third week of October and large Q4 supplementals in November (after assessing taxes) as they did in 2019 for the $0.75. This means that the company is doing well and we can expect Q3 2021 to be very strong likely with a large amount of realized earnings from equity investments.

Capital Southwest Dividends

Source: Seeking Alpha

As mentioned earlier, I am expecting additional increases in the regular dividend plus continued supplemental/special dividends mostly due to:

  • Leveraging its internal operating cost structure
  • Continued portfolio growth
  • Increased returns from its I-45 Senior Loan Fund
  • Reduced borrowing rates
  • Additional realized gains from harvesting equity positions

A large part of my Sustainable Dividends service is not only knowing which BDCs to buy but also knowing when to buy. For example, the “CSWC Updated Projections: Excellent Timing!” recommended purchasing CSWC on June 30, 2021, after it had fallen from $27.50 to $23.23 with an RSI of 32.20 as shown below.

CWSC stock price

Source: Yahoo Finance

 

 


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

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

ORCC Quick Update: Making Progress

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • ORCC target prices/buying points
  • ORCC risk profile, potential credit issues, and overall rankings
  • ORCC dividend coverage projections (base, best, worst-case scenarios)


This update discusses Owl Rock Capital Corporation (ORCC) which remains one of the best-priced BDCs especially for lower-risk investors that do not mind lower yields. ORCC is for risk-averse investors as the portfolio is mostly larger middle market companies that would likely outperform in an extended recession environment. Also, the company has ample growth capital available for increased earnings over the coming quarters.

We generally favor bigger companies for our portfolio. This year, we have already evaluated more than 20 opportunities over $1 billion in size, and invested in or committed to eight of these and continue to evaluate others. This trend continues to accelerate and is creating exciting opportunities for large direct lenders like Owl Rock. We believe we are especially well-positioned for this due to our scale platform with a full suite of financing solutions, large, deeply experienced team with strong relationships in the financial sponsor community.”

ORCC is the third-largest publicly traded BDC (much larger than MAIN, PSEC, GBDC, GSBD, NMFC, and AINV) with investments in 129 portfolio companies valued at almost $12 billion that are mostly first-lien secured debt positions. ORCC is one of the few BDCs rated by all of the major credit agencies.


ORCC Dividend Coverage Update

ORCC’s longer-term (“LT”) target price takes into account improved dividend coverage over the coming quarters mostly due to:

  • Increased use of leverage to grow the overall portfolio
  • Additional prepayments fees and accelerated OID
  • Higher portfolio yield from rotating into higher yield assets
  • Continued lower cost of borrowings
  • Increased dividend income from its Senior Loan Fund

ORCC continues to increase leverage and is now approaching the midpoint of its target debt-to-ratio between 0.90 and 1.25 (currently 1.00 excluding $627 million of available cash) giving the company plenty of growth capital.

“We are now well within our target leverage range and continue to grow the portfolio, which has allowed us to make substantial progress towards covering our dividend. Despite a competitive market backdrop, we’re able to deploy capital into attractive investments and drive incremental yield in the portfolio. The pace of repayments also picked up resulting in a meaningful increase of prepayment related income. And opportunistic financings and improving financing spreads have allowed us to continue to lower our overall cost of funding.”

“As a result of this activity our net leverage increased to 1.00 times approaching the midpoint of our target ranges of 0.90 to 1.25 times. I would expect that we would operate somewhere between there and 1.10 in sort of center of gravity. We look around the portfolios can certainly support that. We’re very focused on keeping really strong ratings for the rating agencies. We’re in constant communication with the agencies and believe that will continue to have good investment grade ratings in that that range. It’s obviously very dependent upon flows in any one quarter. So could dip a little higher, dip a little lower, depending upon one deal plan within a quarter. But 1.00 to 1.10 is probably the right range for folks to be modeling in again be could be a bit higher or lower.”

Management is expecting another strong quarter partially due to higher prepayment-related income which has been taken into account with the updated financial projections and was discussed on the recent earnings call:

“We are encouraged by our visibility on the third quarter and expect another very solid quarter of originations. In terms of repayments, we also expect another strong quarter which should again generate meaningful prepayment income in Q3. Given our strong origination activity, we are confident we will be able to offset repayments by deploying the capital into new originations at attractive spreads. We have visibility on our third quarter. It’s going to be a very active one from an origination standpoint I would say. Again it depends on when everything winds up closing and you just even when you have high visibility until it closes, you’re not sure, but I would expect it to be in line with the second quarter possible possibly exceed it.”

Also taken into account with the updated projections is additional dividend income from its ORCC Senior Loan Fund (previously Sebago Lake LLC) which now accounts for 1.4% of the total portfolio. Management is expecting this joint venture with Nationwide Life Insurance to provide quarterly dividend income of $7 million:

“A few weeks ago we announced an increase in capital commitments towards joint venture loan funds. The fund has generated an attractive average quarterly ROI over the past three years of approximately 10%. ORCC increased its commitment to $325 million, and in addition increased its economic ownership to 87.5% from 50%. We’re also excited to bring a nationwide life insurance as a new partner in the JV. Nationwide, it’s been a meaningful ORCC shareholders since inception, and purchase the remaining 12.5% economic interest from UC Regents effective June 30. In conjunction with these changes, the joint venture will be referred to as ORCC Senior Loan Fund going forward in our disclosures. And so we’ll just be able to increase over time the amount of money ORCC has working and grow that. I think in the most recent quarter, we had about $4 million of dividends that number, when we get all that working it’s going to take some time should be we $7 million a quarter, which is I think terrific.”


Similar to other BDCs, ORCC has been improving or at least maintaining its net interest margin which is the difference between the yield on investments in the portfolio and the rate of borrowings. During the most recently reported quarter, ORCC maintained its portfolio yield but will likely trend higher over the coming quarters as the company rotates into higher yield assets “without sacrificing credit quality”:

“We’ve talked about our desire to rotate a bit and get a little more spread [higher yields] in the portfolio without sacrificing credit quality. And I think what you’re seeing tangible evidence that we’re succeeding on that. Our average spread on new commitments was approximately 670 basis points, up from 640 basis points last quarter. Our overall spread increased as a result of our ability to originate some higher spread unit tranches particularly in the software sector, as well as an increase in second lien investments and a new preferred investment. We’re pleased with our success at increasing the average spread on our investments over the last year which is now roughly 20 basis points higher than it was a year ago. We believe this reflects the strength of our origination capabilities and relationships and the continued attractiveness of our direct lending solutions. ”

ORCC’s average borrowing rate has declined from 4.6% to 3.0% over the last six quarters due to continued issuances of notes and CLOs at lower rates including another $400 million of its 2.875% notes due 2028 issued on August 17, 2021.

“Given ORCC’s scale since inception, we knew it was critical to have a diversified financing landscape and we embarked on building a balance sheet that would provide financial flexibility and ample liquidity from multiple financing sources. In addition to developing a large diverse bank group that provides us with a billion and a half of revolving credit capacity we have also issued almost $4 billion across eight unsecured bond deals, and over $1.5 billion across six CLOs to efficiently finance our balance sheet. We have been able to meaningfully improve pricing since our first issuances in both cases. We’re pleased with the continued growth of our unsecured financing while we continue our efforts to reduce our borrowing costs. We capitalized on strong conditions in the unsecured bond market during the quarter, raising $950 million across two deals of attractive spreads. In addition to the long five year that we issued in April, we raised an additional $450 million in a seven year bond which priced at a fixed coupon of 2.78%. This is our first seven year bond and should help us to enhance the laddering of our debt maturity profile. As of June 30, more than 60% of our outstanding borrowings were from unsecured debt. Our unsecured bond pricing levels have improved over 100 basis points since we’ve been accessing the unsecured market and we believe there is additional improvement we can capture on future issuances.”


As of June 30, 2021, ORCC had around $2.2 billion of liquidity consisting of $627 million of cash and almost $1.6 billion of undrawn debt capacity (including upsizes).



For Q2 2021, ORCC hit its best-case projected earnings due to higher-than-expected prepayment-related, dividend, and fee income as well as higher portfolio growth growing total income to the highest level of $249 million. ORCC was not expected to cover its quarterly dividend but Core NII of $0.305 (excluding excise tax) covered 98% of its regular dividend of $0.310. The Board reaffirmed its third-quarter 2021 dividend of $0.31 per share for stockholders of record as of September 30, 2021, payable on or before November 15, 2021.

“Net investment income for the quarter was $0.30 up from $0.26 per share in the first quarter. We made substantial progress towards covering our $0.31 quarterly dividend and remain on track to cover it in the second half of the year. This was driven by a significant increase in both originations and repayments and continued strong credit performance.”

It should be noted that there was $1.8 million of non-recurring interest expense that negatively impacted earnings during the quarter:

“I would highlight that we had $1.8 million of non-recurring interest expense related to the acceleration of upfront deferred financing fees as we continue to optimize our financing costs through the restructuring of one of our CLOs.”


ORCC Quick Risk Profile Update

Two of its smaller first-lien loans to QC Supply were added to non-accrual status during Q2 2021. CIBT Global, Inc. remains on non-accrual but was restructured during the quarter driving realized losses of $0.07 per share but will likely be back on accrual in Q3 2021. Please keep in mind that ORCC has 129 portfolio companies so there will always be a certain amount on non-accrual which currently account for 0.5% of the total portfolio fair value as shown below.

“While we continue to have a small number of challenge credits, our non-accruals remain extremely low with only two investments on nonaccrual status at the end of the quarter representing less than point 0.5% of the portfolio based on fair value, one of the lowest levels in the BDC sector.”


Investments Rating 3 or 4 which are borrowers performing “below” or “materially below” expectations indicating that the loan’s risk had increased “somewhat” or “materially” are now below 10% of the portfolio. Swipe Acquisition Corporation was previously the only investment with ‘Rating 5’ and was upgraded in Q4 2020.

“We continue to see sequential improvement in the engine our lowest rating category, those names rated four or five. These have decreased from 1.9% to 0.5% of the portfolio quarter-over-quarter.”

As mentioned earlier, ORCC’s portfolio is mostly larger middle market companies that would likely outperform in an extended recessionary environment.

We generally favor bigger companies for our portfolio. This year, we have already evaluated more than 20 opportunities over $1 billion in size, and invested in or committed to eight of these and continue to evaluate others. This trend continues to accelerate and is creating exciting opportunities for large direct lenders like Owl Rock. We believe we are especially well-positioned for this due to our scale platform with a full suite of financing solutions, large, deeply experienced team with strong relationships in the financial sponsor community.”

“We ended the second quarter with NAV per share of $14.90 up $0.08 from the first quarter. Credit quality remains strong with an average fair value of 98 consistent with prior quarters. The overwhelming majority of the portfolio continues to perform very well with 93% of debt investments marked above 95% of par. Most of our borrowers have returned to normalize operating levels and many experienced strong performance in Q2. While we are closely monitoring COVID developments, we have a positive outlook for the overall economy in the second half of the year as consumer demand further rebounds. We believe this will continue to drive good results for our borrowers.”


The portfolio is highly diversified with the top 10 positions accounting for around 19% of the portfolio with low cyclical exposure including retail, oil, energy, and gas.

“Today the portfolio is well diversified across 29 industries and the top 10 positions make up only about 19% of the total portfolio.”


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

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

AINV Quick Update: Higher Yield For A Reason

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • AINV target prices/buying points
  • AINV risk profile, potential credit issues, and overall rankings
  • AINV dividend coverage projections (base, best, worst-case scenarios)


AINV Distribution Update

On August 5, 2021, the Board declared a distribution of $0.31 per share payable on October 8, 2021, to shareholders of record as of September 21, 2021. On August 5, 2021, the Company’s Board also declared a supplemental distribution of $0.05 per share payable on October 8, 2021, to shareholders of record as of September 21, 2021.

Since 2018, the distributions to shareholders have been covered only through fee waivers and not paying the full incentive fees. However, the company will likely start paying incentive fees during the September 30, 2021, quarter which will have a meaningful impact on dividend coverage and was discussed on the recent (August 5, 2021) call:

“Given the total return hurdle feature in our fee structure and the recovery in our portfolio over the last several quarters, we expect to begin to pay a partial incentive fee in the quarter ending September 2021. The exact timing and amount will vary based upon — based on future gains and losses if any, as well as the level of net investment income for the quarter. As we said on last quarters call, we believe AINV net investment income, may fluctuate over the next few quarters as we begin to pay incentive fees. That said we expect to generate higher revenue from certain investments, including Merx, which will help offset the impact from incentive fees.”

As discussed later, AINV’s recurring interest income has recently declined to its lowest level over the last 15 years and the company would have only covered around 86% of the quarterly dividends if the full incentive fees had been paid.

“The quarter-over-quarter decline in interest income was attributable to the pace of the investment activity and a relatively higher yield on repayments versus fundings. The weighted average yield at cost on our corporate lending portfolio was 7.7% at the end of June, down from 7.8% last quarter. Prepayment income was $4 million, up from $3.3 million last quarter.”

Investors should expect dividend coverage to “fluctuate” over the coming quarters but management seems committed to paying the regular quarterly distribution of $0.31 plus the supplemental distribution of $0.05 through March 31, 2022, as discussed on the recent call:

“We remain confident in the trajectory of our earnings, and our long-term plan. As mentioned last quarter, we intend to declare a quarterly based dividend distribution of $0.31 per share, and a quarterly supplemental distribution of $0.05 per share for at least the next two quarters. To be clear, this would be an addition to the distribution declared today.”

There is a chance that AINV could be downgraded to ‘Level 3’ dividend coverage (implying the potential for a reduction in the amount of total dividends paid) depending on the progress of rotating out of “non-earning and lower yielding assets” and improved results/income from its investment in Merx Aviation:

“We believe Merx has successfully navigated this challenging period, and we expect AINV will be able to generate higher revenue from Merx in the coming quarters.”

Management has guided for portfolio growth using increased leverage which is already among the highest in the sector at 1.39 debt-to-equity (net of cash) compared to the average BDC currently around 0.95 as shown in the following table.

“Net leverage increased to 1.39 times at the end of June, up from of 1.36 times last quarter and slightly below our target leverage range of 1.40 times to 1.60 times. As we look ahead, we are confident in our ability to grow our portfolio and operate within our target leverage range, given the tremendous need for creative and flexible private capital and the unique and robust nature of the Apollo mid cap platform.”

The following table shows each BDC ranked by its simple (not effective) debt-to-equity ratio net of cash (non-restricted) along with its portfolio mix. The “Other” column includes everything that is not first or second-lien secured debt.


I have updated the projections for AINV to take into account the recently reported results as well as guidance from management on the recent and previous calls.

From previous call: “We said that we believe a $0.31 base distribution reflects a conservative estimate of the long-term earnings power of our core portfolio, and that the supplemental distribution would be a function of the redeployment of non-earning and lower yielding assets from noncore and legacy assets, as well as an increase in yield we received from our Merx investment. We remain constructive on each of these drivers, although we expect some of the benefits of these drivers will occur after we start accruing incentive fees. As a result, net investment income may fluctuate over the next few quarters as we continue to reposition out of noncore and legacy assets and grow the portfolio to within our target leverage range.”

“Looking ahead to fiscal year 2022, we will continue to seek to optimize and de-risk our portfolio and rotate out of our remaining noncore and second lien assets into core assets. The noncore assets are generating about a 4% or 5% return. So, as we generate cash off those assets and redeploy them into our current yield and we get Merx back to a level of producing income, not to where it was before, but to sort of a new moderated level, we can generate enough income after the incentive fee to cover that dividend.”

During the three months ended June 30, 2021, the Company repurchased 145,572 shares at a weighted average price per share of $13.92, inclusive of commissions, for a total cost of $2.0 million. This represents a discount of approximately 12.72% of the average net asset value per share for the three months ended June 30, 2021. During the period from July 1, 2021, through August 4, 2021, the Company repurchased 44,418 shares at a weighted average price per share of $13.46 inclusive of commissions, for a total cost of $0.6 million. Since the inception of the share repurchase program, the company has repurchased 13,800,150 shares at a weighted average price per share of $16.31 for a total cost of $225.1 million, leaving a maximum of $24 million available for future purchases. On July 9, 2021, the company priced an offering of $125 million of 4.500% Notes due July 16, 2026.

“Regarding liquidity, given the continued improvement in the quality of our investment portfolio, our liquidity position continues to strengthen both quarter end in July, we issued $125 million up 4.5% unsecured notes due on July 26. Despite the dilutive impact of these notes, we believe it was prudent to diversify and extend the maturity of our funding sources.”

“Regarding stock buybacks during the quarter AINV purchased 145,500 shares at an average price of $13.92 for a total cost of $2 million. From July 1 — this is first quarter to August 4, 2021, we purchased an additional 44,000 shares at an average price of $13.46 for a total cost of $600,000, leaving approximately $24 million authorization for future purchases under the Board’s current authorization.”

For calendar Q2 2021, AINV reported between its worst and base case projections due to the continued decline in its portfolio yield driving recurring interest income to its lowest level over the last 15 years. As shown in the following table, the company would have covered around 86% of the quarterly dividends if the full incentive fees had been paid which is a slight decline from the previous quarter.



Previously, AINV was considered a ‘Level 4’ dividend coverage BDC implying that a dividend reduction was imminent and on August 6, 2020, the company announced a decrease in the regular quarterly dividend per share from $0.45 to $0.31. Subsequently, AINV was upgraded to ‘Level 2’ due to the dividend reduction and the strong likelihood that the company would not be paying incentive feesover the coming quarters.

From previous call: “Turning to our distribution, in light of the challenges and uncertainty created by the COVID-19 pandemic and our plans to further reduce the funds leverage, we have reassessed the long-term earning power of the portfolio and included that as a prudent to adjust the distribution at this time. We believe that distribution level should reflect the prevailing market environment and be aligned with the long-term earnings power of the portfolio. Going forward in addition to a quarterly based distribution, the company’s Board expects to also declare supplemental distribution and an amount to be determined each quarter.”

It is important to note that AINV has experienced around $700 million of realized losses over the last ~8 years which is around $10.75 per share using the current number of shares. This compares to other BDCs with a history of realized gains such as ARCC with $725 million of realized gains during the same period. A good portion of AINV’s previous and recent losses were due to higher amounts of exposure to cyclical sectors including extended stay hotels and oil/energy. However, PNNT also had larger amounts of oil/energy exposure with much strong NAV performance during the same period. This is likely due to AINV’s management previously taking on too much risk including concentration risk in the wrong sectors.



AINV Quick Risk Profile Update

During calendar Q2 2021, non-accruals declined from 1.4% to 1.1% of the portfolio fair value (5.6% of the portfolio at cost) due to marking down its investments Glacier Oil & Gas and Ambrosia Buyer Corp partially offset by marking up Spotted Hawk. It should be noted that there will likely be continued realized losses over the coming quarters including previously discussed investments some of which are included in the table below. These investments alone account for $268 million or $4.11 per share of previous unrealized losses but still account for 7.0% of the total portfolio and 16.6% of NAV per share.


Management is working to exit its investment in Spotted Hawk and was discussed on the previous earnings call:

“The oil and gas investments, it’s really Spotted Hawk is the one of size. And we are — sort of now that oil prices have picked up and there’s some sense of — there’s some — visibility is too strong a word. There’s some possibility of sort of constructive transactions, we’re going to be as aggressive as we can there to sort of exit that.”

The largest markdown during the quarter was its equity position in Dynamic Product Tankers which is a shipping business 85% owned by AINV (since 2015) as discussed in previous reports. As shown below, AINV currently has $22 million subordinated loan due July 2024 at a very low rate of LIBOR +500 basis points and continues to mark down its equity position currently 40% of cost accounting for almost $30 million or $0.46 per share of unrealized losses.


Net asset value (“NAV”) per share increased by $0.14 or 0.9% (from $15.88 to $16.02) mostly due to Carbonfree Chemicals partially offset by Dynamic Product and Merx Aviation as well as overearning the dividend by almost $0.03 per share.

“During the quarter our corporate lending portfolio had a gain of $6 million or $0.09 per share. Merx had a slight loss of $1.2 million or $0.02 per share, and our non core and legacy assets had a net gain of $2 million or $0.03 per share. The net gain on non-core and legacy included a $9.8 million gain on Carbonfree, a legacy investment partially offset by losses on oil and gas and shipping.”


As discussed in previous reports, AINV restructured its first-lien loans to Carbonfree Chemicals and now owns 31% of the company. The equity portion was marked up during the recent quarter and now value at 46% of cost but needs to be watched as it could result in higher (or lower) NAV over the coming quarters. Carbonfree produces proprietary technologies that capture and reduce carbon emissions by producing chemicals such as limestone and baking soda for sale or for long term storage and could benefit from the current administration. Management discussed on the recent call:

“As a reminder, our investment in Carbonfree Chemicalsconsists of investment in the company’s proprietary carbon capture technologies and an investment in the company’s chemical plant. Carbonfree is benefiting from the strong interest in carbon capture utilization and storage. The increase in valuation is a result of a recent third party capital raise at Carbonfree.”

Previous call: “Carbonfree Chemicalswhich has some really good developments there. And that’s an all equity debt investment that had been converted to our equity. But that’s all equity and is a carbon-efficient business that has a lot of demand, obviously, where the world is going right now. And so, we hope that one over the next year can have some real significant positive things happen to it.”



Over the last few years, the company has been repositioning the portfolio into safer assets including reducing its exposure to oil & gas, unsecured debt, and CLOs. The “core strategies” portion of the portfolio remains around 92% of all investments:

“We continue to make good progress increasing our exposure to first lien floating rate corporate loans, while reducing our exposure to junior capital and non-core positions. Repayments during the quarter included the exit to second lien investments, as well as a small partial pay down from one of our shipping investments. We remain focused on reducing our exposure to the remaining non-core assets, while ensuring an optimal outcome for our shareholders.”

Its aircraft leasing through Merx Aviation remains the largest investment and remains around 13% of the portfolio and was marked down during the recent quarter as discussed on the call:

“Moving to Merx and beginning with the overall market. We are optimistic that the demand for air travel will continue to improve with the ongoing rollout of the vaccine and the lifting of travel restrictions. Additionally, we expect the aircraft leasing market will continue to be an important and growing percentage of the world fleet, as airlines will need to increasingly look to third party balance sheet to finance their operating assets. As the aircraft sector continues to recover, we have seen a notable pickup in sale leaseback transactions and in the ABS market, an important source to financing for aircraft lessors. Specific to our investment, we believe Merx has successfully navigated this challenging period. The level of lease revenue generated from our fleet has stabilized. We have worked through our exposure to airlines that have undergone restructurings. We’ve been able to remarket aircraft during this period with long term leases or sales. Our current lease maturity schedule is well staggered. Additionally, Merx continues to benefit from a growing servicing business, which has increased in value over time. We believe Merx’s portfolio compares favorably to other lessors in terms of asset, geography, age, maturity, and lessee diversification. Merx’s portfolio skewed towards the most widely used air — types of aircraft, which means demand for Merx’s fleet is anticipated to be resilient. Merx’s fleet primarily consists of narrowbody aircraft serving, both U.S. and foreign markets. At the end of June, Merx’s own portfolio consisted of 78 aircraft, 10 aircraft types, 39 lessees in 25 countries with an average aircraft age of 11.5 years, and an average lease maturity of 4.3 years. Merx’s fleet includes 75 narrowbody aircraft, two widebody aircraft and one stryder. The Apollo aviation platform will continue to seek to opportunistically deploy capital. To be clear, Merx is focused on its existing portfolio and is not seeking to materially grow its own balance sheet portfolio. However, growth in the overall Apollo aviation platform will nurture the benefit of Merx as the exclusive servicer for aircraft owned by other polyflon.”


What Can I Expect Each Week With a Paid Subscription?

Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.

  • Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
  • Deep Dive Projection Reports – Detailed reports on at least two BDCs each week prioritized by focusing on ‘buying opportunities’ as well as potential issues such as changes in portfolio credit quality and/or dividend coverage (usually related). This should help subscribers put together a shopping list ready for the next general market pullback.
  • Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.

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

CGBD Quick Update: Buy For Higher Yield

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • CGBD target prices/buying points
  • CGBD risk profile, potential credit issues, and overall rankings
  • CGBD dividend coverage projections (base, best, worst-case scenarios)


CGBD Summary

  • I have increased the target prices for CGBD to take into account continued improvement in credit quality and earnings potential likely driving quarterly supplementals of $0.05/share.
  • CGBD accounts for almost 3% of my portfolio providing investors with 70% total returns over the last 12 months.
  • Some of the reasons that CGBD remains a ‘Tier 3’ are discussed in this report including portfolio investments with a risk rating between 3 and 5 (implies downgraded) remains around 25.4% of the portfolio and non-accruals are still around 5.3% of the portfolio cost (3.3% of FV). I would like to see the company consistently earn $0.37 or more per share per quarter to cover the $0.32 regular quarterly dividend plus the $0.05 of quarterly supplemental dividends.

CGBD Dividend Coverage Update

Previous reports predicted a reduction in the regular quarterly dividend (from $0.37 to $0.32) due to lower income from its Credit Fund I, declines in portfolio yield and interest income primarily due to the decrease in LIBOR and additional loans placed on non-accrual as well as the need to reduce leverage. Similar to other BDCs, CGBD converted to a “variable distribution policy” with the objective of “paying out a majority of the excess above the $0.32 and we would anticipate doing the same going forward”.

From previous call: “Similar to last quarter, as we look forward to the rest of 2021, we remain very confident in our ability to comfortably deliver the $0.32 regular dividend, but continue the sizable supplemental dividends. In line with the $0.04 to $0.05 we have been paying the last few quarters.”

On August 3, 2021, the company announced a regular quarterly common dividend of $0.32 plus a supplemental dividend of $0.06, which are payable on October 15, 2021 to common stockholders of record on August 30, 2021. It should be noted that this was slightly above my base projected supplemental of $0.05.

“We generated net investment income of $0.38 per common share, and declared a total dividend of $0.38. This includes a base dividend of $0.32 and a $0.06 supplemental dividend in line with our policy of regularly distributing substantially all of the excess income earned over our base dividend. We see earnings continuing in the context of $0.36 to $0.37, as we’ve reported over the last several quarters, which remains comfortably in excess of our $0.32 base dividend.”

 


For Q2 2021, CGBD reported between its base and best-case projections covering its regular and supplemental dividends by 106% mostly due to higher-than-expected amendment and underwriting fees during the quarter. Also, there was another increase in its portfolio yield from 7.63% to 7.73%. Dividend income from its Credit Funds remained stable that currently represent around 13.9% of the total portfolio.


As mentioned in previous reports, the amount of payment-in-kind (“PIK”) interest income has been increasing and needs to be watched as it now accounts for 7.1% of interest income as compared to only 1.5% in Q1 2020.


Upcoming Share Repurchases:

On November 2, 2020, the Board authorized an extension as well as the expansion of its $150 million stock repurchase program at prices below NAV per share through November 5, 2021. The company previously repurchased around $86 million worth of shares but “paused” in Q2 2020. CGBD has reduced its debt-to-equity ratio increasing liquidity and management “intends to pursue the appropriate balance of both share repurchases and attractive new investment opportunities”.

During Q2 2021, the company repurchased 0.6 million shares at an average cost of $13.62 per share for $8.2 million resulting in accretion to NAV per share of $0.02. As of June 30, 2021, there was $39.4 million remaining under the stock repurchase program.

“We repurchased $8 million of our common stock, resulting in $0.02 of accretion to net asset value. We care deeply about our shareholders total return and at our stock’s current valuation, we’ll continue to be consistent active repurchasers of our shares.”

Management discussed on the previous call including less share repurchases if the stock price continues higher and I have taken into account with the updated projections:

“We will obviously scale those who purchases based on how accretive they are overall, and that will fluctuate as our as our stock price fluctuates. So, it shouldn’t be a surprise that we purchased a bit less this quarter. Repurchasing our shares was a bit less accretive this quarter than it had been in prior quarters. But nevertheless, again we continue to see great value in our shares. So, you should continue to see repurchases at least in the near future. And we have just as a side note, we have plenty of room and plenty of time left on our repurchase authorization that the Board gives us each year.”


Middle Market Credit Funds:

Previously, the company announced a new joint venture (“JV”) with Cliffwater to “create Middle Market Credit Fund II (“Credit Fund II”), a move that’s intended to better capitalize on senior-loan opportunities that have emerged from recent market volatility”. CGBD sold senior secured debt investments with a principal balance of $250 million to Credit Fund II in exchange for 84.13% of Credit Fund II’s membership interests and gross cash proceeds of $170 million. The new venture gives TCG BDC enhanced balance sheet flexibility, including increased capital to deploy into an attractive origination environment and additional capacity to repurchase shares.

Previously, there was a decline in income recognized from its Credit Fund I from $7.0 million in Q4 2019 to $5.5 million in Q2 2020 due to lower yields, OID, and lower leverage. During Q2 2021 ORCC recognized almost $7.5 million in income (same as previous quarter) related to the funds compared to $6.5 million in Q4 2020. Management expects the amount of dividend income to remain around $7.5 million and is taken into account with the ‘base case’ projections.

“Moving on to the performance of our 2 JVs. Total dividend income was $7.5 million in line with last quarter. On a combined basis, our dividend yield from the JVs inched up from 10% closer to a 11%. Given we’re able to make return of capital at MMCF 1 following a recent favorable amendment under our primary credit facility. Total assets at the JVs increased from $1.2 billion to $1.3 billion reversing the recent trend of declines that have been driven by repayment headwinds. This was particularly evident in the MMCF 1 portfolio with fair value increasing by over 10% in the second quarter. Going forward, we continue to expect stable dividend generation from the 2 JVs similar to this quarter’s results.”

As of June 30, 2021, CGBD had cash and cash equivalents of around $59 million and almost $323 million available for additional borrowings under its revolving credit facilities. Management is targeting a debt-to-equity ratio between 1.00 and 1.40 including the recently issued preferred equity and is taken into account with the projections.

“We continue to be very well positioned with the right side of our balance sheet. Statutory leverage was again stable at about 1.2x, while net financial leverage, which as soon as the preferred is converted in a risk metric we used to manage the business was again right around one turn of leverage. So we’re sitting close to the lower end of our target range of 1.00x to 1.40x giving us flexibility to invest prudently in the current robust field environment.”

In May 2020, the company issued $50 million in Series A Convertible Preferred Stock, purchased by an affiliate of The Carlyle Group, Inc. with the proceeds used to pay down outstanding debt. The Series A Convertible Preferred Stock pays dividends, at the Company’s option, at a rate of either 7% (to the extent paid in cash) or 9% (to the extent paid in kind) and is convertible into common shares at an implied conversion price of $9.50, or 57% above the current 30-day VWAP. This transaction improved the overall capitalization/liquidity but with a dilutive impact to current shareholders. Management continues to mention that “there is no intention to convert” into common shares:

Recent call: “And regarding the preferred equity issuance for May 2020. I’ll reiterate again, this instrument was a strong sign of support by Carlyle during the darkest days of the global pandemic. And it continues to be a long-term investment by Carlyle in our BDC. So currently, there is no intention to convert.”

Previous call: “And regarding the preferred equity issuance for May of 2020, our stock is now trading well above the conversion price. But as we’ve noted previously, this instrument remains a long-term investment by Carlyle in our BDC. So there currently is no intention to convert.”

Also discussed on the recent call was potentially refinancing the preferred stock especially given the current market for unsecured debt with many of the larger BDCs borrowing between 2% to 3% compared to the 7% currently being paid. I fully agree but management perceives this as “permanent equity” capital and provides the company with increased financial flexibility”:

Q. “You guys have been able to issue liability, unsecured notes recently at 4.5%. I wouldn’t be surprised if you could do something less than that in today’s market. So why is paying 7% cash on a convertible preferred, an attractive source of financing when you’re able to tap unsecured notes at 4.5% and then depending on your answer that we can get into converting that, what does that look like? How does that look like from a manager converting at a sizable discount, the external manager converting and having and making a sizable profit from supporting the BDC, I don’t know if that’s a great look either, but I just don’t understand that comment why paying 7% is attractive source when you guys are issuing debt for significantly below that.”

A. “So just to kind of reiterate if you recall, when we put the convert in place, life was pretty dire, right our stock price was half of what it is today, we’re in the middle of the pandemic, we’re looking at really how to make sure our balance sheet was strong and defensible during a time that was – just an enormous amount of uncertainty. And Carlyle coming in and doing the preferred was a really great testament not only to their support of our business, but also to just really help us achieve the goals that we wanted to achieve at that point in time. So, I’d like really people to kind of just put all of this in context. For Carlyle, it’s a great show support, but let’s not forget it, it is $50 million for Carlyle, and it’s $50 million for our balance sheets. So it’s relatively small, and Carlyle, this is strategic right they’re not looking to convert this anytime soon, it’s here to support the business, and we really look at this as equity. So, compared to our dividend yield on our common stock, this is paying 7%, which is we think, actually a pretty attractive piece of equity for our balance sheet. And converting it is just not really in the cards. So I would just encourage people to think of this really as permanent equity, which you may view as expensive, but we actually view as pretty, pretty cheap. And know that this is not something that is going to dilute our current shareholders really in the foreseeable future that that we can tell. So and we’re pretty conscious of that, when back when we issued this, we didn’t want to dilute shareholders especially back in the Spring of 2020 and that’s still our view now, there’s no reason to dilute current shareholders, not when Carlyle is standing behind the business like it is. We have the financial flexibility, effectively equity, we manage the business as if it’s equity, we get credit under our leverage facilities as if it’s equity. So certainly from the financial flexibility perspective, we think it’s well priced equity. So managing the business would mean we have to have this in the capital structure, we would have better capital structure.”

CGBD has an average fee structure of 1.50% base management fee (compared to 1.00% to 2.00%) and an incentive fee of 17.5% (compared to the standard 20.0%) but is not best-of-breed as it does not include a ‘total return hurdle’ to take into account capital losses when calculating the income incentive fees. This was discussed on the recent call:

Q. “I agree that life was pretty dire when the parents stepped up in during COVID. But it was also rather bright and sunny in 2018 when the BDC lost a lot of money and was paying the parent a full incentive fee. So I guess the question is, against your opening remarks about caring deeply about the shareholders total return. Do you perhaps care more deeply about the advisor or should something give – like, should there be sort of pick one between the convert and not having a credit look back?”

A. “We do believe that Carlyle, Carlyle has a very fair and balanced management fee structure. We think that in the shareholders are getting a lot of value for that. Keep in mind that, we do manage the JVs and don’t take a fee for that. So sometimes, I think that gets a little bit lost when people look at our overall fee structure. So we’re kind of getting the management the JVs at a very nice discount on the management fee. So our management fee and not having a look back, I’m not really sure that that is what is going to be driving our stock price higher, it’s really, we’ve got to continue on this straightforward consistent performance get our non-accruals down, which is looking better and better. And really keep our shareholders satisfied by knowing that we can generate our dividends, perform well on credits. And ultimately, we think that will get our stock price up. I’m not sure our management fee is really the issue.”


CGBD Quick Risk Profile

Non-accrual investments remain around 3.3% of the portfolio fair value as there have been no investments added over the last four quarters. If these investments were completely written off it would have an impact of around $1.14 to its net asset value (“NAV”) per share or around 7.1%.

“We have seen no new non-accruals in the last year and we’re confident in the trajectory and progress we’re making in each of our four non-accrual names. We’re proud of the performance of the portfolio through COVID. And most importantly, we see the current trajectory of improving performance and solid credit continuing on its current upward path. Total non-accruals were flat at 3.3% based on fair value, and this was the fourth consecutive quarter with no new additional non-accruals. Similar to last quarter, we don’t see any additional loans at risk of non-accrual.”


It should be noted that Direct Travel and Product Quest currently have a risk ranking of 4 compared to Derm Growth Partners and SolAero with a lower risk ranking of 5 and have been discussed in previous reports.

Risk Rating 4 – Borrower is operating materially below expectations and the loan’s risk has increased materially since origination. In addition to the borrower being generally out of compliance with debt covenants, loan payments may be past due, but generally not by more than 120 days. It is anticipated that we may not recoup our initial cost basis and may realize a loss of our initial cost basis upon exit.

Risk Rating 5 – Borrower is operating substantially below expectations and the loan’s risk has increased substantially since origination. Most or all of the debt covenants are out of compliance and payments are substantially delinquent. It is anticipated that we will not recoup our initial cost basis and may realize a substantial loss of our initial cost basis upon exit.

CGBD previously had 6 categories of risk ratings and basically combined the previous rating 3 and 4 that accounted for 16.7% of the portfolio as of Q1 2020 into the new rating 3 which is now 21.4% and needs to be watched. However, the total amount of investments with risk rating between 3 and 5 (which implies that these investments have been downgraded) declined from 26.8% (as of Q1 2021) to 25.4% (as of Q2 2021) of the portfolio but is still considered high and is one of the reasons that CGBD remains a ‘Tier 3’ BDC as discussed earlier.

“The total fair value of transactions risk rated 3 to 5, indicating some level of downgrade since we made the investment improved again this quarter by $14 million in the aggregate. While over $15 million in transactions experienced some level of upgrade. While there remain some unfinished work, we’re very pleased with the continued positive momentum and the performance of the overall portfolio.”


SolAero was marked slightly lower again in Q2 2021 (now valued at 20% of cost) and was discussed on the previous call:

From previous call: “So on SolAero that’s a deal we actually restructured about a year and a half ago, that had just fundamental issues based on the industry solid industry. It’s highly typical, and you’re exactly right, that this is had some issues based on its ties to one web that’s one that we are in the equity see in that transaction and it’s one that we see a positive resolution going forward or at least we’re in negotiations and hoping to have positive resolution in terms of that company, turning the corner and working with their top customer one web as one way emergence from their bankruptcy. Direct Travel probably one of, if not the most severely COVID impacted name on our book and that was the other transaction I noted, we had two deals that restructured that deal also restructured in early October timeframe and the lenders again supporting that business and are the majority owners going forward it providing the capital for that, for that business. I will say is each all four of those situations what I’d highlight is we are the original debt and existing debt is in the first lien position in each case. In three cases the lenders are there now all in the equity or we anticipate will own the equity. So we think we’re in a good position based on our seniority and based on our equity position to drive strong outcomes in recoveries in those situations.”

As discussed in previous reports, U.S. Dermatology Partners defaulted on a $377 million financing provided by a group of investment firms. The Washington Post previously reported that the company may have received financing from the Paycheck Protection Program. The dermatology practice owner was reviewing its options, including a recapitalization or debt-for-equity swap with its current lenders, Golub Capital, The Carlyle Group Inc. and Ares Management. CGBD’s investment in Derm Growth Partners (Dermatology Associates) was added to non-accrual status during Q4 2019. This investment will likely be restructured over “the next couple of quarters”.

From previous call: “Dermatology Associates is one we have been engaged and we remain engaged and we anticipate a similar resolution on that transaction or that current capital structure within, let’s call it the next couple of quarters.”

Also mentioned in previous reports, Direct Travel completed a restructuring whereby the lenders received the majority of the equity in Direct Travel but maintained the principal balance in the existing debt. As part of the transaction, the lenders also provided a delayed draw term loan facility to support ongoing liquidity of the business, CGBD received an approximate 9% ownership stake in Direct Travel and the debt remains on non-accrual.

From previous call: “You’ll see in the cases of Direct Travel and Central Security that we closed successful restructurings and now hold both debt and equity instruments. In both cases, we think with lenders now holding majority of the equity, we’re better positioned to achieve superior recoveries.”

During Q2 2021, CGBD’s net asset value (“NAV”) increased by another $0.44 or 2.8% mostly due to net unrealized appreciation of $0.39 per share driven by “stronger overall credit performance, particularly in those names impacted by COVID” including Derm Growth Partners and Direct Travel as well as accretive share repurchases adding $0.02 per share.

“Net asset value per share increased 2.8% or $0.44 from $15.70 to $16.14 while improving market yields drove some of this increase, NAV was substantially bolstered by stronger overall credit performance, particularly in those names impacted by COVID. We’ve taken an appropriately conservative approach to valuation through this cycle and we expect continued underlying fundamental improvement to drive positive NAV migration in the coming quarters. Additionally, we repurchased $8 million of our common stock, resulting in $0.02 of accretion to net asset value.”

“On evaluations our total aggregate realized and unrealized net gain was $21 million for the quarter. The fifth consecutive quarter of positive performance following the drop in March 2020. Using the same buckets I’ve outlined in prior quarters, we again saw improvement across the board. First, performing lower COVID-impacted names plus our equity investments in the JVs, which accounts for combined 70% of the portfolio increased in value about $8 million compared to 3/31. Second, the assets that have been underperforming pre-pandemic, so which have COVID exposure were up $4 million, marking the fifth consecutive quarter of stability or improvement. This included in exit at par of our investment in Plano Molding. The final category is the moderate to heavier COVID-impacted gains. We continue to see improvement in fundamentals and recovery prospects for these investments. Collectively they experienced a net $9 million increase in value.”


Full BDC Reports

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

FSK Quick Update: Dividend Falling Back To Previous Levels

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • FSK target prices/buying points
  • FSK risk profile, potential credit issues, and overall rankings
  • FSK dividend coverage projections (base, best, worst-case scenarios)


FSK Summary

  • I have updated the projections for FSK to take into account the recently issued unsecured notes, changes to portfolio credit quality, and guidance from management on the recent call.
  • FSK will announce its Q4 dividend during the second week of November and investors should expect $0.60 which could have an impact on the stock price.
  • This is supported by the Leverage Analysis projecting earnings of $0.561/share using a $15 billion portfolio with a stable yield and not including temporary fee waivers contributing $0.05/share.
  • FSK has experienced over $1 billion in realized losses which does not include in the realized losses from FSKR. This is more than almost every other BDC, especially when measured on a per-share basis as shown below.
  • The total amount of investments considered non-accrual, related, or on the ‘watch lists’ accounts for almost $1.3 billion or 8.5% of the portfolio’s fair value. See details below.

This report discusses FS KKR Capital (FSK) which is considered a higher risk BDC for the reasons discussed in this report including historical NAV declines and realized losses driven by higher cyclical exposure that accounts for around 25% of the total portfolio. The company has many of the same sector exposures in its SCJV which is almost 10% of the portfolio. Also, management has removed the ‘total return’ hurdle or ‘look back’ provision that was previously protecting shareholders from additional capital losses.

As discussed later, the total amount of investments considered non-accrual or related as well as on the ‘watch list’ account for almost $1.3 billion or 8.5% of the portfolio fair value. This is close to the amount of investments that the company has identified with its ‘Investment Rating’ 3 and 4 which are considered “underperforming investments” with “some loss of interest or dividend possible” and/or “concerns about the recoverability of principal or interest”. These investments have a total cost basis of almost $1.9 billion or 13% of the total portfolio and could result in additional realized losses over the coming quarters. Also, if additional watch list investments are added to non-accruals status this would likely drive additional declines in NAV per share, earnings, and dividend coverage.

FSK announces dividends when it reports financial results which are typically around the second week of November and there will likely be investors disappointed with the lower dividend payment and could impact its stock price. Please see the full discussion below.

 


Comparison of Realized Gains/Losses & Changes in NAV

Gains or losses are said to be “realized” when an investment is actually sold or exited as compared to “unrealized” gains and losses due to an increase or decrease in the value of an investment that has not yet been sold. When a BDC incurs realized losses there is generally no way to reverse these losses but can potentially be offset by positive performance from other investments and/or over-earning the dividend.

Since 2014, FSK has experienced over $1 billion in realized losses which does not include in the realized losses from FSKR. This is more than almost every other BDC even when measured on a per-share basis as shown below. These losses were due to lower portfolio credit quality and the primary driver of NAV per share declines and two dividend cuts. It should be noted that FSK still has a meaningful portion of its portfolio in cyclical sectors and/or companies that are more likely to be impacted by supply chain issues as well as rising input costs especially labor. Many of these investments have been discussed in previous reports and some are discussed later



Operating Cost as a Percentage of Available Income

The last line in the projected financials (included in the Deep Dive Projection reports for each BDC) shows “Operating Cost as a Percentage of Available Income” which measures operating, management, and incentive fees compared to available income. BDCs with lower operating expenses can pay higher amounts to shareholders without investing in riskier assets.

  • “Available Income” is total income less interest expense from borrowings and is the amount of income that is available to pay operating expenses and shareholder distributions.

Many BDCs have been temporarily waiving fees or have fee agreements that take into account previous capital losses. The following table shows the average adjusted operating cost ratios for each BDC over the last four quarters without the benefit of temporary fee waivers (including SUNS) with examples for GBDC and PSEC.


BDC Leverage Versus Portfolio Mix

The following table shows each BDC ranked by its debt-to-equity ratio net of cash along with its portfolio mix. The “Other” column includes everything that is NOT first or second-lien secured debt. I do not cover most of the higher-risk BDCs for many reasons but mostly because these are not typically buy-and-hold investments. BDCs with higher quality portfolios can support higher leverage. Many of the BDCs with lower leverage also have lower dividend coverage over the last four quarters including SUNS, GAIN, GBDC, MAIN, and ORCC. I am expecting improved dividend coverage for many BDCs as leverage increases as well as higher amounts of first-lien positions (to support higher leverage).

PTMN, FSK, FCRD, PSEC, and OXSQ have higher risk portfolios that require lower leverage and are separated from the others. These companies typically have higher amounts of cyclical exposure and/or non-secured debt, joint ventures, senior loan programs, CLOs, or equity positions that all carry much higher external leverage. Typically these assets do not qualify for lower cost BDC credit lines and revolvers which is why many of these BDCs have higher cost unsecured notes as well as using less leverage to maintain credit ratings.

 


FSK Dividend Coverage Update

On August 9, 2021, FSK declared a quarterly dividend of $0.65 for Q3 2021 which is an increase from the previous $0.60 due to higher-than-expected earnings for Q2 2021. As mentioned in the previous report, management has adopted a ‘variable dividend policy’ based on ANV per share and expected earnings:

“Consistent with our variable dividend policy of seeking to provide shareholders with an annualized 9% dividend yield on our NAV over time, we are committed to paying out additional levels of NII during quarters where our portfolio generates additional income. As a result, during the third quarter our dividend will be $0.65.”

However, as discussed in this report and by management on the recent call, investors should expect $0.60 of quarterly dividends for the following quarters;

“From a forward-looking dividend perspective, our third quarter dividend will be $0.65 per share, with the increase in this quarter’s dividend being tied directly to the additional net investment income we generated during the second quarter. All else being equal, given that we expect our third quarter adjusted NII to approximate $0.61 per share, we believe it is reasonable for investors to expect that should we achieve our adjusted NII guidance for the third quarter, that our fourth quarter dividend would be $0.60 per share; however, I should note that dividends are subject to the discretion of our board and applicable legal requirements, and this forward guidance, while intended to be helpful to investors, should not be interpreted as a formal dividend announcement.”

“Looking forward to the third quarter, while we expect our one-time fee and dividend income to return to a normalized level, we expect our adjusted NII to be $0.61 per share. Our recurring interest income on a GAAP basis is expected to approximate $275 million. We expect recurring dividend income associated with our joint venture to approximate $44 million. We expect other fee and dividend income to approximate $33 million during the third quarter.”

This is supported by the Leverage Analysis shown earlier projecting quarterly earnings of $0.561 per share using a portfolio of around $15 billion with a stable yield and not including the $15 million of temporary fee waivers which are around $0.05 per share.

FSK announces dividends when it reports financial results which is typically around the second week of November and there will likely be investors disappointed with the lower dividend payment and could impact its stock price.

Historically, FSK has covered its dividend only due to no incentive fees paid driven by the ‘total return’ hurdle from previous realized/unrealized losses. However, the ‘total return’ hurdle or ‘look back’ provision was removed as a part of the merger agreement.

FS/KKR has agreed to waive $90 million of incentive fees spread evenly over the first six quarters following the closing. This waiver equates to $15 million per quarter. It is important to note that the company would have paid almost $90 million in incentive fees over the previous five quarters without the look-back provision which is almost $18 million per quarter. However, that is based on 20.0% income incentive fees compared to 17.5% but also only for FSK. The merger will double the size of the company with similar holdings and credit issues implying that the $15 million per quarter could be insufficient if there are continued/additional credit issues. FSKR’s NAV per share has declined by almost 30% over the last three years.


On October 4, 2021, FSK priced an offering of $750 million of 3.125% (YTM of 3.176%) unsecured notes due 2028 and $500 million of 1.650% (YTM of 1.703%) unsecured notes due 2024 that will likely be partially used to repay some of its higher rate borrowings and are taken into account with the updated projections. Management has guided for increased leverage driving portfolio growth over the coming quarters and is also taken into account:

“We’re at the end of this quarter roughly 0.9 times net. Our stated goals or targets there remain the same, really a range of 1.0 times to 1.25 times with probably a sweet spot around 1.1 times. We’ve got some room to grow there. We think that was one clear benefit of the merger. I think that can translate into additional deployment growth, additional income growth. I think we feel good about that, and then going back to the prior question, I think we feel quite good about the liability side of our balance sheet, how that all sort of stacks up. We do feel good about the macroeconomic environment, but I think we also want to be ready to play if there’s volatile times, and where we stand at our current leverage definitely allows us to do that. But you should expect us trending up to the one time-plus target over the coming quarters.”




There are many factors to take into account when assessing dividend coverage for BDCs including portfolio credit quality, realized losses, fee structures including ‘total return hurdles’ taking into account capital losses, changes to portfolio yields, borrowing rates, the amount of non-recurring and non-cash income including payment-in-kind (“PIK”). Most BDCs have around 2% to 8% PIK income and I start to pay close attention once it is over ~5% of interest income. Higher amounts of PIK is typically a sign that portfolio companies are not able to pay interest expense in cash and could imply potential credit issues over the coming quarters.

The amount of PIK interest income declined but still accounts for almost 14.0% of total interest income compared to 15.6% during Q1 2021. There is a chance that FSK could be downgraded to ‘Level 3’ or ‘Level 4’ dividend coverage over the coming quarters if there is another round of credit issues driving additional realized losses and higher PIK similar to previous quarters and responsible for dividend reductions.


There is a good chance that management will be repurchasing shares during Q3 and Q4 2021:

“We also expect our previously announced $100 million board-approved stock buyback and program to begin during the third quarter. I think we’ve historically done these under a 10b5-1 plan. I think the expectation is we will continue to do that. I think going almost essentially exactly to your last point, we’ve probably thought about that more in the environment than if the stock was trading materially down, you want to try to be buying more if it was trading closer to book. We think that is starting to get into the numbers about it potentially being less attractive. We thought it was important as part of this merger to put another plan together, but I Think you should have the expectation it will be done under a 10b5-1.”

Management continues to reduce the amount of non-income producing equity investments from 9.3% to 6.8% partially related to the recent merger with FSKR.

For Q2 2021, FS KKR Capital (FSK) easily beat its best-case projections due to much higher-than-expected dividend income from Sound United, as well as a higher amount of fee and other income some of which is non-recurring:

“During the quarter, we materially out-earned our quarterly dividend due to strong originations as well as positive portfolio company performance, which included a significant one-time portfolio company dividend payment. The largest components of our fee and dividend income included $22 million of dividend income from our joint venture during the quarter. Other dividends from various portfolio companies totaled approximately $32 million during the quarter, of which $20 million was from our investment in Sound United. Finally, fee income totaled $23 million during the quarter, representing an increase of $12 million quarter-over-quarter with the change directly tied to our origination and repayment activity during the quarter.”

Also, it should be noted that the merger with FS KKR Capital II (FSKR) was near the end of the quarter which means that there is not a full quarter of income and expenses but also the amount of outstanding shares is now over 285 million compared to the weighted average of only 150 million used for calculating NII of $0.74 during Q2 2021.


FSK Quick Risk Profile Update

My primary concern is the higher amount of cyclical exposure including retail, capital goods, real estate, energy, and commodities that account for around 25% of the total portfolio. It also has many of the same exposures in its SCJV which is almost 10% of the portfolio. There is a good chance that many of FSK’s equity positions in these sectors have been benefiting from the recent recovery that could reverse at some point.

Also, many of the companies in FSK’s portfolio are more likely to be impacted by supply chain issues as well as “inflationary pressures” and rising input costs especially labor. On the August 2021 earnings call management views these issues as “transitory” and “supply chain disruptions to be resolved over the ensuing quarters”:

“The Fed’s comments in July regarding their belief of the transitory nature of many of the inflationary pressures currently affecting certain industries dovetails with our own views, as we expect many issues caused by COVID-related supply chain disruptions to be resolved over the ensuing quarters.”

During Q2 2021, FSK placed its first-lien loan from ATX Networks on non-accrual status but will likely be back on accrual during Q3 2021 and is taken into account with the updated projections. It should be noted that this investment was marked 8% over cost as of June 30, 2021, as shown in the following table.

“During the second quarter, we placed one investment on non-accrual, ATX Networks. ATX design radio frequency, optical and other video networking equipment used primarily by cable operators. The company’s earnings have been negatively impacted by lower cable company capex spend. We owned $80 million of the $227 million first lien term loan marked at 64% of cost as of June 30, down from 69% of cost as of March 31. The company, a group of first lien lenders holding more than two-thirds of the first lien term loan, and other parties in the capital structure have made significant progress on a resolution of ATX’s breach of its Q1 financial covenant, and we expect the transaction resolving such breach to close in the third quarter. The anticipated impact of this potential transaction has been factored into the Q2 mark.”

Total non-accruals currently account for around 4.7% of the portfolio at cost and 3.1% of the portfolio fair value but do not take into account the additional investments FSK has with these companies that account for another 1.9% of the portfolio at cost and 1.1% of the fair value. Also, there are quite a few investments that remain on its ‘watch list’ including Sequential Brands Group which filed for bankruptcy on August 31, 2021.

“The Company determined that, as a result of the significant debt on its corporate balance sheet, it was no longer able to operate its portfolio of brands. Accordingly, in conjunction with the filing, the Company will pursue the sale of all or substantially all of its assets under Section 363 of the U.S. Bankruptcy Code. In connection with this in-court process, Sequential will be obtaining $150 million in debtor-in-possession (“DIP”) financing from its existing Term B Lenders. The Company expects this new financing, together with cash generated from ongoing operations, to provide ample liquidity to support its operations during the sale process.”

As shown in the following tables, the total amount of investments considered non-accrual or related as well as on the ‘watch list’ account for almost $1.3 billion or 8.5% of the portfolio fair value. This is close to the amount of investments that the company has identified with its ‘Investment Rating’ 3 and 4 which are considered “underperforming investments” with “some loss of interest or dividend possible” and/or “concerns about the recoverability of principal or interest”. It should be noted that these investments have a total cost basis of almost $1.9 billion or 13% of the total portfolio and could result in additional realized losses over the coming quarters. Also, if additional watch list investments are added to non-accruals status this would likely drive additional declines in NAV per share, earnings, and dividend coverage.




The following “Timeframe of Recovery of Credit Metrics to 2019 Levels” from S & P Global Ratings on February 17, 2021, shows their view of the recovery prospects for each sector. BDCs such as FSK and AINV have much higher concentrations of sectors that will likely take longer to recover which is taken into account with their risk ranks and pricing.

 


Full BDC Reports

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

GAIN Quick Update: Another Dividend Increase

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • GAIN target prices/buying points
  • GAIN risk profile, potential credit issues, and overall rankings
  • GAIN dividend coverage projections (base, best, worst-case scenarios)


GAIN Summary

  • GAIN currently has among the lowest leverage in the sector (net debt-to-equity 0.58) but management is growing the portfolio including the recent infrastructure-related acquisition of Utah Pacific Bridge & Steel.
  • GAIN has the best NAV growth record of 28.7% (last 5 years) and there is a very good chance of another dividend increase for the reasons discussed in this report.
  • GAIN is not expected to cover its Q3 monthly dividends with NII due to being underleveraged but management is actively growing the portfolio with plenty of realized gains for additional coverage.

BDC Leverage Versus Portfolio Mix

The following table shows each BDC ranked by its debt-to-equity ratio net of cash along with its portfolio mix. The “Other” column includes everything that is NOT first or second-lien secured debt. GAIN, CSWC, MAIN, and FDUS prefer to have a higher portion of their portfolio invested in equity positions providing them with realized gains and dividend income to support supplemental dividends.

BDCs with higher quality portfolios can support higher leverage and companies with lower leverage typically have lower dividend coverage (last four quarters) including GAIN, SUNS, GBDC, MAIN, and ORCC. I am expecting improved dividend coverage for many BDCs as leverage increases as well as higher amounts of first-lien positions (to support higher leverage).

  • GAIN’s management has guided for portfolio growth given its extremely low leverage with a current debt-to-equity of 0.64 (0.58 net of cash) which is currently among the lowest in the BDC sector.

 


GAIN Realized Gains & Dividend Coverage Update

GAIN is considered a ‘Level 1’ dividend coverage BDC implying that there is a very good chance that the company will increase its dividends paid to shareholders due to plenty of capacity to grow the portfolio, lower non-accruals and NAV increases, additional dividend income from equity investments, maintaining a higher portfolio yield, and continued realized gains all of which are discussed in this update. Previously, GAIN had around $11.3 million or $0.34 per share of undistributed income “available for distribution at any one point”:

From previous call: “That is available for distribution at any one point. And we ended last year with a good amount of – the last fiscal year with a good amount of spillover as well. So that obviously started the year off with some cushion. As you know, this amount is already reduced by the book accrual of the GAAP capital gains-based incentive fee, and is not contractually due. We really manage our earnings on an annual basis. So we try to match the annual income to the annual dividend and that’s how we operate.”

As predicted earlier this month in “GAIN Deep Dive Projections: Upcoming Dividend Announcement”, GAIN announced a supplemental dividend of $0.09 per share for Q4 2021 which was higher than my conservative estimate of $0.03 per share. More importantly, the company increased its monthly dividend by 7% (from $0.070 to $0.75).

“GAIN announced that its Board declared the following monthly cash distributions to common stockholders, increasing monthly distributions from $0.07 to $0.075 per share, or approximately 7%. The Company also announced its plan to report earnings for its second fiscal quarter ended September 30, 2021. The Company will also pay a supplemental distribution of $0.09 per share to holders of its common stock in December 2021. The board of directors will continue to evaluate the amount and timing of any additional, semi-annual or incremental, supplemental distributions in future periods.

There is a good chance that GAIN will report closer to its ‘best case’ projections including increased portfolio growth and leverage (driving the increased regular dividend) as well as rotation out of equity positions with realized gains driving the larger supplemental dividend. As mentioned in the report, I was waiting for the company to report results before upgrading to ‘Level 1’ and ‘Tier 1’ but given the recent announcement (and my faith in management to do the right thing) I have already upgraded GAIN in the BDC Google Sheets.


Over the last three years, GAIN has increased its dividend three times and while paying supplemental dividends and growing its NAV per share by 9.4%. Also, GAIN has relatively low amounts of leverage with the potential for improved coverage through portfolio growth and rotating out of equity investments.

“The good news is that we are seeing more activity, meaning more companies that are looking to be sold that we have an opportunity to look at. It’s really more a question of how rapidly we can add to our assets and continue to increase the income and thereby obviously slightly increase our monthly dividend payoutSo that’s really our target, our goal. But it’s what we do every day.”


Most dividend coverage measures for BDCs use net investment income (“NII”) which is basically a measure of earnings. However, some BDCs achieve incremental returns with equity investments that are sold for realized gains often used to pay supplemental/special dividends. These BDCs include GAIN, FDUS, CSWC, TSLX, PNNT, TPVG, HTGC, and MAIN.

“Consistent with our policy, our Board will continue to evaluate any supplemental distributions which we can make and may make from capital gains. When we started the semiannual dividends distributions, which are a function of realized capital gains as we’ve stressed, we’ve been able to maintain it pretty effectively. We made the one in June as we move forward during the year in part as a function of liquidity ourselves being that we’re doing new deals also.”


In June 2021, GAIN sold its investment in Head Country, Inc. and received cash proceeds of $16.7 million, including the repayment of its debt investment of $9.1 million at par which resulted in a success fee income of $2.0 million and a realized gain of $3.6 million or $0.11 per share that can be used to support additional supplemental dividends.

“With the sale of Head Country and from inception in 2005, Gladstone Investment has exited over 20 of its management supported buy-outs, generating significant net realized gains on these investments. Investments like Head Country prove out our focus on buying high quality businesses, backing outstanding management teams and our ability to be patient through longer hold periods.”


As shown in the following table, GAIN has significant unrealized gains in many of its preferred stock positions that will likely continue to drive additional realized gains over the coming quarters to support larger supplemental dividends in 2022. If GAIN exited these investments at their current fair value it would result in almost $95 million or $2.85 of realized gains. However, there are other investments valued below cost (please see the Risk Profile section) and management is taking a careful approach to exiting these investments:

“When and if they believe the time is right to exit for a variety of reasons, we will take that seriously. As we have pointed out we have had exits, as we go forward we will certainly be faced with opportunities for exits. And we’ll do that on a very careful basis, because, frankly, again, we exit a really good company and then we just have to figure out how we’re going to get a new opportunity to so to speak to replace it, right. Because, as you know, we keep focus very much on the income that we generate, because we want to keep growing our dividend our distributions to shareholders. So the debt pieces are really important. So again, yes, we will certainly entertain opportunities to exit if it really makes sense. And we might see some of that over the next six to nine months. But we’re not just going to rush out there and just do it just for the sake of doing it very frankly. We want to keep balance, and I think we’ve done a good job of that.”


During calendar Q4 2020, GAIN had $9.1 million or $0.27 per share of net realized gains which easily covers the upcoming monthly dividends of $0.07 per share.


The company will likely not fully cover its monthly dividends with net investment income for the quarter ended September 30, 2021, due to being underleveraged. Also, GAIN has lumpy dividend coverage partially due to its volatile dividend and other income and the company typically manages its dividend policy on an annual basis:

“Now just keep in mind that this other income we refer to can vary and probably will vary quarter-to-quarter. But we look at it and we try to manage this on an annualized basis. And we hopefully should be able to see some opportunity to continue generating this other income category during our calendar year 2021.”

The amount of preferred/common equity increased from 25.6% to 30.2% of the portfolio fair value due to additional markups and needs to be partiallymonetized and eventually reinvested into income-producing secured debt.


I am expecting additional portfolio growth through increased leverage over the coming quarters including an additional first-lien debt investment in Nocturne Villa Rentals in July 2021 and a $24.3 million investment in Utah Pacific Bridge & Steel through a combination of secured first-lien debt and preferred equity. Utah Pacific is a manufacturer of large steel components used in bridge replacement, rehabilitation, and construction.

“Subsequent to 6/30/21, we financed the add-on of another operating company to our recent bio platform investment, which is called Nocturne Villas, and we close on a new buyout investment, which is called Utah Pacific Bridge & Steel. This company actually provides large steel components in bridge replacement, rehabilitation and construction, so somewhat playing into the whole infrastructure developments that will occur in this country. Those are really good companies and evaluations that work for our model. So we’ll make a couple new acquisitions yet over the next year or so. But we’re not going to rush out and just go crazy because multiples are just really pretty, pretty bizarre to be perfectly honest with you on companies that we see.”

Q. “On Utah Pacific that really seems to fit your business model quite well, and now in an industry that is getting a lot of attention. Can you give us a sense of what sort of terms you paid on that in terms of leverage, and maybe the interest rate?”

A. “When we buy a business, roughly 30% of the dollars that we put out are going to be in the equity component, and the balance is going to be in the debt component. Generally, again, as we publish our yield on the debt component of our portfolio is generally in the solid 12% range. We generally try to stay in and companies we’re looking at, we need to stick within kind of the six to maybe seven, seven and a half times EBITDA, and so as long as we’re kind of in that range, it works well for our model. This particular companies has a very strong ownership, owned by an individual really built the business and that fortunately, we’ve been able to have them stay involved with us. So we got really strong management, good team going forward. And it’s kind of deal that other people might have overlooked very frankly, and that’s where we worked a little bit harder to find those kind of transactions. Yeah, we’re very excited about this one, given their position that they have in their market area.”

As leverage increases the company will likely earn around $0.22 per share each quarter covering 106% of the current dividend which is basically ‘math’ driven by an annual hurdle rate of 7% on equity before paying management incentive fees. It is important to note that the company could earn less than $0.22 per share but management will not be paid incentive fees as shown in the previous projections.

“The income-based incentive fee rewards the Adviser if our quarterly net investment income (before giving effect to any incentive fee) exceeds 1.75% [quarterly] of our net assets, adjusted appropriately for any share issuances or repurchases during the period (the “Hurdle Rate”). No incentive fee in any calendar quarter in which our pre-incentive fee net investment income does not exceed the Hurdle Rate (7.0% annualized)”

During calendar Q2 2021, the company did not sell any additional common shares under its ATM program. Similar to all BDCs, GAIN continues to reduce its overall borrowing rates and is taken into account with the updated projections:

  • On August 11, 2021, GAIN priced its $117.0 million of 4.875% Notes due November 1, 2028, (GAINZ) and used the proceeds to fully redeem its 6.375% Series E Cumulative Term Preferred Stock due 2025 (GAINL).
  • On February 24, 2021, GAIN priced its $112.5 million of 5.00% Notes due May 1, 2026, (GAINN) and used the proceeds to fully redeem its 6.25% Series D Cumulative Term Preferred Stock due 2023 (GAINM).

For calendar Q2 2021, GAIN hit its best-case projections due to much higher-than-expected portfolio yield and growth driving interest income to its highest level at $16.0 million compared to $12.7 million the previous quarter. However, a large portion of the increase was from the payments of past-due interest from portfolio companies previously on non-accrual status which has been taken into account with the updated projections.

“Investment income increased quarter-over-quarter, as interest income was lifted by the collection of past due interest from those loans that were previously on nonaccrual, and other income benefits from the close up transactions and related other income in the current quarter.”

Q. “On reported yields in the quarter, they were really strong up nearly 200 basis points quarter-on-quarter. Was there any one-time items in that? And can you give us a sense for your outlook going forward there?”

A. “That was related to my earlier comment on the loans returning to nonaccrual. So as you often see in periods where loans come back on accrual, they’ve made some catch-up payments, and that’s what particularly lifted yield this quarter.”

Q. “Could you give us a sense of how much interest you recognized back past due interest you recognized on B&T and Horizon? And did you reverse anything for SPS?”

A. “We did not reverse anything for SPS, so that was solely within this quarter. And then the amount that was collected in past dues this period was roughly $2 million.”

Also, there was a $2.0 million decrease in dividend and success fee income, the timing of which can be variable. ‘Core NII’ takes into account incentive fees related to capital gains.

“We ended the first quarter fiscal year ‘22 with adjusted NII of $0.24 per share, which is continuing improving trend started over the last two quarters of fiscal year ‘21, where we reported adjusted NII per share at $0.20 and $0.24, respectively. So we’re very pleased again with this positive trend, hopefully continuing forward.”



GAIN Risk Profile Quick Update

As predicted/discussed in the previous report, there was a meaningful improvement in the portfolio credit quality including reduced non-accruals as Horizon Facilities Services and B+T Group Acquisition, Inc. were added back to accrual. However, SBS Industries Holdings was added to non-accrual status during the quarter but remains valued at 100% similar to Horizon Facilities Services from previous quarters with a full recovery. Management is expecting SBS to be added back to accrual status “pretty quickly” and was discussed on the recent call:

“While, we added one loan to nonaccrual this quarter, which we believe will be at a relatively short-term change. Over the last two quarters, we returned four portfolio companies to accrual status. So with all that said, as of 6/30, only two of our portfolio companies were nonaccrual status.”

“The one that did go on nonaccrual it’s in a position to pay. But again, because of just some constraints regarding senior bank, we just had to put it on nonaccrual, but it will probably come back on accrual pretty quickly. So generally, I feel pretty good about where we are with all of those, again, somewhat temporarily. But now we feel really good about going forward.”

Also, The Mountain Corporation remains on non-accrual status. The fair value of non-accruals decreased to $17.6 million accounting for 2.6% of the portfolio at fair value (previously 7.7%).

From previous call: “We are seeing two of our portfolio companies that were on non-accrual come back on accrual status this quarter and hope to continue that trend during the next fiscal year with at least two other companies. We believe we can expect further improvement going into this new fiscal year for us. One, generally, things that we have been, as you know, work on with our portfolio companies, whether that’s a change in management or improved management or that sort of thing, I’d say, it’s a combination, frankly. Generally, their business were improving, but they also were doing a good job managing the companies. And as we said in there, hopefully, there are a couple more. And if that all happens here by the end of this calendar year, we pretty much could be out of all our non-accruals with maybe exception of one company.”


GAIN’s NAV per share increased by another 10% (from $11.52 to $12.66) mostly due to markups during the quarter including many of its equity positions.

“Assets increased to $713 million from $644 million. This is in large part due to the continuing recovery of the values of our equity holdings, which do make up about 25% of our total portfolio at cost.”

 

 


Full BDC Reports

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

PFLT Quick Update: Improving Dividend Coverage

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • PFLT target prices/buying points
  • PFLT risk profile, potential credit issues, and overall rankings
  • PFLT dividend coverage projections (base, best, worst-case scenarios)


PFLT Summary

  • I have updated the projections for PFLT to take into account the $85 million of unsecured 2026 notes with a YTM of 3.875% which is an improvement from the previous issuance.
  • I am expecting continued improvement in dividend coverage due to portfolio growth using higher leverage, increased PSSL returns, and rotation out of equity positions into income-producing assets.
  • PFLT will likely not fully cover its dividend for the coming quarter but had around $0.22 per share of undistributed/spillover income that can be used for temporary dividend coverage issues.

PFLT Dividend Coverage Update

Leverage continues to decline and is now well below its targeted debt-to-equity ratio range of 1.40 to 1.50, currently at 1.07 net of cash giving the company plenty of capital for upcoming portfolio growth and improved earnings.

“We have ample liquidity and are prudently levered. Our GAAP debt to equity ratio was 1.1 times, while GAAP net debt to equity after subtracting cash was 1 times. The regulatory debt to equity ratio was 1.2 times and our regulatory net debt to equity ratio after subtracting cash was 1.1 times. With regard to leverage, we have been targeting a debt-to-equity range of up to 1.5 times.”

I am expecting continued improvement in dividend coverage mostly due to portfolio growth using higher leverage, increased returns from its PennantPark Senior Secured Loan Fund (“PSSL”), and rotation out of non-income producing equity positions:

“We are poised to significantly grow NII through a three pronged strategy, which includes number one, growing assets on balance sheet at PFLT, as we move towards our target leverage ratio of 1.50 times debt to equity from 1.10 times. Number two, growing our PSSL JV with Kemper to about $730 million of assets from approximately $500 million. And number three, rotating the equity value in the portfolio that has come from a strong equity co-investment program into cash paying debt instruments.”

On October 6, 2021, PFLT priced an additional $85 million of 4.25% unsecured notes due 2026 at a premium resulting in a yield-to-maturity of 3.875%. This is a lower rate than the $100 million notes issued in March 2021 at a discount resulting in a yield-to-maturity of 4.375% and has been taken into account with the updated projections. These notes further strengthen the overall balance sheet giving the company additional flexibility for long-term portfolio growth. Effective January 19, 2021, PFLT reduced the size of its credit facility from $520 million to $400 million in order to reduce the cost of the unused facility fees.

PFLT will likely not fully cover its dividend for the coming quarter but had around $0.22 per share of undistributed/spillover income that can be used for temporary dividend coverage issues. On October 4, 2021, PFLT reaffirmed its monthly distribution for October 2021:

The company is looking to improve returns from its PennantPark Senior Secured Loan Fund (“PSSL”) through previously refinancing the borrowing facilities and growing the portfolio using higher leverage. Total investments in its PSSL portfolio have increased from $393 million to almost $530 million over the last three quarters and the weighted average yield on investments increased from 6.8% to 7.2%. These increases are driving higher dividend income that increased to $2.3 million for the most recent quarter.

“With regard to the PSSL JV, with the CLO financing we completed earlier this year, as well as additional capital contributions from PFLT and Kemper, the JV will grow over time. The capital contributions from PFLT are targeted to generate a 10% to 12% return. During the June quarter, PFLT invested $20 million of capital and we intend to invest another 42 million over time in order to bring PFLT’s investment into PSSL to approximately $243 million.”


Similar to other BDCs, PFLT is expecting lower amounts of repayments over the coming quarters driving higher portfolio growth using leverage:

“We are well on our way to implementing the NII growth strategy. Since June 30th PFLT has had new originations of $102 million and PSSL has had new origination of $29 million. Although in the June quarter repayments exceeded new loans and in the September quarter so far, repayment activity has abated and new originations have accelerated. Our portfolio performance remains strong.”

“Quarter-to-date, repayments have been light and newer originations have been heavy. So last quarter, there were a lot of repayments. This quarter so far we’ve seen lighter repayment. We’re seeing a lot of new companies come in. Sometimes there’s the same more companies that get recycled and they go from one private equity firm to another, one private lender to another. This quarter, we’re seeing many more new companies come into the system.”

Also, PFLT will likely be rotating out of non-income-producing assets and reinvesting into higher-yielding assets over the coming quarters.

From previous call: “The combination of potential income growth from equity rotation, a larger and more efficiently financed PSSL, and a growing more optimized PFLT balance sheet should help grow the company’s net investment income relative to the dividend over time.”

There is a good chance that PFLT will be selling its equity positions in Cano Health, Inc. (CANO), Walker Edison Furniture, By Light Professional IT Services, and PT Networks. These investments account for $28.3 million or 2.7% of the portfolio and the proceeds will likely be reinvested into income-producing assets. As shown in the following table, these investments are marked well above cost and could result in $25.7 million or $0.66 per share of realized gains if sold at the current fair values potentially driving supplemental dividends in 2022. However, the company has offsetting realized losses from previous years and will likely be used to support temporary dividend coverage shortages.

Management discussed some of these investments on the recent call mentioning additional NAV upside as well as increased earning potential through reinvestment:

“By Light is one that we talked about a lot, that’s about a $1 million market value there. We’ve got a company called Infosoft about $5.7 million of equity, GCOM of over 4 million of equity. PFLT is $7.6 million of equity. There’s still another $6.9 million of equity value in Walker Edison. So still some nice equity bites to be potentially exited and rotated over the coming year or two.”

From previous call: “We are pleased that we have significant equity investments in three of these companies, which can substantially move the needle in both NAV and over time net investment income. Cano, Walker Edison and By Light. All three of these companies are gaining financial momentum in this environment. And our NAV should be solidified and bolstered from these substantial equity investments as their momentum continues. Over time, we would expect to exit these positions and rotate those proceeds into debt instruments to increase income at PFLT. Walker Edison is leading e-commerce platform focused on selling furniture exclusively online through top e-commerce companies. As of March 31st, our equity position had a cost of $1.4 million and a fair market value of $12.1 million. Shortly after quarter end, the company executed a refinancing and dividend recap, which resulted in shareholders receiving approximately two times their costs, while maintaining the same ownership percentage in the company. This resulted in PFLT receiving a $2.8 million cash payment on its equity position. By Light is a leading software, hardware and engineering solutions company focused on national security challenges across modeling and simulation, cyber and global defense networks. Our position has a cost of $2.2 million and a fair market value of $11.8 million as of March 31st.”

For the three months ended June 30, 2021, PFLT slightly beat its base case projected net investment income (“NII”) of $0.261 due to higher-than-expected other income and maintained dividend income from its PennantPark Senior Secured Loan Fund (“PSSL”).

Art Penn, Chairman/CEO: “We are pleased with the strong performance of our portfolio this past quarter. Our PSSL joint venture saw significant growth. We believe that the growth of PSSL in conjunction with the Company’s growing, more optimized balance sheet and the rotation of equity positions into debt instruments, positions the Company well for increased income over time.”


PFLT Quick Risk Profile Update

For calendar Q2 2021, PFLT’s net asset value (“NAV”) per share increased by 0.8% but there was net realized losses of almost $13 million due to exiting its non-accrual investment in Country Fresh Holdings which has been discussed in many previous reports.

“The main driver of the realized loss was Country Fresh, which was a non-accrual which went through bankruptcy and is now not on the balance sheet anymore.”

“There were two capital events for Walker Edison in this past quarter. One was a dividend recap where two times we got back two times our money on the equity and then there was an investment by Blackstone where we got another two times our investment. So that was a nice cash realization on Walker Edison that came our direction on equity. Just looking at the quarter, I mean, that was the big one. It was about four point — that was a realized gain of about $4.3 million in the quarter. It was offset by Country Fresh. So the realization of the Country Fresh loss offset that, we had about a $1.4 million realized gain on DecoPac equity. And we had about $700,000 gain on WBB equity.”

American Teleconferencing Services was added to non-accrual status during the quarter. As of June 30, 2021, non-accrual accounted for 2.8% and 2.7% of the overall portfolio on a cost and fair value basis, respectively. If these investments were completely written off the impact to NAV per share would be around $0.72 or 5.6%.

“We did have a non-accrual — we had additional non-accrual American teleconferencing which is called Premier Global that was unrealized loss. We have only two non-accruals out of 105 different names in PFLT and PSSL. This represents only 2.8% of the portfolio of cost and 2.7% at market value.”

“As of June 30th average debt to EBITDA in the portfolio was 4.2 times and average interest coverage ratio, the amount by which cash income exceeds cash interest expense was 3.3 times. This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry.”

“We have largely avoided some of the sectors that have been hurt the most by the pandemic such as retail, restaurants, health clubs, apparel, and airlines and PFLT also has no exposure to oil and gas. The portfolio is highly diversified with 100 companies in 42 different industries. Our credit quality since inception over 10 years ago has been excellent. Out of 381 companies in which we have invested since inception, we’ve experienced only 14 non-accruals.”


 

 


Full BDC Reports

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

ARCC Quick Update: Supplemental Dividend In 2021?

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • ARCC target prices/buying points
  • ARCC risk profile, potential credit issues, and overall rankings
  • ARCC dividend coverage projections and worst-case scenarios


ARCC Dividend Update

As of March 31, 2021, ARCC had around $454 million or $1.04 per share of “undistributed taxable income” which is the amount of earnings in excess of what has been paid to shareholders. Similar to other BDCs such as TSLX, GAIN, and CSWC, there is a good chance that ARCC will need to pay a portion of this amount as a supplemental dividend in 2021 to satisfy the Regulated Investment Company (“RIC”) requirements set forth by the Internal Revenue Code (“IRC”) even when utilizing the spillback provision. For now, management is retaining this amount as a cushion to support “our goal of maintaining a steady dividend throughout market cycles”:

“I want to discuss our undistributed taxable income and our dividends. We currently estimate that our spillover income from 2020 into 2021 will be approximately $454 million or $1.04 per share. We believe having a strong and meaningful undistributed spillover supports our goal of maintaining a steady dividend throughout market cycles and sets us apart from many other BDCs that do not have any spillover.”

ARCC continues to reduce its overall borrowing rates as well as laddering its maturities. On June 3, 2021, ARCC priced $850 million of 2.875% notes due June 15, 2028, which is an extremely low fixed rate for an unsecured note due 2028 and is taken into account with the updated projections. Also taken into account are additional returns from its investment in Ivy Hill Asset Management as discussed by management on the recent call:

“We have continued to invest in Ivy Hill and with that obviously, we generate typically more funds under management, assets under management there that obviously increases the management fees of that company. As you know, we also invest securities in a lot of the funds and vehicles that they put together, which also just allows us to ramp up the investment income from Ivy Hill. So it is simply just an increased dividend this quarter that you should expect to see. As we invest more, obviously, we should be taking in more income from Ivy Hill. And obviously, a dividend increase just represents our continued belief that it is a very attractive investment vehicle and relationship with Ivy Hill, so just continuing upwards.”

For Q1 2021, ARCC reported another strong quarter slightly beating its best-case projections mostly due to much higher-than-expected dividend income and capital structuring service fees. Leverage (debt-to-equity) declined due to the recent accretive equity offering as well as no portfolio growth (slight decline). Its portfolio yield (at cost) decreased slightly from 8.0% to 7.9% due to new investments at lower yields.

ARCC is now near its lower targeted leverage with a debt-to-equity ratio of 1.01 (adjusted for $337 million in cash). Through April 22, 2021, the company has already funded $630 million of new investments partially offset by $432 million of exits.

“After considering our investment in capital activities during the quarter, we ended the first quarter with nearly $5.2 billion of total available liquidity and a debt-to-equity ratio net of available cash of $285 million of 1.02 times, down from 1.17 times at the end of the fourth quarter. While our leverage ratios will vary overtime, depending on activity levels, we will continue to work to operate within our stated target leverage range of 0.9 to 1.25 times.”


 

During Q1 2021, ARCC issued $1.0 billion of 2.150% unsecured notes due 2026 at a slight discount to par partially used to redeem $230 million of 6.875% unsecured notes which resulted in a realized loss on the extinguishment of debt of $43 million. In February 2021, ARCC completed a public equity offering of 14 million shares at $17.85 per share resulting in total proceeds, net of estimated offering expenses, of approximately $249.4 million. As of March 31, 2021, ARCC had $337 million in cash and cash equivalents and approximately $4.9 billion available for additional borrowings under its existing credit facilities.

“During the quarter, we extended our corporate revolving credit facility to a full five-years and upsized it by nearly $350 million, bringing the total facility size to $4 billion, which is the largest single credit facility for any BDC. In addition, we took advantage of the historically low rate environment and issued $1 billion of 2.15% unsecured notes maturing in July 2026, which was a record low coupon for us or any BDC, while also optimizing our liability structure by exercising our option to early redeem our 2047 notes at par. These $230 million of notes, which we assumed in our acquisition of Allied Capital over 10-years ago, represented the highest interest rate of any of our outstanding debt securities at 6 7/8%. We also returned to the equity markets for a secondary issuance for the first time since 2014, issuing 14 million shares of our common stock at a premium to our net asset value, bringing us net proceeds of approximately $250 million.”

Penni Roll, CFO: “With $5.2 billion of available liquidity and a predominately unsecured funding profile, we believe that our balance sheet remains one of our most significant competitive advantages and provides us with significant flexibility.”

 

Previously, ARCC’s Board reaffirmed its second quarter dividend of $0.40 per share payable on June 30, 2021:

 

As discussed in the Dividend Coverage Levels report, only BDCs that can cover dividends by at least 90% using the lower-yield Leverage Analysis with a debt-to-equity ratio of 0.80 will be considered for ‘Level 1’ dividend coverage.

 


Full BDC Reports

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

OCSL Quick Update: More Dividend Increases?

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • OCSL target prices/buying points
  • OCSL risk profile, potential credit issues, and overall rankings
  • OCSL dividend coverage projections and worst-case scenarios


OCSL Distribution Update

Oaktree Specialty Lending (OCSL) remains a ‘Level 1’ dividend coverage BDC and as predicted in multiple previous projections, I was expecting dividend increases to $0.12 for calendar Q1 2021 and $0.13 for Q2 2021. On May 6, 2021, OCSL announced a $0.13 per share, up 8% from the prior quarter paid on June 30, 2021, to stockholders of record on June 15, 2021.

Armen Panossian, CEO and CIO: “The closing of the Merger on March 19 was, of course, another highlight of the quarter. We believe the combined company will provide significant value to our shareholders. As a result of our continued strong performance and potential to improve earnings following the merger, our Board of Directors announced a fourth consecutive quarterly dividend increase to $0.13 per share, up 37% from the level one year ago. OCSL generated solid earnings results in the second quarter. Net asset value per share grew by 4%, supported by continued price appreciation on our high-quality investment portfolio. Additionally, we capitalized on the current market environment by harvesting realized gains on some of our liquid debt securities and rotating out of lower yielding investments into higher yielding, proprietary ones.”

On March 19, 2021, OCSL announced the closing of the previously discussed merger with Oaktree Strategic Income (OCSI). In connection with the merger agreement, Oaktree has agreed to waive $750,000 of base management fees payable in each of the eight quarters following the closing and is taken into account with the previous projections. As shown in the ‘best case’ projections, there is the possibility of additional increases in its quarterly dividend partially due to the merger. In connection with the merger, former OCSI stockholders will receive 1.3371 shares of OCSL for each share of OCSI based on the final exchange ratio.

“I’d like to spend a few moments discussing the closing of the merger with OCSI, which occurred on March 19. As we have emphasized previously, we believe that this transaction has resulted in several benefits to OCSL, including a larger, more scaled BDC with $2.3 billion of assets, up from $1.7 billion in the prior quarter. And improvement in portfolio diversity, including the increase in first lien loans to 68% of the portfolio at fair value from 60%, increased trading liquidity. And we also expect the merger to be accretive to NII over both the near and long-term through cost savings and the two-year fee waiver. In addition, part of our rationale for the merger was improved access to more diverse, lower-cost funding sources.”

I am expecting continued improvement in earnings over the coming quarters through the use of higher leverage, continued rotation into higher yield investments, accretive impacts from the merger including fee waivers as well as higher returns from its Kemper and Glick joint ventures.

“The Kemper joint venture had $352 million of assets invested in senior secured loans to 57 companies, this compared to $341 million of total assets invested in 56 companies last quarter. Assets increased quarter-over-quarter, mainly due to the increase in the market value of its investments and net portfolio growth as purchases exceeded sales and repayments. As a result of the underlying portfolio depreciation, OCS sales investment and the JV were written up by $5 million or 4% from the prior quarter. Leverage at the JV was 1.3 times at quarter end, up slightly from 1.2 times in the December quarter. Given the strong balance sheet and earnings power at the Kemper JV, we anticipate that we will begin to receive quarterly dividends starting next quarter. Regarding the Glick joint venture, it had $137 million of assets at March 31. These consisted of senior secured loans to 36 companies. Leverage at the JV was 1.2 times at March 31. OCSL subordinated note in the Glick joint venture, totaling $55 million is current, and we expect to receive ongoing payments, consisting of coupon interest and principal repayments of $1.3 million per quarter on a run rate basis going forward.”

On May 11, 2021, OCSL announced that it had priced $350 million of 2.700% of unsecured notes due January 15, 2027, which has been taken into account with the updated projections. OCSL had growth capital available given its historically low leverage with a debt-to-equity ratio of 0.84 as of March 31, 2021. On May 4, 2021, the company amended its Syndicated Credit Facility increasing the size to $950 million used to repay borrowings under its higher cost Deutsche Bank Facility from OCSI:

“We amended our syndicated credit facility, increasing the size to $950 million from $800 million and extending maturity by 2 years to 2026. We also retired a higher cost credit facility that was acquired from OCSI. While there are still some more to be done, we believe these actions position us well to optimally fund investments and will help reduce our overall cost of debt capital. Overall, we are very pleased with the quarter.”


The following table excludes “interest income accretion related to merger accounting” to calculate net investment income similar to the company:

 

 


Full BDC Reports

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

TCPC Update: Reduced Borrowing Rates & Dividend Coverage Update

The following information was previously provided to subscribers of Premium BDC Reports along with:

  • TCPC target prices/buying points
  • TCPC risk profile, potential credit issues, and overall rankings
  • TCPC dividend coverage projections and worst-case scenarios


TCPC Dividend Coverage Update

 

For Q1 2021, TCPC slightly beat its base-case projections due to much higher-than-expected dividend income partially offset by lower portfolio yield and only $0.01 per share of prepayment-related driving lower interest income. Payment-in-kind (“PIK”) income continues to decline from 7.6% in Q2 2020 to 3.2% in Q1 2021 the lowest level of PIK income in three years.

“Investment income for the three months ended March 31, 2021 included $0.01 per share from prepayment premiums and related accelerated original issue discount and exit fee amortization, $0.03 per share from recurring original issue discount and exit fee amortization, $0.02 per share from interest income paid in kind, $0.06 per share of dividend income and $0.02 per share in other income. Notably, this was our lowest level of PIK income in more than 3 years. Origination, structuring, closing, commitment, and similar upfront fees received in connection with the outlay of capital are generally amortized into interest income over the life of the debt investment.”


Similar to most BDCs, TCPC continues to improve or at least maintain its net interest margin through reducing its borrowing rates including its SVCP Credit Facility reduced to L+1.75% announced on June 24, 2021, and $175 million of 2.850% notes due 2026 issued on February 9, 2021. Both Fitch and Moody’s reaffirmed the Company’s investment-grade rating with stable outlook during Q1 2021.

“We also took advantage of the favorable bond market during the quarter to lower our borrowing costs. We issued an additional $175 million of unsecured notes at an attractive rate of 2.85%, which was record pricing for sub index eligible BDC bond issuance. In February, both Moody’s and Fitch, also reaffirmed our investment-grade rating with stable outlook. We ended the quarter with total liquidity of $420 million. This included available leverage of $396 million, cash of $14 million and net pending settlements of $10 million. Unfunded loan commitments of 2 portfolio companies at quarter end equaled just 4% of total investments or $75 million, of which $29 million were revolver commitments. Combined, the weighted average interest rate on our outstanding liabilities decreased to 3.48%, down from 3.54% at the beginning of the quarter.”


 

I am expecting higher amounts of dividend income partially related to Edmentum, Inc. but not as much as there was in Q1 2021. Management discussed the recurring amount of dividend income on the recent call:

“Dividend income in the first quarter included $1.3 million or $0.02 per share of recurring dividend income on our equity investment in Edmentum. I would say I would note that, that is — we view it as recurring dividend income. We had about $0.5 million from Iracore this quarter. We also had about, I think, $800,000 from 36th Street and then some other income from Amtech dividend income this quarter, about $800 million from Amtech as well. I would say most of that should be recurring. 36th Street, as you know, has a preferred rate contractual, and then we have a participation in dividend income a majority split, which has actually been — we’re well into that each quarter, and it’s growing. So that is actually partly recurring and then the variable component actually takes us up quite a bit over the recurring amount, which we like. So the majority — I would say the majority of it is recurring, but then where it’s not, we’re actually seeing good, consistent variable income that has actually been growing as it ties to 36th Street.”

Previous reports correctly predicted the reduction of TCPC’s quarterly dividend from $0.36 to $0.30 which was at the top of my estimated range of $0.28 to $0.30. At the time, the company had spillover or undistributed taxable income (“UTI”) of around $0.78 per share. However, this is typically used for temporary dividend coverage issues. Please do not rely on UTI as an indicator of a ‘safe’ dividend.

The previously projected lower dividend coverage was mostly due to lower LIBOR and portfolio yield combined with management keeping lower leverage to retain its investment-grade rating.

The previous declines in interest rates (LIBOR) were mostly responsible for the decline in portfolio yield with “limited exposure to any further declines”.

“Since December 31, 2018, LIBOR has declined 261 basis points or by 94%, which has put pressure on our portfolio yield. However, our portfolio is largely protected from any further declines in interest rates as 84% of our floating rate loans are currently operating with LIBOR floors.”


As shown below, TCPC’s portfolio is highly diversified by borrower and sector with only 4 portfolio companies that contribute 3% or more to dividend coverage:

“As the chart on the left side of Slide 6 of the presentation illustrates, our recurring income is spread broadly across our portfolio and is not reliant on income from any 1 portfolio company. In fact, over half of our portfolio companies each contribute less than 1% to our recurring income. 94% of our debt investments are floating rate. Additionally, 86% of our debt investments are first lien.”


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

On the previous earnings call, management was asked about resetting the dividend higher (closer to the previous level) and mentioned the lumpy nature of fee, dividend, and prepayment-related income, “investors take comfort from dividend stability” and “great pride and comfort from knowing that we’ve got good dividend coverage”. I agree.

Q. “Knowing that you folks never like to do anything in a herky jerky way and having just trimmed your dividend from 36 to 30 last year for reasons that are understandable kind of in the middle of the lockdowns. And so I’m just kind of wondering, again, not for the next quarter, two or three. But just philosophically, what would you be looking forward to or is it a goal to get back to the prior distribution?”

A “I just want to remind you of something that we had said earlier about a decrease in LIBOR, which basically cost $0.09 a share. So yes, we did this during the lockdown. But we were also reacting to the very significant change in LIBOR, and the math is set out. And so when we made that decision, it was really primarily looking at LIBOR as opposed to events in the portfolio. We’re very proud of having earned our dividend every quarter. We think investors take comfort from dividend stability, knowing that it’s well-earned and appropriately covered. And that’s really been our focus. I think the other thing is, as you look at our earnings, we benefited from prepayment fees. And as we discussed earlier on the call, those are lumpy. We’ve had significant prepayment fees the last couple of quarters. We don’t always — we did into Q1 of last year. In fact, we had very few of them. And Q1 tends to be a seasonally slower quarter. Paul pointed out, we hadn’t received any in a material way yet this quarter. We take great pride and comfort from knowing that we’ve got good dividend coverage. But we also know that there’s a certain lumpiness to the extra earnings from additional fees, dividends and prepayments and the more unusual items.”


Full BDC Reports

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