BDC Market Update

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 and worst-case scenarios

Summary

• CSWC will likely continue to increase its regular dividend and pay supplementals as predicted in previous reports.
• I have increased the LT target to take into account additional/continued quarterly increases in addition to the $0.10 supplemental, improved credit quality, and NAV increases.
• The stock is likely overpriced at these levels and I will not be making changes to this position until after updating the CSWC Projections & Pricing report.
• My primary concern is the recent increase in non-cash PIK income during the quarter from $1.6 million to $2.8 million which could include some one-time items. AGKings was exited and there are no non-accruals.
• NAV increased by 1.7% mostly due to accretive share issuances through its ATM program.

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CSWC Dividend Coverage Update

As mentioned in the previous projections “there is a good chance of dividend increases over the coming quarters”.

CSWC’s Board declared a total dividend of $0.53 per share for the quarter ended June 30, 2021, including the increased regular quarterly dividend of $0.43 per share (previously $0.42) and a supplemental dividend of $0.10 per share.

“Based on our continued strong performance, the Board of Directors has increased our total dividends to $0.53 per share for the quarter ending June 30, 2021 by increasing our Regular Dividend to $0.43 per share and maintaining our Supplemental Dividend at $0.10 per share.”

• Ex-Dividend Date: June 14, 2021
• Record Date: June 15, 2021
• Payment Date: June 30, 2021

CSWC’s target pricing and dividend yield in the BDC Google Sheets already takes into account $0.10 per share of quarterly supplemental/special distributions that will likely continue beyond 2021. Similar to MAIN, the supplemental dividends are typically covered by realized capital gains and over-earning the regular dividend. As of March 31, 2021, CSWC had $0.92 per share of undistributed taxable income. Management is likely going to maintain its supplemental dividends going forward as they need to distribute UTI over the coming quarters.

For calendar Q1 2021, CSWC beat its base case projections due to higher-than-expected portfolio growth and lower employee expenses partially offset by lower dividend income from its I-45 Senior Loan Fund as well as lower fee and other income. However, total interest income continues to increase to highest level (over $15 million as predicted) which should improve dividend coverage as the company leverages its internal operating cost structure driving continued dividend increases.

“For the quarter ended March 31, 2021, Capital Southwest reported total investment income of $17.2 million, compared to $19.0 million in the prior quarter. The decrease in total investment income was primarily attributable to prepayment fees and a one-time dividend received in the prior quarter, partially offset by an increase in average debt investments outstanding.”

The company remains below its upper targeted leverage (1.20) with a debt-to-equity ratio (net of available cash) of 1.05. On April 20, 2021, the company received approval to form a new SBIC subsidiary with access to an additional $175 million of low-cost capital excluded from certain BDC lending ratios.

My primary concern is the recent increase in non-cash payment-in-kind (“PIK”) income during the quarter from $1.6 million to $2.8 million which could include some one-time items. The company has not released the updated 10-K filing with necessary details and this may be discussed on the upcoming earnings call. I will include a full update in the CSWC Projections & Pricing report.

As of March 31, 2021, CSWC had almost $32 million in unrestricted cash and almost $217 million in available borrowings under its credit facility for upcoming portfolio growth. Previously, management was targeting a debt-to-equity ratio between 1.00 and 1.20 but will likely use higher amounts of leverage over the coming quarters due to improved portfolio mix (safer investments) and access to SBA leverage:

“From an economic leverage perspective, we really have targeted between 1.20 and 1.30, even getting the SBA money when that does happen, we don’t plan on levering up economic leverage beyond there. We probably will show up with 1.00 to 1.15 on regulatory leverage and stick to 1.20 to 1.30 on our total economic leverage.”

Dividend coverage will likely improve due to reduced borrowing expenses including the recent issuance of $65 million of notes at 4.00% and the redemption of its 5.95% Baby Bond “CSWCL” and continued portfolio growth. As mentioned later, there was slightl negative imact to its NAV per share due to writing off the unamortized debt issuance costs during the quarter:

“On January 21, 2021, the Company redeemed the remaining $37,136,175 in aggregate principal amount of issued and outstanding December 2022 Notes. Accordingly, during the three months ended March 31, 2021, the Company recognized realized losses on the extinguishment of debt of $0.5 million, equal to the write-off of the related unamortized debt issuance costs during the quarter ended March 31, 2021.

In March 2019, CSWC established its equity “At-The-Market” (“ATM”) program of slowly issuing small amounts of shares at a premium to book value/NAV and accretive to shareholders. As CSWC’s stock price continues higher, management will likely use the ATM program for raising equity capital, rather than larger equity offerings. This approach is beneficial for many reasons including being more efficient, delivering higher net proceeds to the company, and less disruptive to market pricing.

During Q1 2021, the company sold 1,137,476 shares at a weighted-average price of $21.21 per share (35% premium to previous NAV per share), raising $23.6 million of net proceeds through its “At-The-Market” (“ATM”) equity program.

In February 2021, the company issued an additional $65 million of its January 2026 Notes at a price of 102.11% resulting in a yield-to-maturity of approximately 4.0%.

Its I-45 Senior Loan Fund accounts for around 8% (previously 10%) of the total portfolio and is a joint venture with MAIN created in September 2015. The portfolio is 95% invested in first-lien assets with CSWC receiving over 75% of the profits providing 10.2% annualized yield (previously 10.6%) paying a quarterly dividend of $1.5 million (previously $1.7 million).

CSWC Quick Risk Profile Update

There was an improvement in overall credit quality mostly due to exiting its only non-accrual investment in AG Kings Holdings that was purchased by Albertsons as discussed in previous reports driving a slight realized loss for the quarter:

Similar to other BDCs, my primary concern is the 9.2% (previously 12.5% in calendar Q1 2020) of the portfolio considered ‘Investment Rating 3’ which implies that the “investment may be out of compliance with financial covenants and interest payments may be impaired, however, principal payments are generally not past due.”

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

For calendar Q1 2021, CSWC’s NAV per share increased by $0.27 or 1.7% (from $15.74 to $16.01) mostly due to the previously discussed shares issued at a 35% premium to NAV adding around $0.27 per share. The company overearned the regular dividend and there was portfolio appreciation but mostly offset by the supplemental dividend of $0.10 per share and the early redemption of CSWCL. Again, CSWC has not released its updated 10-K SEC filing with details to properly assess changes to NAV.

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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.

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 and worst-case scenarios

Summary

• ORCC is slowly increasing leverage to fully cover the dividend later this year. Management provided guidance for a much stronger Q2 2021 taken into account with the updated projections.
• There will likely be a meaningful increase in income related to prepayment fees, accelerated OID, a full quarter of benefit from Q1 investments, increased leverage, and portfolio growth.
• These repayments will likely be mostly offset by new investments including the recently announced $2.3 billion loan to finance Thoma Bravo’s acquisition of online trading services provider Calypso Technology.
• ORCC is for risk-averse investors as the portfolio is mostly larger middle market companies that would likely outperform an extended recession environment. Credit quality remains solid with no new non-accruals that remain at 0.2% of fair value.
• As discussed in previous reports/updates there has been some technical selling pressure related to Regents that continued through April/May 2021.

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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 relatively low leverage with ample growth capital available for increased earnings over the coming quarters.

ORCC is the third-largest publicly traded BDC (much larger than MAIN, PSEC, GBDC, GSBD, NMFC, and AINV) with investments in 120 portfolio companies valued at over $11 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 10% Owner Sales

As discussed in previous reports/updates and the public article “Technical Pressure Driving 12% Yield For Owl Rock” (from July 2020), the Regents of the University of California (ORCC’s largest shareholder) was previously selling its pre-IPO shares each time the stock was above ~$12.50 but had not sold shares since September 2020. However, there have been additional sales and could be the start of another round of selling. I would suggest holding off on purchases for now. There is a chance that the stock could dip below $14.00 (again) and I will update subscribers on additional sales and provide updates as needed.

ORCC Dividend Coverage Update

ORCC remains a ‘Level 2’ dividend coverage BDC implying that the regular quarterly dividend is stable. The company was not expected to fully cover its Q1 2021 dividend and was discussed on the previous call:

“We continue to make good progress toward earning our dividend and are on track to achieve our target leverage by the second half of 2021. We expect to continue to pay our regular dividend of $0.31 per share and would anticipate returning a modest amount of capital in the interim. ”

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

• Increased use of leverage to grow the overall portfolio
• Prepayments fees and accelerate OID
• Higher portfolio yield from rotating into higher yield assets
• Continued lower cost of borrowings

ORCC remains underleveraged and is targeting a debt-to-equity ratio up to 1.25 (currently 0.93 net of cash) giving the company plenty of growth capital.

“Thinking ahead to the rest of this year, we expect interest income to continue to increase each quarter over the coming quarters, as we modestly increase our leverage within our target range. We’ve made steady progress to get to the low end of our targeted range of 0.90 to 1.00 in a quarter and expect to modestly increase our leverage within that range in the coming quarters.”

“As we expected first quarter NII was temporarily down. Our originations were largely first lien investments, which once again were weighted toward the end of the quarter and as a result, the net one penny per share of growth in NII is not reflective of the full benefit of Q1 originations. In addition, dividend income was lower this quarter, which also impacted NII by approximately one penny per share. However, we expect that we will make meaningful progress in the second quarter towards earning our dividends. We believe we are still on track to fully cover our dividend from NII in the second half of the year. We don’t typically provide forward guidance, but I can say that sitting here today as we are expecting a very active second quarter and originations in excess of the first quarter and more in line with the fourth quarter.”

Management is expecting a much stronger Q2 2021 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:

“So we only had about $250 million of actual repayments. And we expect that number to go up materially in the second quarter. That obviously is very impactful for earnings. Because as we get through repayments, we are able to recognize the OID that remains on those investments and oftentimes, pre-payment penalties. So we’re calling attention to that because it generates earnings. For the second quarter, we also have visibility on increased pre-payments, which will generate additional fees from accelerated OID and call protection. Based on the net effect of the pipeline borrowing something unexpected, we believe we will continue to modestly increase our leverage level as well as improve earnings in second quarter. As a result, we expect Q2 earnings to grow and then make solid progress towards covering our $0.31 per share dividend, which we ultimately expect to occur in the second half of this year. We do expect repayments to pick up later this year based on the continued seasoning of our portfolio. I would also note that we had some higher yielding repayments early on in the quarter.”

These repayments will likely be mostly offset by new investments including the recently announced $2.3 billion loan to finance Thoma Bravo’s acquisition of online trading services provider Calypso Technology:

“We are pleased that we continue to be successful in winning the deals that we want to win. In names in situations where we have high conviction around the asset and the sponsor are able to demonstrate the value of our platform and often take a sole or lead position in these deals. As a great example of this, it was recently announced that Owl Rock is leading the $2.3 billion unitranche loan to finance Thoma Bravo’s acquisition of Calypso, which is expected to close later this year. We believe this will be the largest unitranche facility ever we done in the U.S. and is a reflection of our ability to provide attractive sizeable financing commitments for top tier investment opportunities. It also highlights our expertise in the software space. Calypso reflects the continued growth of the private credit space as increasingly larger borrowers are choosing direct lending solutions over the syndicated market. Given our large capital base, Owl Rock is very well positioned for this trend. We’re very excited about the continued growth of the platform and the sourcing opportunities that we expect to generate as a result of the Blue Owl transaction closing. We look forward to discussing the Blue Owl platform in more detail in the quarters to come.”

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 is expecting “modestly higher” in Q2 2021:

“The visibility we have on second quarter, I would expect spreads to be a bit wider than we’d gotten the first quarter. But I think we’re continuing to find investments that have a spread consistent with today’s weighted average spread in our portfolio, in some cases, higher, some cases slightly lower. But our visibility in the second quarter I would say it’s modestly higher.”

ORCC’s average borrowing rate has declined from 4.6% to 3.2% over the last five quarters due to continued issuances of notes and CLOs at lower rates including another $398 million on May 5, 2021. On April 26, 2021, the company issues $500 million of 2.625% notes due 2027.

“We continue to focus on optimizing our funding costs. In that regard, we had two notable transactions we did that helped further us in reducing costs on the right side of our balance sheet. We priced our sixth CLO this one for $260 million of incremental financing at a blended spread of 149 basis points a great print and very cost efficient for us. And we issued our seventh bonds, this one for $500 million of incremental financing at a fixed coupon of 2.158% or tightest print ever.”

As of March 31, 2021, ORCC had around $2.5 billion of liquidity consisting of $244 million of cash and almost $1.24 billion of undrawn debt capacity (including upsizes).

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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.

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 and worst-case scenarios

Summary

• I have updated the projections for AINV to take into account the recently reported results and guidance from management on the earnings call yesterday (see below).
• AINV’s recurring interest income declined to its lowest level over the last 15 years and the company would have only covered around 87% of dividends if incentive fees were paid.
• Management guided for earnings to “fluctuate” over the coming quarters due to upcoming incentive fees hopefully offset by increasing leverage, portfolio rotation, and Merx Aviation.
• There is a chance of a downgrade to ‘Level 3’ (implying the potential for a reduction) depending on the progress of rotating out of “non-earning and lower-yielding assets” and improved results/income from its investment in Merx.
• AINV is likely fully priced at these levels and continues to have among the highest leverage (1.37) in the sector combined with exposure to Merx (13%) and “non-core” investments (8%).

AINV Distribution Update

On May 20, 2021, the Board of Directors declared a distribution of $0.31 per share payable on July 7, 2021 to shareholders of record as of June 17, 2021. On May 20, 2021, the Company’s Board also declared a supplemental distribution of $0.05 per share payable on July 7, 2021 to shareholders of record as of June 17, 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 call:

“Given the total hurdle feature in our fee structure and the net losses recorded during the look-back period, we have not paid an incentive fee since the quarter ended December 2019. Given the significant recovery in the portfolio over the past several quarters, we wanted to make sure everyone is aware that we may begin paying a partial incentive fee in the quarter ending September 2021. The exact timing and amount may vary based upon future gains and losses as well as the level of the net investment income.”

Management is working to improve dividend coverage through the “redeployment of non-earning and lower-yielding assets from non-core and legacy assets, as well as an increase in yield we received from our Merx investment”:

“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.”

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 87% of the quarterly dividends if the full incentive fees had been paid. 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 call:

“That said, we currently intend to declare a quarterly distribution of $0.31 and a quarterly supplemental distribution of $0.05 for the next four quarters.”

Q. “On the maintaining the $0.05 per quarter for the next four quarters, does that include the one that you announced today? So, it’s three after this, or it’s four into the future?”

A. “No, it’s four, including the one that we announced 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 (discussed later). Management is also actively growing the portfolio with the use of higher leverage which is already among the highest in the sector which is currently averaging around 0.94 debt-to-equity (net of cash).

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

“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.”

“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 and MidCap platform.”

“From April 1st to May 18th, we’ve made new commitments of approximately $193 million, all of which were first lien corporate loans. Gross fundings have totaled $157 million; sales and repayments have totaled $149 million, including $57 million of second lien corporate lending positions.”

AINV was previously upgraded to ‘Level 2’ due to the expected dividend reduction and the strong likelihood that the company would not be paying incentive fees over the coming quarters. 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.

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. We believe a $0.31 distribution reflects the long-term earning power of the core portfolio including Merx.”

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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.

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

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

Summary

• I have updated the TSLX projections (slightly higher supplemental dividends) and pricing (no change) to take into account recent guidance from management.
• “I feel pretty confident that we’re going to grow the book in the near term. I feel more bullish today than I have historically”.

• Q1 2021 was another strong quarter for TSLX between its base and best case projections covering its regular dividend by 130% and paying another supplemental of $0.05 per share.
• There was an additional $14.6 million or almost $0.21 per share of net realized gains during Q1 2021 to support additional supplemental dividends.
• As expected NAV per share declined due to previous supplementals/specials. However, using adjusted NAV there was an increase of 3.5% due to accretive offering, overearning the dividend, and portfolio markups.
• Total non-accruals declined to 0.02% of the portfolio fair value (previously 0.90%) due to its first-lien position in American Achievement added back to accrual status.
• TSLX has higher quality management maintaining margins, reducing leverage, and 89% of the portfolio is considered ‘Performance Rating 1’

• Over the last 5 to 6 years, TSLX has provided me with annualized returns of 15% and likely headed higher as the company continues to pay special/supplemental dividends.
• Also included is a comparison table showing returns for each BDC over the last five years taking into account changes in book value/NAV and dividends paid.
• One of the many reasons that I consider TSLX to have higher quality management is the focus on ROE with each decision including equity offering, debt issuances, the amount of distributions paid, excise tax.

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Over the last 5 to 6 years, TSLX has provided me with annualized returns of 15% and likely headed higher as the company continues to pay special/supplemental dividends. The “Annualized” return shown does not use a simple average but shows the actual compounding of annual returns. This is the true return each year. Please disregard the annualized total returns for 2020 purchases as the time frame is not long enough to accurately reflect.

Historical BDC Returns

The following table shows the returns for each BDC over the last five years taking into account changes in book value or net asset value (“NAV”) and dividends paid. It is important to note that when BDCs pay out large special/supplemental dividends it directly impacts NAV which is why both are taken into account. Also, some BDCs use conservative or aggressive valuations and their current NAV could be understated or overstated. One of the many reasons that I consider TSLX to have higher quality management is the focus on return on equity (“ROE”) with each decision including equity offering, debt issuances, the amount of distributions paid, excise tax:

“As we look ahead to the year, we continue to target a return on equity of 11.5% to 12%, corresponding to a range of $1.82 to $1.90 for full year 2021 adjusted net investment income per share. We did a small equity issuance sized at less than 6% of our pro forma market cap with net proceeds approximating the size of our special dividend payment. What we did essentially was swap out capital that had excise tax associated with it and replaced it with new capital without the burden of excise tax. This allowed us to create NAV and ROE accretion for our shareholders while remaining leverage neutral.

Return on equity (“ROE”) for Q1 2021 was 13.3% and 22.1% on a net investment income and a net income basis, respectively.

TSLX Upcoming Supplemental Dividends

On May 4, 2021, the company reaffirmed its regular quarterly dividend of $0.41 plus another supplemental dividend of $0.06 per share which was between the previous base and best-case projections of $0.03 and $0.08, respectively. Previously the company paid a special cash dividend of $1.25per share and a supplemental dividend of $0.05 per share.

Over the last five years, TSLX has increased the amount of supplemental dividends paid:

When calculating supplemental dividends, management takes into account a “NAV constraint test” to preserve NAV per share. This is one of the reasons that management prefers not to pay large supplemental dividend payments even though the amount of undistributed/spillover income continues to grow. However, management also likes to avoid paying excessive amounts of excise tax by “cleaning out” the spillover as it “creates a drag on earnings” which is why the company paid a total of $1.30 per share in supplementals during Q1 2021.

During Q1 2021, there was an additional $14.6 million or almost $0.21 per share of net realized gains (mostly due to the sale of its equity position in Capsule Technologies to Philips) to support additional supplemental dividends.

“The realization of our small equity investment in Capsule Technologies upon a sale to Philips drove the bulk of our realized gains this quarter.”

TSLX still has around $1.02 per share of undistributed/spillover income as well as its Series A preferred shares of Validity, Inc. valued at $8.5 million over cost and will likely result in upcoming realized gains of $0.12 per share to support additional supplemental dividends.

 

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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.

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

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

Summary

• I will be updating the projections and pricing for NEWT to take into account the following information including the increased 2021 dividend forecast of $3.00 to $3.30.
• NEWT reported below base-case projected ANII of $1.154 per share mostly due to timing differences of SBA 7(a) loans that were funded but not sold.
• This will likely drive a stronger Q2 2021 and will be taken into account with the updated report. However, this is likely already priced into the stock that remains a ‘Hold’.
• The company declared a Q2 2021 dividend of $0.70 per share which is a 25%increase over the Q2 2020 dividend. As shown below, $0.70 per share was the best-case projected Q2 2021 dividend from the previous projections.

This update discusses Newtek Business Services (NEWT) which is an internally-managed BDC that was previously added to the suggested ‘Total Return’ portfolio. As discussed later, NEWT has a differentiated and diversified model that provides multiple streams of revenue including loan origination, including SBA 7a loans, 504 loans, PPP loans (Paycheck Protection Program), and conventional loans. Also, the company provides various services to small and medium businesses including electronic payment processing, payroll processing, web solutions, insurance services, and technology:

As shown below, analysts are expecting lower earnings in 2022 which is expected and NEWT’s management has a variable dividend program and will adjust accordingly as not to overpay. This is obviously a good thing for the company but investors should expect lower dividends next year and I will continue to adjust NEWT’s target prices to accommodate.

NEWT Dividend Discussion & Expectations

I will be updating the projections and pricing for NEWT to take into account the following information including increased 2021 dividend forecast of $3.00 to $3.30 per share for 2021 as well as guidance from management on the upcoming earnings call. Also, the company has not released its updated 10-Q so we have limited information regarding non-accruals and NAV.

NEWT uses Adjusted Net Investment Income (“ANII”) as a measure of its operating performance which includes short-term capital gains from the sale of the guaranteed portions of SBA 7a loans and a non-conforming conventional loan, capital gain distributions from controlled portfolio companies, which are reoccurring events. Additionally, NEWT’s business model is seasonal/cyclical in nature which is why the company pays an irregular/variable quarterly dividend and is managed on annual basis (not quarterly).

For Q1 2021, NEWT reported below base case projected ANII of $1.154 per share mostly due to timing differences of SBA 7a loans that were funded but not sold. This will likely drive a stronger Q2 2021 and will be taken into account with the updated NEWT Projections & Pricing report. The company declared a Q2 2021 cash dividend of $0.70 per share which is a 25% increase over the Q2 2020 dividend of $0.56 per share, and a 52% increase over the Q2 2019 dividend of $0.46 per share. As shown below, $0.70 per share was the best case projected Q2 2021 dividend from the previous projections.

The last three lines in the table below use the average over the last four quarters to help identify trends in dividend coverage.

NEWT’s NAV per share increased by another 5.4% but the company has not released its updated 10-Q so we do not have the details as well as non-accrual information.

NEWT currently has ‘Level 1’ dividend coverage mostly due to the positive impacts from continued stimulus programs discussed in the previous report that has also helped with the recent NAV performance:

From previous call: “We still believe that there is pandemic effects that reduced valuation, although we also believe that the stimulus that we’re having in the economy is certainly improving all asset values and we do and hope that we can anticipate seeing the NAV rise again in the future.”

NEWT increased its 2021 annual dividend forecast from $2.40 to $2.90 to $3.00 to $3.30, with a midpoint of $3.15, which is 54% higher than the amount of dividends paid in 2020.

In April 2021, the company signed a joint-venture agreement to originate commercial loans to middle-market companies as well as small businesses and is currently negotiating an additional joint-venture agreement with a global investment management firm with over $500 billion in assets under management.

 

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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.

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

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

Summary

• Same as the previous quarter, four investments are responsible for PSEC’s NAV growth and ‘other income’ needed for covering the dividend.
• PSEC reported just below its base-case projections mostly due to much lower-than-expected recurring interest income partially offset by other income from NPRC and First Tower.
• NAV per share increased by 4.7% due to unrealized appreciation primarily related to the same control/affiliate investments as previous quarters (InterDent, First Tower, PGX Holdings, and NPRC).
• These four investments have been continually marked up and now account for $2.3 billion, 39% of the total portfolio or over 62% of NAV per share.

PSEC March 31, 2021, Quick Update

Prospect Capital (PSEC) reported just below its base-case projections mostly due to much lower-than-expected recurring interest income driven by a lower portfolio yield (from 9.9% to 9.4%) partially offset by higher-than-expected ‘other income’ from its control investment (mostly National Property REIT and First Tower Finance discussed later)

PSEC’s dividend coverage potential and risk profile will be discussed in the updated PSEC Projections & Pricing report over the coming weeks.

Leverage remains low with a current debt-to-equity at 0.62 (below the lower end of its target range) after taking into account the convertible Perpetual Preferred stock that continues to increase and discussed at the end of this update.

NAV per share increased by 4.7% (from $8.96 to $9.38) due to unrealized appreciation primarily related to the same control/affiliate investments as previous quarters (InterDent, First Tower Finance, National Property REIT, and PGX Holdings).

The following table details net change in unrealized gains (losses) on investments for the nine months ended March 31, 2021, showing these four same investments account for over $411 million or $1.08 per share of the recent gains:

More importantly is that four investments (National Property REIT, PGX Holdings, InterDent, and First Tower Finance) have been continually marked up and now account for $2.3 billion, 39% of the total portfolio or over 62% of NAV per share. It should be noted that these investments have a cost basis of under $1.5 billion resulting in around $793 million or $2.04 per share of unrealized appreciation compared to the current NAV per share of $9.38. This is very high concentration risk, especially if management is using aggressive valuation measures.

• Please see below for extensive discussions from the previous earnings call regarding National Property REIT (“NPRC”) and InterDent.

On August 3, 2020, PSEC launched a $1 billion 5.50% “Perpetual Preferred” stock offering to “enhance balance sheet liquidity, including repaying our credit facility and purchasing high-quality short-term debt instruments, and to make long-term investments in accordance with its investment objective.” For common shareholders this creates additional risks as the preferred is cumulative and has to be paid in full before common stock shareholders receive their distributions. The preferred stockholders have the option to convert into common at any time and there is a chance that PSEC could redeem these shares at “any time” converting into common stock based on the most recent 5-day trading price. This could be another way for management to issue additional shares below NAV.

As shown in the following table, a good portion of the recent unrealized gains, as well as over $200 million of income, has come from its control investments over the last nine months which includes a large portion of the ‘other income’:

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.

 

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Monroe Capital (MRCC) Update

• During Q4 2020, there was a meaningful increase in the amount of PIK income from 12.8% to 33.4% of interest income.
• This 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.
• Q4 2020 earnings would have been around $0.196 per share without the benefit of fee waivers covering 79% of the quarterly dividend which is down from 85% in Q3 2020.
• Dividend coverage should improve as the company benefits from a full quarter of interest income from new investments and reduced borrowing costs due to the redemption of its Baby Bond (MRCCL).
• MRCC is trading below NAV yielding 10.4% for a reason.

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There are many factors to take into account when assessing dividend coverage for BDCs including portfolio credit quality, potential portfolio growth using leverage, 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”). During Q4 2020, there was a meaningful increase in the amount of PIK income from 12.8% to 33.4% of interest income. It should be noted that most BDCs have between 2% to 8% PIK income and I start to pay close attention once it is over ~5% of interest income.

This 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. New investments during Q4 2020 were mostly near the end of the quarter so the company did not benefit from a full quarter of interest income for those investments. However, the total amount of PIK interest income increased 135% from $1.6 million in Q3 2020 to $3.7 million in Q4 2020 and could result in an eventual downgrade to ‘Level 3’ or ‘Level 4’ dividend coverage especially if there is another round of credit issues.

Management discussed this on the recent call and mentioned that $1 million was related to onetime activity which doesn’t account for the entire increase and there will still be a very large portion of PIK income:

“some of this is — I would consider about $1 million of this to be what I would consider non-reoccurring, sort of onetime PIK interest that we got in connection with some restructuring activities. So, we did like, for example, we did a restructuring that was very favorable on Familia, where we refinanced out a significant portion of our debt and got some PIK interest as a result and then took back considerable amount of upside equity as it applied to that deal. And so, that income is not likely to reoccur. And then, on HFZ and HFZ Member RB, we did a restructuring there as well. It was also favorable. The valuations are still very strong, and we took in some PIK interest that was kind of onetime, associated with it. There is some of that interest that will recur but some will not.”

It should be noted that we heard the same conversations with the management team at Medley Capital (MCC) just before the serious credit issues hit.

For Q4 2020, earnings would have been around $0.196 per share without the benefit of fee waivers covering 79% of the quarterly dividend which is down from 85% the previous quarter. Dividend coverage should improve in Q1 2021 as the company benefits from a full quarter of interest income from new investments. Also, on March 1, 2021, MRCC repaid $28.1 million in SBA debentures, and on January 25, 2021, the company issued $130 million of 4.75% notes due 2026 using the proceeds to redeem its 5.75% Baby Bond (MRCCL) on February 18, 2021.

Chief Executive Officer Theodore L. Koenig: “We had a very active late fourth quarter, redeploying a portion of the proceeds we received from recent repayment activity into current yielding assets which should positively contribute to earnings in future quarters. We are also very pleased with the January 25, 2021 issuance of $130.0 million in senior unsecured notes at an interest rate of 4.75% per annum with a maturity date of February 15, 2026 (the “2026 Notes”). The proceeds from the 2026 Notes were used to redeem all of the outstanding 5.75% 2023 Notes and repay a portion of the outstanding revolving credit facility. This refinancing lowered our debt financing costs which should positively impact our Adjusted Net Investment Income and earnings in future quarters.”

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Non-accrual investments currently account for 4.1% of the total portfolio fair value and if completely written off would impact result in a NAV per share decrease of around 10%.

“As of December 31, 2020, we had 12 borrowers with loans or preferred equity securities on non-accrual status (BLST Operating Company, LLC, California Pizza Kitchen, Inc., Curion Holdings, LLC (“Curion”), Education Corporation of America (“ECA”), Incipio, LLC (“Incipio”) last out term loan and third lien tranches, Luxury Optical Holdings Co. (“LOH”), NECB Collections, LLC, Parterre Flooring & Surface Systems, LLC, SHI Holdings, Inc., The Worth Collection, Ltd. (“Worth”), Toojay’s Management, LLC and Valudor Products, LLC preferred equity), and these investments totaled $22.3 million in fair value, or 4.1% of our total investments at fair value.”

“We are pleased to report another quarter of strong financial results. During the fourth quarter, we reported another increase in our Net Asset Value and we again fully covered our dividend with Net Investment Income. We continue to believe the vast majority of our portfolio companies have strong long-term outlooks and we have seen recovery and stabilization in many of our portfolio companies that have been impacted by the COVID-19 pandemic. As market volatility resulting from the uncertainty related to the impacts of COVID-19 continued to decline during the fourth quarter, we saw spreads continue to tighten and valuations for portfolio companies without significant long-term COVID-19 impact continue to rebound, consistent with our experience in the prior two quarters.”

Grade 3 – Includes investments performing below expectations and indicates that the investment’s risk has increased somewhat since origination. The issuer may be out of compliance with debt covenants; however, scheduled loan payments are generally not past due.

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

Grade 5 – Indicates that the issuer is performing substantially below expectations and the investment risk has substantially increased since origination. Most or all of the debt covenants are out of compliance or payments are substantially delinquent. Investments graded 5 are not anticipated to be repaid in full.

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Full BDC Reports

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

 

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FS KKR Capital (FSK) Update

• Non-accruals declined to 2.5% due to restructurings/exits driving an additional $0.71/share of realized losses. FSK had a total of $4.01/share of realized losses in 2020.
• FSK has much higher cyclical exposure including retail, capital goods, real estate, energy, and commodities that account for over 28% of the total portfolio.
• FSK is for traders, considered higher risk due to its lower credit quality driving a 33% decline in NAV per share and two dividend reductions over the last 3 years.
• FSK dividend coverage has been reliant on no incentive fees paid over the last 5 quarters. However, management is removing this ‘lookback’ feature in connection with the merger with FSKR.
• FSK is trading at a 23% discount to NAV with a 12.4% yield for a reason.

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During Q4 2020, total non-accruals declined from 2.9% to 2.5% the portfolio fair value due to restructuring/exiting its investments in DEI Sales Inc, Chisholm Oil & Gas, and Z Gallerie driving an additional $88 million or $0.71 per share of realized losses. If non-accruals were completely written off would impact NAV per share by around $1.39 or 5.6%. Most of the investments on non-accrual have been discussed in previous reports and management typically refers to most of them as “legacy investments”.

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It should be noted that FSK had a total of $490 million or $4.01 per share of realized losses during 2020 that included the restructuring of Borden Dairy, FourPoint Energy, and Mood Media during Q3 2020.

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FSK has much higher cyclical exposure including retail, capital goods, real estate, energy, and commodities that account for over 28% of the total portfolio. It also many of the same sector exposures in its SCJV which is over 10% of the portfolio.

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As mentioned in previous updates, I will be updating the risk profiles for each BDC taking into account sector exposures. I found the following “Timeframe of Recovery of Credit Metrics to 2019 Levels” from S & P Global Ratings on February 17, 2021, to be an interesting view of the recovery prospects. I will likely take a more conservative approach when updating the risk rankings. BDCs such as FSK, FSKR, 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.

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During Q4 2020, its net asset value (“NAV”) per share reflated by 2.3% (from $24.46 to $25.02) due to unrealized gains in the portfolio and overearning the dividend.

“We were pleased to conclude 2020 with such a positive quarter. Across our BDC franchise during the fourth quarter, we originated approximately $1.9 billion of new investments, $613 million of which were within FSK. At FSK, our net investment income per share more than covered our $0.60 quarterly dividend, and our net asset value increased by 2.3% quarter over quarter. Additionally, in November we announced the proposed merger of FSK and FSKR, which would create a single BDC with approximately $16 billion in assets, and in December we accessed the public debt markets raising $1 billion in long term, unsecured capital at attractive rates. As a result, we enter 2021 with excitement regarding our prospects from both an operational and investment standpoint.”

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Over the last three years, FSK’s NAV per share has declined by almost 33%.

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The amount of investments with ‘Investment Rating 3 and 4’ decreased from 13% to 10% of the portfolio fair value or 23% of NAV per share and needs to be watched. ‘Investment Rating 3 and 4’ are identified as “Underperforming investment concerns about the recoverability of principal/interest and/or some loss of interest or dividend possible, but still expecting a positive return on investment”.

 

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FSK has been covering its dividend only due to no incentive fees paid driven by the ‘total return’ hurdle and continued capital losses. The company will eventually need to start paying an incentive fee for the following quarters:

Q. “Do you know how many quarters of additional incentive fee waivers we have in front of us before they’re absorbed if we’d look back?”

A. “Probably two quarters ago now that we said we expected it to be kind of in the five to six quarter range from that period of time. Clearly in our guidance for the fourth quarter, there’s not an incentive fee. Clearly the books moved in a positive direction, too. So forgive me for not having the exact math. But hopefully, that’s maybe a bit of a bookend for you and we can also follow up offline.”

On November 24, 2020, FS/KKR Advisor, LLC announced that FSK and FS KKR Capital II (FSKR) entered into a definitive merger agreement. In connection with the merger, the board has approved an amended advisory agreement for the combined company permanently reducing its income incentive fee to 17.5% from the existing 20.0%. However, the ‘total return’ hurdle or ‘look back’ provision will be removed. 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 last 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. Please see additional merger information/slides included later in this report.

On the previous earnings call management mentioned that the company might be switching a portion of its quarterly dividend to include a variable component similar to Apollo Investment (AINV) and TCG BDC, Inc. (CGBD):

“As a reminder, over the long term, we expect our dividends per share will equate to a 9% yield on our net asset value per share, but we acknowledge there will be certain quarters where our annualized yield may be greater or less than this range due to quarter-to-quarter fluctuations in the business from an operational standpoint. Obviously, our dividend policy of achieving a 9% target dividend yield on our net asset value means that over time, it would be normal for our quarterly dividend to fluctuate somewhat in concert with the quarter-to-quarter change in our net asset value.”

Q. “Should we think of this variable policy as more transitory or permanent concept?”

A. “I think it’s probably a bit of a combination of creating a sense of stability. But also, I think, understanding what this product is and what the BDC is, I think that a variable component does make some real sense to us. We think of this more as a permanent shift, rather than a transitory shift. And we think, frankly, the industry would benefit itself in the same way, not just our platform. There’s so many variables, every quarter that BDC’s deal with in terms of changing interest rate environments, changing deal environments, we’ve talked a lot about pricing a pipeline, credit quality, it’s just lots of inputs that you handle every quarter as an operator. And to have a fixed dividend over time, this becomes very difficult for all BDC. So we think having more of a floating type policy that matches NAV and creates a target yield for investors over a long sustained period of time, as we think of a more enlightened, better way to go for the industry as the industry continues to mature, frankly.”

FSK had spillover or undistributed income of around $200 million which can be used for temporary dividend coverage shortfalls only and will likely reset its dividend as needed (similar to the previous two reductions).

 

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Full BDC Reports

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

 

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MAIN Dividend Coverage Update

On November 4, 2020, Main Street Capital (MAIN) reaffirmed its regular monthly dividend of $0.205 per share:

“Despite the negative impact of these items and the resulting level of DNII in the quarter as a result of our diversified investment portfolio, together with the advantages of our differentiated investment strategy, the increasing benefits from our asset management business, our strong investment pipeline, our efficient operating structure and alignment of interest with our shareholders, combined with our conservative capital structure and strong liquidity position, we remain comfortable with our commitment to maintaining a stable monthly dividend payment level going forward. To that end, earlier this week, our Board declared our first quarter 2021 regular monthly dividends of $0.205 per share payable in each of January, February and March, an amount that is unchanged from our monthly dividends for the fourth quarter.”

The company will likely not cover its dividend over the coming quarters partially due to lower dividend income from equity investments. However, management is expecting higher amounts over the next few quarters:

“These results reflect the continued negative impact of the pandemic on the overall economy, most specifically in the significant decrease in the amount of dividend income we realized from our equity investments and an increase in the number of investments on non-accrual status at quarter end. We remain confident that the decrease in dividend income is a temporary issue, partly due to the conservative approaches many of our portfolio companies are taking in managing their capital and liquidity in response to the pandemic. And we believe this dividend income will recover as the impacts of the pandemic subside.”

“Part of the reason we expect the dividend income to start recovering is that as we touched on our prior comments that the view that our management teams across the portfolio have about their current business conditions is significantly better today than it was couple of quarters ago. So they continue to get more comfortable, they will be more comfortable in paying out dividends as opposed to retain that as liquidity for their business. We don’t expect them to take all that liquidity that they have built over the last couple of months and pay it out in the fourth quarter, we think that they will continue to be gradual in their approach to utilizing their liquidity. So we don’t expect that it will be a one-time event, we think it will be something that will play out over the next three to four quarters as our results continue to improve and the economy overall heals and they continue to be more and more comfortable releasing some of that liquidity that they have retained over the last 6 months.”

 

 

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I am expecting dividend coverage to improve over the coming quarters due to:

• Increased dividend income from portfolio companies.
• Effective October 31, 2020, MAIN became the sole adviser/manager to HMS and the company will now receive 100% of all management and incentive fees.
• Lower non-accruals (increased interest income from restructured investments).
• Portfolio growth (increased interest income).

All of this was recently discussed on the earnings call with management and is taken into account with the updated base and best-case projections that I will be watching closely:

Q. “I am wondering if you could just further expand upon your comments in terms of the key drivers for improving foreseeing potential improving distributable net investment income over the near-term, just curious as to potentially what kind of assumptions are being built in?”

A. “So there is a couple of drivers there. One, obviously, is the transaction that we completed through which we became the sole advisor to HMS. So we have not had that prior to 9/30 really that relationship as we announced in our press release last week starts on October 30. So, that will be a driver both in Q4, with incremental income versus Q3, but also additional benefit in Q1 as we have that benefit for the full quarter as opposed to 2 months. So, that’s one of the drivers. I think, David touched on his comments and we have given him some of our responses here to the questions, dividend income from our lower middle-market companies will be another big driver. We do expect that, that benefit or that improvement to be gradual over multiple quarters, but we are seeing improvement there. So, we expect to see that number continue to increase both in Q4 and Q1 and going forward as we continue to move forward from where we have been over the last couple of quarters. The last big driver is just the new investment activity. As we touched on, we are seeing robust activity and very attractive opportunities both in our lower middle-market business and private loans. So as we see those new investments come on in Q4 and then Q1 as well, that incremental investment income that comes from those investments will also be a key driver of that improvement.”

“Based upon the positive developments we have seen in our existing portfolio companies, coupled with the future benefits of the growth in our asset management business and the attractive new investment opportunities we are seeing in our lower middle-market and private loan strategies, we are confident that the third quarter represented the low point for our distributable net investment income, or DNII and we expect to see increases in our DNII in the fourth quarter and future quarters.”

“As we look forward to the fourth quarter, we expect that we will generate distributable net investment income of $0.53 to $0.56 per share as our results begin to recover from the impacts of the pandemic and set us on a pace and expectation to cover our monthly dividend rate with distributable net investment income over the next few quarters.”

Effective October 31, 2020, MAIN became the sole investment adviser and administrator to HMS Income Fund (“HMS”), and HMS Income changed its name to MSC Income Fund, Inc. The new advisory agreement includes a 1.75% management fee (reduced from 2.00%) and the same incentive fee calculations as under the prior advisory agreement, with the External Investment Manager receiving 100% of such fee income (increased from 50% previously).

“We are also very pleased with our recent announcement of the completion of the transaction under which we became the sole investment adviser to HMS Income Fund, which is now known as MSC Income Fund. We are excited about positioning the fund for the future, while also continuing to execute our overall strategy to grow our asset management business within our internally managed BDC structure and continuing to provide this unique benefit to our Main Street stakeholders.”

Over the last 12 months, its DNII per share has fallen by 24% mostly due to declining rates and portfolio yield, and lower dividend income. DNII was only $0.50 per share for Q3 2020 compared to dividends paid of $0.615.

 

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If MAIN reports closer to its ‘worst-case’ Q4 2020 projections, the company will be downgraded as there is a chance that its conservative management will follow suit with GBDC and proactively reduce its monthly dividend (to over earn the dividend).

 

 

Previously, the semi-annual/supplemental dividends were covered through overearning the regular dividend and realized capital gains. However, as predicted in previous reports, the company suspended its semi-annual/supplemental dividend until dividend coverage improves. Historically, MAIN had better-than-average dividend coverage due to its many advantages over other BDCs, including the lower cost of capital and the lowest operational cost structure. Also, MAIN has an excellent history of portfolio credit quality that delivers a consistent stream of recurring interest income, the potential for increased earnings through its asset management business, the ability to use higher leverage through its SBIC licenses and management with conservative dividend policy.

“Since its October 2007 initial public offering, Main Street has periodically increased the amount of its regular monthly dividends paid per share and has never reduced its regular monthly dividend amount per share. Including all dividends declared to date, Main Street will have paid $30.22 per share in cumulative cash dividends since its October 2007 initial public offering at $15.00 per share.”

For Q3 2020, MAIN hit its base case projections with NII per share of $0.46. As mentioned earlier, distributable net investment income (“DNII”) was only $0.50 per share compared to its regular dividends of $0.615 implying 81% coverage (with DNII). The lower dividend coverage is due to lower interest rates (LIBOR) driving a lower portfolio yield as well as a meaningful decrease in dividend income from equity investments:

“Our total investment income in the third quarter decreased over the same period in 2018 to a total of $52 million primarily driven by a decrease in the dividend income due to the negative impacts from the COVID pandemic and a decrease in interest income, primarily due to lower LIBOR rates. The change in total investment income also includes a decrease of $1.3 million related to lower levels of accelerated income for certain debt investments when compared to the third quarter of last year.”

“The $8.1 million decrease in total investment income in the third quarter of 2020 from the comparable period of the prior year was principally attributable to a $4.4 million decrease in dividend income from investment portfolio equity investments, primarily resulting from the negative impacts of the COVID-19 pandemic on certain of our portfolio companies’ operating results, financial condition and liquidity and a $4.1 million decrease in interest income, which was primarily due to lower floating interest rates on investment portfolio debt investments, based upon the decline in the London Interbank Offered Rate (“LIBOR”).”

 

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MAIN Risk Profile Update

Non-accrual investments increased due to adding Independent Pet Partners, Central Security Group, and California Pizza Kitchen. Bluestem Brands and VIP Cinema were previously marked down and exited during Q3 2020. As of September 30, 2020, there were 12 investments on non-accrual status (previously 11 investments) that increased to 2.6% of the total investment portfolio at fair value (previously 1.8%) and 7.1% at cost (previously 6.3%). However, management (as well as myself) is expecting fewer non-accrual investments for Q4 2020 some of which will be restructured and put back on accrual status. MAIN has 193 portfolio companies so a certain amount on non-accrual is to be expected.

“Our current expectation is that we will reduce the number of investments on non-accrual status by 3 to 4 investments during the fourth quarter as we continue to proactively work through these non-accrual investments with management teams and financial sponsors of these companies. We do expect to have, a number of those non-accruals that we work through and would expect to see that number of decrease as we move into the fourth quarter. The negative impact of COVID-19 began to lessen and visibility improved for our portfolio of companies. As a result, we saw the general environment for our existing portfolio companies stabilized as compared to earlier this year.”

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Datacom, LLC a provider of communication and data transfer technology solutions to the oil & gas exploration and production and marine industries, was added to non-accrual status during Q2 2018 and needs to be watched as the debt portions are still marked over 80% of cost. But there is a good chance that this will be one of the companies placed back on accrual status.

It is important to note that MAIN has additional investments in some of its non-accrual portfolio companies that are still on accrual and need to be watched including California Pizza Kitchen, AAC Holdings, and Independent Pet Partners:

 

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Similar to Capital Southwest (CSWC), MAIN added American Addiction Centers or AAC Holdings, Inc. (AAC) to non-accrual status during Q3 2019 and has been discussed in previous reports. In June 2020, AAC filed for bankruptcy and its lenders agreed to provide the company with $62.5 million of incremental financing aimed at reducing the company’s debt and providing financial stability for long-term growth.

Its non-accrual oil/energy investments in Rocaceia, LLC (Quality Lease and Rental Holdings) previously filed for bankruptcy but has already been written off with no further impact to NAV. During Q1 2018, Access Media Holdings, a private cable operator, was placed on non-accrual status with the equity portion written off, and the debt is marked at 17% of cost which was previously converted to “payment-in-kind” (“PIK”) income and the accrued portions were deducted from Q1 2018.

American Teleconferencing Services, Ltd. (“ATS”) is an investment also held by CSWC, PFLT and SUNS that operates as a subsidiary of Premiere Global Services (“PGi”), offering conference call and group communication services. This investment remains on accrual status marked at 70% of cost (likely has improved over the recent quarter) and previously rated by Moodys as Caa2: “characterized by fundamental challenges from the high rates of decline in its legacy audio conferencing business as a result of competition from cloud-based communications and collaboration offerings.”

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Full BDC Reports

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

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OCSL Distributions Update

As mentioned in the public article “Still Waiting For a Dividend Increase From Oaktree”, I have been expecting Oaktree Specialty Lending (OCSL) to increase its dividend for a while. In August 2020, the company announced an increase in the quarterly dividend from $0.090 to $0.105, and on November 19, 2020, the dividend was increased to $0.110 paid on December 31, 2020, to shareholders of record on December 15, 2020.

Armen Panossian, CEO and CIO: “Based on our consistent performance and our expectations for continued strong earnings, our board increased our quarterly dividend by 5% to $0.11 per share, the second consecutive quarter with a dividend increase. So we raised the dividend in the last two quarters and part of that was actually driven by COVID in terms of taking advantage of the investment environment COVID created to put more assets in the BDC at higher yields, which generated more income. So COVID actually was helpful in terms of the dividend for us, given the investment activity we did during that period. I think being conservative on the dividend with the view that increasing NAV is a good thing as well. So those are kind of all the things that we put into the equation as we speak to the Board and think about the dividend.”

 

On October 28, 2020, OCSL entered into an agreement to merge with OCSI and is expected to close in calendar Q1 2021. The combined company will trade under the ticker symbol “OCSL”. 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 (please see merger slides at the end) and is taken into account with the updated projections. As shown in the ‘best case’ projections, there is the possibility of additional increases in its quarterly dividend partially due to the merger with OCSI that is expected to close in Q1 2020:

“As you know, OCSL and Oaktree Strategic Income Corporation, entered into a merger agreement with OCSL to be the surviving company. We believe this merger represents a great opportunity for shareholders of both OCSL and OCSI. We expect it will create a larger, more scaled BDC with increased trading liquidity, potentially broaden our institutional shareholder base and may improve access to lower cost sources of debt. We also anticipate that it will drive NII accretion over both the near and long-term. We feel that now is the right time to move forward with this merger. Both portfolios are in great shape and our transition out of non-core assets that we’ve been working on since 2017 is nearly complete. In terms of the next steps, we anticipate filing the N-14 during proxy statements in the coming weeks and expect the transaction will close in the first calendar quarter of 2021, subject to shareholder approval and satisfaction of other closing conditions as outlined in the merger agreements.”

 

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I am also expecting improved earnings over the coming quarters through the use of higher leverage, continued rotation into higher yield investments, and higher returns from its Senior Loan Fund (“SLF JV I”):

“Leverage at the JV was 1.3 times at year-end, down slightly from the June quarter. The Kemper JV continues to present an opportunity for us to improve returns. As of year end, the JV had $82 million of investment capacity. We believe that the prudent growth of the JV will also be accretive to ROE over time.”

 

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OCSL’s incentive fee agreement includes a “hurdle rate” of 6% (relatively low and not shareholder-friendly) is applied to “net assets” to determine “pre-incentive fee net investment income” per share before management earns its income incentive fees. As shown in the following table, the company will likely earn around $0.097 per share each quarter before paying management incentive fees covering around 89% of the recently increased dividend which is ‘math’ driven by an annual hurdle rate of 6% on equity. It is important to note that OCSL could earn less than $0.097 per share but management would not be paid an incentive fee.

 

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For the three months ended September 30, 2020, OCSL beat its best-case projections due to “higher make-whole interest income, original issue discount (“OID”) acceleration, and prepayment fees” mostly related to the prepayment of NuStar Logistics.

“The increase was due mainly to higher interest income resulting from increased make-whole interest, OID acceleration and higher prepayment fees on loan payoffs. We also experienced a slightly higher average yield on our floating rate debt investments despite LIBOR being down again for the quarter. The higher make-whole interest and fee income quarter-over-quarter was mostly due to the prepayment of the NuStar loan, which generated over $8 million of nonrecurring interest income and fees.”

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There was another increase in the overall portfolio yield from 8.1% to 8.3%. OCSL has covered its dividend by an average of 129% with average earnings of around $0.127 per share over the last four quarters partially due to reduced borrowing rates.

“This deliberate shift in our portfolio has led to higher yielding investments. The average yield in our new debt investments increased over the course of the year and was 10.6% for investments made in the fourth quarter. This all occurred against the backdrop of decreasing interest rates with LIBOR declining by over 180 basis points in the same timeframe. Another major accomplishment in fiscal year 2020 was the further improvements we made to our capital structure, reducing funding costs and improving our finance and flexibility. In February, we successfully completed $300 million note offering that was attractively priced at a coupon of 3.5%. Part of the proceeds were used to redeem our higher coupon bonds, which had a blended interest rate of around 6%.”

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There was a slight decline in income generated from its Senior Loan Fund (“SLF JV I”) with $1.8 million during the recent quarter down from $2.0 the previous quarter likely due to lower leverage or the slight increase in non-accruals as shown below:

“Shifting now to the Kemper joint venture. As of September 30th, the JV had $313 million of assets invested in senior secured loans to 56 companies. This compared to $315 million of total assets invested in 53 companies last quarter. Assets were basically flat quarter-over-quarter as the increase in the market value of its investments was offset by payoffs and exits. Leverage at the JV was 1.3 times at year-end, down slightly from the June quarter. The Kemper JV continues to present an opportunity for us to improve returns. As of year end, the JV had $82 million of investment capacity. We believe that the prudent growth of the JV will also be accretive to ROE over time.”

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OCSL has growth capital available given its historically low leverage with a current debt-to-equity ratio of 0.78. As of September 30, 2020, OCSL had $39 million of cash and $285 million of undrawn capacity on its credit facility. In June 2019, shareholders approved the reduced asset coverage requirements allowing the company to double the maximum amount of leverage. The investment adviser reduced the base management fee to 1.0% on all assets financed using leverage above 1.0x debt-equity. Moody’s and Fitch have previously assigned OCSL investment-grade credit ratings (Moody’s, Baa3 / Stable, and Fitch, BBB- / Stable).

“Our net leverage ratio decreased to 0.74 times from 0.83 times at June 30th, reflecting both the increase in NAV at $38 million in net payoffs and exits. We are presently just below the low end of our leverage target range of 0.85 times to 1.0 times. So as we see things right now, the 0.85:1 seems like the right level, kind of works for all of our constituents. But that could change, I don’t think it will change tomorrow but that could change down the road if we see kind of a more interesting investment environment.”

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OCSL Risk Profile Update

Over the last three years, management has made meaningful progress shifting the portfolio from ‘non-core’ legacy assets that now account for around 9% (same as the previous quarter) of the portfolio fair value.

“We continued our portfolio repositioning during the year and successfully monetized $50 million of non-core investments, which resulted in aggregate proceeds of $59 million. At year-end, noncore investments represented only 9% of the portfolio.”

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Net asset value (“NAV”) per share increase by 6.5% mostly due to “unrealized gains resulting from price increases on liquid debt investments and the impact of tighter credit spreads on private debt investment valuations following the improvement in broader credit market conditions, realized gains on equity investments and undistributed net investment income.”

“Our NAV staged an impressive recovery from the decline in the March quarter when the markets concern over the impact of pandemic was at its peak. The rebound was $1.15 per share, recapturing 91% of the decline in that quarter. We had another strong year of origination. During the year, we originated over $800 million of new investments, representing over half of the value of our portfolio at the start of the year. Notably, a large portion of our originations occurred during the post-COVID period. Following the market disruption last March, valuations continue to improve in the September quarter, resulting in a NAV increase of 6% from the June quarter to $915 million, reflecting price recovery in our liquid debt investments and tighter credit spreads. In addition, our investments in the Kemper joint venture were written up by $7 million or 7%, reflecting continued appreciation in this mostly first lien loan portfolio.”

NAV remains 1.7% lower from $6.61 as of December 31, 2019 primarily due to:

“depreciation of certain debt and equity investments related to increased market volatility resulting from the onset of the COVID-19 pandemic in March 2020, partially offset by undistributed net investment income.”

California Pizza Kitchen and PLATO Learning remain on non-accrual status but were previously written down and only account for 0.1% of the portfolio fair value:

“Our credit quality remains strong, with only 2 out of our 113 portfolio companies on nonaccrual status, representing one-tenth of 1% of the total portfolio at fair value. During the quarter, all of our portfolio companies made their scheduled interest payments with the exception of one company that, consistent with prior quarters, made its interest payments in kind.”

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A few of the ‘watch list’ investments (Zep Inc., Dominion Diagnostics, and William Morris Endeavor Entertainment) were discussed on the recent call:

“Zep is a cleaning materials company. It did have some execution issues over the pre-COVID that resulted in the company looking more levered as a result of EBITDA declines. People are cleaning more and sanitation products are doing better as is Zep. Now it remains levered and that’s why we have it marked the way we do. But the leverage is, at least post COVID, heading in the right direction, as in down. But we don’t feel comfortable marking it more aggressively, because we do still think that the company is more levered than we would like it to be and that’s the reason why Zep is where it is.”

“Dominion is a little bit of a different issue, it’s a diagnostics laboratory company. They are modestly helped by the coronavirus but there’s some puts and takes, because although there is more work being done around coronavirus and the company certainly benefits from that, there is a decline in elective surgeries, elective cases, going to the doctor for a checkup, et cetera, because of coronavirus as well. So there are puts and takes on that business. There’s some countervailing pressures as well. And as you know, we’re going to be fair and err on the side of conservatism generally in the way we mark things. And we’d like to be proven wrong if and when it’s appropriate that the company’s performance necessitate a markup, but we don’t want to be ahead of that curve.”

“William Morris, as you’re familiar with, is a leading entertainment management and media rights company. You’re right that directionally, with vaccine news and live events starting to come back, NBA in a bubble, baseball, et cetera, that’s generally a good thing for William Morris. And our loan has nice call protection, has a pretty rich coupon relative to the pari passu, LIBOR plus $2.75 first lien term loan that the company has. And that term loan is something that could be observed in terms of trading prices in the market. And it’s moved up nicely. I think that’s all I would say about William Morris. I would hesitate to drive forward guidance, because we also think that COVID cases are going to spike, so there’s going to be some choppiness in the next few quarters. But the company has taken out some cost and is managing very well in terms of its liquidity needs for the foreseeable future.”

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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.