April 26, 2011: Earnings season is coming up for the bulk of BDC companies. The BDC Reporter is usually not concerned about projecting every quarter’s earnings for every company in this ever-widening circle of BDC participants. There are numerous highly competent firms in that business already, covering virtually every participant. Moreover, as every commentator will tell you, it’s not a good idea to take any one quarter’s earnings too seriously (either up or down) as a number of factors can cause temporary blips which even out over time.
“ALL THE ABOVE NOTWITHSTANDING”
Nonetheless, we’re going to comment on what we think may be the short term direction of earnings (no, it’s not good news) in the short term for the five larger BDCs which operate in what we’ll call the upper middle market segment of the market. These are the largest companies in the sector with market capitalization of $0.7bn and above, and include some of the best known names to investors: American Capital, Apollo Investment, Ares Capital, Solar Capital and BlackRock Kelso. (We’re not including Fifth Street Finance, which is equal in market capitalization with the Famous Five, but which appears to lend to a different universe of borrowers, and which is performing differently).
IQ 2011 EARNINGS OUTLOOK: POOR ?
We reviewed the Analyst consensus for the five companies under discussion, and came to the conclusion that earnings expectations are already muted amongst the professionals. 4 of the 5 companies (AINV, ARCC, SLRC and BKCC) current IQ 2011 estimates are lower than what was projected by this same group of analysts 90 days ago. Mostly the reduced expectations are minor (just 1 cent down), with the exception of BKCC where 90 days ago the Consensus was $0.31 and is now $0.25. (That’s reflected in BKCC’s price, which has dropped substantially in recent weeks).
Projected IQ earnings when compared to last quarter actual numbers are more mixed, with AINV and ARCC expected to be unchanged, SLRC and BKCC expected to increase and ACAS to drop (just 1 cent).
We’d like to stick our neck out and suggest that for this particular group of BDCs earnings for the next couple of quarters could be a lower than what the Consensus is showing. We’re going to avoid specific earnings numbers for each company but we wouldn’t be surprised if the results come in materially below. We’re going to tell you why we think so in general terms, and why it might be important for existing and prospective shareholders.
REASONS FOR BEING A GLOOMY GUTS
Reason Number One, and in one word: refinancing. In the upper middle market there has been a refinancing party going on for several quarters and the first quarter of 2011 is unlikely to have been any different. Any well performing company with expensive debt has been a candidate for a refi, and many have taken the opportunity. The result is that the Famous Five have seen record number of deals coming off their books.
On the other hand, the market for upper middle market buy-outs has yet to get going in a big way. As a result, there have been relatively few new deals being done. In fact, from an anecdotal reading of the press releases much of the new loan activity in this sector has been recapitalizations, and not so many traditional buy-outs where a private equity group buys a private company from its owner (even if that owner is another private equity group).
The upshot is that these larger BDCs, primed with plenty of capital to spend from equity offerings, long term debt issuance and increased Revolvers (often at lowered pricing), have often been unable to grow net investment assets.
Or put another way there’s a lot of running in place. That’s resulted in plenty of fees in some cases from new loans and from prepayments of existing loans, but total investment assets that have gone nowhere over the last 12 months. We compared the investment portfolios of the Famous Five at year end 2009 and 2010 and found that 3 (ACAS, AINV and BKCC) had lower assets in 2010 than a year earlier, 1 was flat (SLRC) and only 1 was up (ARCC). Even Ares was only marginally bulkier when the Allied Capital purchase is stripped away. In the fourth quarter of 2010 the Company booked $487mn in new commitments, but repayments were $424mn. In the subsequent period to February 25,2011 Ares admitted repayments outstripped new fundings by $242mn, bringing aggregate total investment assets below the 2010 year end number. (Since we wrote that last sentence, Ares announced $537mn in new financing transactions in the Senior Secured Loan Program, which is their JV with GE Capital).
The Ares news notwithstanding, we get the impression new loan activity is muted this quarter (which is not unusual), while refis continue apace. The likely result: lower net investment assets and lower recurring interest income.
A second drag on earnings is likely to be (and this is deliciously ironic as we’ll explain) higher management fees. True, the Famous Five may not be adding investment assets at cost but the fair market value of the portfolios have been increasing. As management fees are based on these fair market assets mostly, base management fees should grow even as interest income flattens or drops.
Finally, these top flight BDCs have been busy (and rightfully so) raising medium and long term debt financing at the expense of short-term Revolving lines of credit. However, this will result in higher average cost of capital in the short term. Or put another way: a higher interest expense bill. Down the road these BDCs expect interest rates to increase and their gross income with it, but that’s a way off. In the interim all we get is higher operating expenses and lower earnings.
IMPLICATIONS
Should we be right (and we’re not certain by any means) and earnings “disappoint”, it will be interesting to see how the market reacts. A complicating factor is that 3 of these BDCS have been paying out a dividend well above their current earnings rate. BKCC is paying out 32 cents a quarter, but the Consensus for the IQ of 2011 is 25 cents. SLRC is paying out 60 cents a quarter, but only earned 51 cents in the fourth quarter of 2010. AINV has a 32 cents a quarter dividend, but earnings are 6 cents lower.
Below forecast earnings for some or all the Famous Five might cause the market to become concerned about the sustainability of the dividend in the future. The writing is already on the wall in some ways. Looking forward into 2012, the Consensus earnings for AINV and BKCC are still both below the current dividend level. SLRC’s situation is a little more positive, with earnings projected to cover the current dividend before the end of fiscal 2012, but with several quarters of shortfall still ahead.
ACAS is a different kettle of fish because the company does not currently pay a dividend. Nonetheless, if the factors we’ve been worrying about slow-down American Capital’s earnings, and appear to delay even further a return to dividend paying status, the market (which has been bidding up it’s stock in recent months but still at a level below NAV) may become concerned.
Less at risk from a growing gap between earnings and dividends is Ares Capital, which has been managing its dividend policy very conservatively. The company has kept its payout very close to its historical earnings performance. Moreover the Consensus is that earnings will outstrip the dividend in 2011. Nonetheless, ARCC’s stock price has remained at an elevated level, substantially above NAV, for many months. Even Ares is susceptible to it’s stock price being marked down should actual results not meet the high expectations that the market seems to have for the company.
It’s going to be an interesting next few weeks.
WE ARE LONG ACAS,ARCC,AINV,BKCC AND SLRC
Implications for Biggest BDCs If Earnings Disappoint
April 26, 2011: Earnings season is coming up for the bulk of BDC companies. The BDC Reporter is usually not concerned about projecting every quarter’s earnings for every company in this ever-widening circle of BDC participants. There are numerous highly competent firms in that business already, covering virtually every participant. Moreover, as every commentator will tell you, it’s not a good idea to take any one quarter’s earnings too seriously (either up or down) as a number of factors can cause temporary blips which even out over time.
“ALL THE ABOVE NOTWITHSTANDING”
Nonetheless, we’re going to comment on what we think may be the short term direction of earnings (no, it’s not good news) in the short term for the five larger BDCs which operate in what we’ll call the upper middle market segment of the market. These are the largest companies in the sector with market capitalization of $0.7bn and above, and include some of the best known names to investors: American Capital, Apollo Investment, Ares Capital, Solar Capital and BlackRock Kelso. (We’re not including Fifth Street Finance, which is equal in market capitalization with the Famous Five, but which appears to lend to a different universe of borrowers, and which is performing differently).
IQ 2011 EARNINGS OUTLOOK: POOR ?
We reviewed the Analyst consensus for the five companies under discussion, and came to the conclusion that earnings expectations are already muted amongst the professionals. 4 of the 5 companies (AINV, ARCC, SLRC and BKCC) current IQ 2011 estimates are lower than what was projected by this same group of analysts 90 days ago. Mostly the reduced expectations are minor (just 1 cent down), with the exception of BKCC where 90 days ago the Consensus was $0.31 and is now $0.25. (That’s reflected in BKCC’s price, which has dropped substantially in recent weeks).
Projected IQ earnings when compared to last quarter actual numbers are more mixed, with AINV and ARCC expected to be unchanged, SLRC and BKCC expected to increase and ACAS to drop (just 1 cent).
We’d like to stick our neck out and suggest that for this particular group of BDCs earnings for the next couple of quarters could be a lower than what the Consensus is showing. We’re going to avoid specific earnings numbers for each company but we wouldn’t be surprised if the results come in materially below. We’re going to tell you why we think so in general terms, and why it might be important for existing and prospective shareholders.
REASONS FOR BEING A GLOOMY GUTS
Reason Number One, and in one word: refinancing. In the upper middle market there has been a refinancing party going on for several quarters and the first quarter of 2011 is unlikely to have been any different. Any well performing company with expensive debt has been a candidate for a refi, and many have taken the opportunity. The result is that the Famous Five have seen record number of deals coming off their books.
On the other hand, the market for upper middle market buy-outs has yet to get going in a big way. As a result, there have been relatively few new deals being done. In fact, from an anecdotal reading of the press releases much of the new loan activity in this sector has been recapitalizations, and not so many traditional buy-outs where a private equity group buys a private company from its owner (even if that owner is another private equity group).
The upshot is that these larger BDCs, primed with plenty of capital to spend from equity offerings, long term debt issuance and increased Revolvers (often at lowered pricing), have often been unable to grow net investment assets.
Or put another way there’s a lot of running in place. That’s resulted in plenty of fees in some cases from new loans and from prepayments of existing loans, but total investment assets that have gone nowhere over the last 12 months. We compared the investment portfolios of the Famous Five at year end 2009 and 2010 and found that 3 (ACAS, AINV and BKCC) had lower assets in 2010 than a year earlier, 1 was flat (SLRC) and only 1 was up (ARCC). Even Ares was only marginally bulkier when the Allied Capital purchase is stripped away. In the fourth quarter of 2010 the Company booked $487mn in new commitments, but repayments were $424mn. In the subsequent period to February 25,2011 Ares admitted repayments outstripped new fundings by $242mn, bringing aggregate total investment assets below the 2010 year end number. (Since we wrote that last sentence, Ares announced $537mn in new financing transactions in the Senior Secured Loan Program, which is their JV with GE Capital).
The Ares news notwithstanding, we get the impression new loan activity is muted this quarter (which is not unusual), while refis continue apace. The likely result: lower net investment assets and lower recurring interest income.
A second drag on earnings is likely to be (and this is deliciously ironic as we’ll explain) higher management fees. True, the Famous Five may not be adding investment assets at cost but the fair market value of the portfolios have been increasing. As management fees are based on these fair market assets mostly, base management fees should grow even as interest income flattens or drops.
Finally, these top flight BDCs have been busy (and rightfully so) raising medium and long term debt financing at the expense of short-term Revolving lines of credit. However, this will result in higher average cost of capital in the short term. Or put another way: a higher interest expense bill. Down the road these BDCs expect interest rates to increase and their gross income with it, but that’s a way off. In the interim all we get is higher operating expenses and lower earnings.
IMPLICATIONS
Should we be right (and we’re not certain by any means) and earnings “disappoint”, it will be interesting to see how the market reacts. A complicating factor is that 3 of these BDCS have been paying out a dividend well above their current earnings rate. BKCC is paying out 32 cents a quarter, but the Consensus for the IQ of 2011 is 25 cents. SLRC is paying out 60 cents a quarter, but only earned 51 cents in the fourth quarter of 2010. AINV has a 32 cents a quarter dividend, but earnings are 6 cents lower.
Below forecast earnings for some or all the Famous Five might cause the market to become concerned about the sustainability of the dividend in the future. The writing is already on the wall in some ways. Looking forward into 2012, the Consensus earnings for AINV and BKCC are still both below the current dividend level. SLRC’s situation is a little more positive, with earnings projected to cover the current dividend before the end of fiscal 2012, but with several quarters of shortfall still ahead.
ACAS is a different kettle of fish because the company does not currently pay a dividend. Nonetheless, if the factors we’ve been worrying about slow-down American Capital’s earnings, and appear to delay even further a return to dividend paying status, the market (which has been bidding up it’s stock in recent months but still at a level below NAV) may become concerned.
Less at risk from a growing gap between earnings and dividends is Ares Capital, which has been managing its dividend policy very conservatively. The company has kept its payout very close to its historical earnings performance. Moreover the Consensus is that earnings will outstrip the dividend in 2011. Nonetheless, ARCC’s stock price has remained at an elevated level, substantially above NAV, for many months. Even Ares is susceptible to it’s stock price being marked down should actual results not meet the high expectations that the market seems to have for the company.
It’s going to be an interesting next few weeks.
WE ARE LONG ACAS,ARCC,AINV,BKCC AND SLRC