May 24,2012: We wrote an article about Apollo Investment (ticker: AINV) on April 2nd, and discussed the decision by it’s parent to invest $50mn in equity in the Company. Frankly, we felt that the outlook, for what is one of the largest and oldest BDCs, was still opaque and that the $50mn equity contribution from the parent a very modest vote of confidence. Yesterday, Apollo announced its FY 2012 results and in the Conference Call that followed delineated some of the new direction promised for a couple of quarters. We had re-printed our article in Seeking Alpha, and a reader wrote to us today summarizing some of the new developments at Apollo with the comment: :”The picture is certainly clearing up at AINV”.
This spurred us to a long response on the comments page of Seeking Alpha which we are re-posting here for the few, the proud, the brave readers of The BDC Reporter. As you will quickly determine, although Apollo’s stock price has jumped up on the news, we continue to believe there are more than a normal number of unanswered questions about Apollo Investment’s strategy, earnings, prospects and credit risk going forward. An investment therein may not be a “shot in the dark” as we famously said previously, but key questions remain.
Here is what we wrote:
“The picture is certainly clearing up at AINV, but several key uncertainties remain which we highlight below. Still, we’re delighted to see that the company has a new CEO and a new CFO on the way.
[We note that the new CFO comes out of the Apollo Global Management organization. At a time when ARCC is trying to think outside the box that's not a great leap forward but we get that the Company could not afford to take too long to find a CFO after the last announced candidate withdrew at the last minute].
We also note that the Company has reaffirmed that no new equity raise, except its own subsidized $50mn equity investment, is envisaged, which removes some disquiet in the market.
BORROWING FROM PETER TO GIVE COLLATERAL TO PAUL
The new Revolver, with lower pricing, is very good news, as it reduces AINV’s cost of capital at a time when that will be a major issue going forward (read on). Note, though, that the lenders did tighten up on the advance rates, so there was some horse trading involved. Like many BDCs, Apollo has been able to get rock bottom pricing from its lenders by pledging its most liquid loan assets to the Revolver lenders (reducing their risk) while raising unsecured debt which has no direct collateral and very loose covenants. This creates a two tier debt capital structure, and it’s working so far. Reading between the lines of the Conference Call, it seems like the borrowing base on the Revolver is about equal to the facility amount or $1.1bn, which leaves a huge amount of availability. On the other hand, if AINV had not been able to raise unsecured debt earlier, net availability under the Revolver alone would be minimal as total debt outstanding at March 31 was $1.0bn. Anyway, that metric was helped in the quarter by Apollo shrinking its balance sheet. As the CEO said: “We methodically sold select investments, reduced leverage and redeployed capital into other strategies which we believe have more attractive risk adjusted returns”.
WE CAN (SEMI) CLEARLY NOW
So far, so good. Moreover, we’ve gotten a glimpse of what the new strategy will look like. First of all, Apollo wants to reduce the proportion of subordinated debt investments to very large private companies in its portfolio. Instead AINV wants to move up the balance sheet to make senior loans, which are seen as less volatile and obviously less risky. Changing course is crucial because sticking with what Apollo has been doing reduces NAV by an average of 5% a year.
It may seem churlish to point out but Apollo’s credit history has been abysmal. Realized and Unrealized Losses in its 8 year history amount to 40% of all capital raised. In the FY 2012 just ending Realized Losses were $341mn, 2x the Net Investment Income Earned and the two years before that not materially better. Both as a lender and an equity investor AINV has mostly gotten it wrong.
[Yet in FY 2012 the Company received $100mn in management/incentive fees even as NAV dropped by $1.48 a share or $276mn. But that's another story ].
WE ARE NOT YET CONVINCED
The question now is whether new management/new strategy/new financing/new $50mn invested from parent can result in better credit results and a more stable NAV ? That remains to be seen for 3 reasons:
1. AINV will continue to be a subordinated lender in the ill fated upper mid-market. Here’s a quote from the Q&A:
“We foresee it [subordinated debt] over the next 24 to 36 months… going from 85% of our portfolio to approximately around half of our portfolio.”
That means AINV will continue to make new loans in this sector going forward. If past is prologue remains to be seen, but we’re pessimistic about the risk-return in this segment. The loans may be relatively liquid due to their size but are at risk of major write-offs when the economy turns.
2. The existing portfolio of loans is not clean yet. The portfolio still has $170mn of Unrealized Depreciation, which means the portfolio three years after the end of the Great Recession, is valued at 94% of cost despite a host of huge write-offs and refinancings. We looked at the marks on individual names and found that 10-15% of the portfolio qualifies for our Watch List even though on paper Apollo has only 1 non-accruing borrower (ATI).
3. Management is caught in the trap of wanting to maintain earnings while decreasing risk. You can see this in the new, much touted Madison Capital transaction. Here is an extract from the Conference Call:
“Greg Mason – Stifel, Nicolaus & Co., Inc., Research Division
Could you talk a little bit more about the Madison agreement? You put in $40 million of $250 million of assets. That kind of feels like a $210 million of leverage above you, a 5x leverage vehicle that seems a bit high. Could you walk us through a little bit of that structure? And then what your expectations are for your yield on your $40 million investment there?
Elizabeth Besen-Apollo
I mean, I think you have the map right on the leverage. I don’t know that it would be high when you think about it in the context of middle-market, CLO equity to make the — a comparison point. I think the other — we’re fairly transparent about targeting mid-teen returns on our equity investment.”
Yes, the capital invested will go into senior (even asset based) loans to smaller sized middle market companies (essentially the opposite of what Apollo has done to date). However, AINV , to get the mid-teens return they need, has structured this investment in the form of equity in the Madison vehicle. That means Apollo will bear the first loss risk of any bad debts made by a vehicle controlled by a third party (again another issue that rankles). We probably won’t know till the next recession if that structure provides an adequate risk-return. It’s an “outside the box” segment for Apollo to invest in (neither Ares nor Solar Capital has ventured there), but the structure is reminiscent of what Ares is doing with GE Capital in a joint venture.
“HOUSTON: WE HAVE A NEW LENDER”
AINV is also aiming to enter the energy market, which is sector it’s parent has become interested in. That’s a trend for most of the big private equity houses. KKR is a major player in this area, so this might be a copycat strategy. However, we don’t know much how these new energy loans will be structured and to whom and with what risks and rewards. We do know from the Conference Call, though, that initial forays are being made into the energy market and that AINV is ultimately targeting “other investments” (which includes energy to be 10% of the portfolio or about $250mn from zero recently. Here’s a brief quote from the CC:
“In fact, our recent established energy team in Houston has made 2 energy investments subsequent to quarter end.”
We like the ambition but it’s also true that until recently PE groups kept away from energy because of the specialized knowledge required to be successful and its wildly cyclical qualities. Prospect Capital started out as an energy lender and almost lost its shirt at first and NGP Capital has taken major hits and is re-branding itself as a general lender. Success is not guaranteed even after we find out what Apollo is going to do in this area.
CANNOT HAVE CAKE AND EAT IT TOO
Over the long term all that matters is the direction of earnings and Net Asset Value. Management says they have NOI targets but we do not know what they are. However, common sense tells us that to reduce higher coupon paying subordinated debt and replacing it with less volatile, senior debt will ultimately cause a drop in yields, everything else being equal. This last quarter new assets added paid higher yields than loans paid off and management indicates there are $1bn off lower yielding assets yet to circulate out. However this can only provide a short term benefit. If Apollo really wants to improve credit quality and move up the balance sheet of borrowers earnings will have to suffer. That would be a wonderful trade-off if properly executed.
Our concern is that AINV will just shift the risk it is taking into new areas with structures like the Madison Capital transaction and potentially risky energy deals by seeking to maintain yield. We would have been more impressed to see AINV make direct senior secured loans to middle market borrowers at sub-10% yields than create a CLO like equity investment with 5x built-in leverage.
SIT,WAIT,WATCH
Given that 2 years from now Apollo’s portfolio will be 50% or more different than it is today, both in terms of borrowers and market segments and the team of people finding and managing the loans we’d be rather safe than sorry and keep on gathering better insights into the new model. We’d surmise that, in any case, there is little risk of a major uptick in earnings or in NAV in the rest of 2012. The equity investments left on AINV’s books do not seem to offer much upside potential and it’s unlikely that much of the Unrealized Depreciation will reverse course. With debt to equity already high the Company won’t be able to deploy much of its inexpensive Revolver into new assets, so we expect earnings per share to range within a narrow band of $0.20-$0.23 quarterly. Bad debts are anyone’s guess.
How do you think the Madison structure (in terms of risk/reward) compares to the GE JV structure ARCC has and with the CLOs that TICC and KCAP have? Personally, I don’t care for the approach, in light of what happened to the equity tranches of CLOs investing in supposedly safe assets (e.g., private label mortgages and senior buyout loans) after 2007.
I hope someone is paying you for your work. I have followed the sector since the late 1990s and your stuff is among the best I have seen.
Thanks for the questions/kind comments. My partner and I run a hedge fund that invests in BDCs and leveraged debt so I guess my investors are compensating me (which we greatly appreciate). Use the BDC Reporter as a useful way to transmit some of the research we do every day to anyone out there interested, but without getting into Buy this /Sell that.
As for your question, on Madison versus GE JV: Interestingly on the reward size, the return is about the same: 13-17% current yield. This suggests that the risk may be equivalent (that’s a pretty efficient risk pricing machine out there). The type of companies being lent to by the two vehicles are very different with Ares and GE lending to very large private companies at the senior level (but unlikely to be fully secured with receivables, inventory and fixed assets). The credit argument is,probably, that these larger companies default less often than smaller companies because they have greater resources, deeper management teams, multiple business lines etc. It’s hard to evaluate without more disclosure, which is one of the weaknesses of this approach by Ares from an investor’;s perspective. We’d imagine that Ares is assuming write-offs will run -over the long term- at 2% a year on average or lower. On $5bn of loan assets that’s a write off of $100mn versus annual income of $180mn. To date there have been no non-performers and no losses. No wonder both GE and Ares have doubled down. However, we believe that bad debts are inevitable and that in the next Recession Ares will have to pay the piper. If losses are modest it will have all been worthwhile. However, if write-offs amount to 10% or more of loans outstanding (or $500mn or 45% of capital invested or three years worth of income) this will have been a mistake.
As to the Madison Capital structure: Apollo is investing in asset based loans to middle market companies. Without any supporting info I seriously doubt all the loans are fully secured with easily liquidatable assets because such Asset Based Loans are being made by banks and finance companies at very aggressive rates. I’d guess there is some element of collateral and an “overadvance”, which means that in liquidation the lender may not recover all the loan. In a Recession these types of borrowers should default more frequently than the large cap borrowers Ares lends to, but the collateral should mitigate the amount of losses as will the diversification of a pool of loans (the Ares JV is much more concentrated with just 33 lenders. One bad apple is 3.3%. As the song goes: the bigger they are, the harder they fall.
Still, I’d guess net losses taken over time should end up the same. The biggest difference between the two facilities is that in the JV Ares and GE are working as partners (with Ares presumably as the lead partner). In the Apollo facility, Madison Capital Funding is doing the heavy lifting, with Apollo serving as a more passive equity investor (as far as we can tell).
Only time will tell if either or both these structures will be successful. We can say with certainty that avoiding losses during an economic expansion is by itself no guarantee that this will not end badly, but it’s a good start. However, investors need to recognize that the equity/JV vehicle means transparency is at a minimum and by the time word gets out that losses are mounting it may be too late to act. When loans are held directly by the BDC,rather than through an opaque subsidiary, there is a certain degree of greater transparency.
Hope that’s useful. I’ll be delving more into both structures in the months ahead.