July 2, 2012: Today BDC Reporter is introducing a new feature: Brief articles about possible “investment ideas” in the Business Development Company space. These are suggestions for investments, drawn from our 24/7 coverage of the sector. We will tell you about the prospective upside, highlight the downsides (there are always downsides) and we’ll circle back regularly to see how these ideas have panned out.
Hercules Technology-Stock Or Debt ?: We start our series with Hercules Technology (HTGC). Those of you who read our Tweet feed will know that the company has recently issued a second round of Senior Secured Notes, due in 2019, and with a coupon of 7.0%. The ticker for the Notes is HTGZ. The common stock had been a big run-up concurrently with the drum beating about the Facebook IPO (presumably because HTGC had a small position in Facebook stock), and peaked at $11.50 May 7th. That was a 21% increase from a low of $9.53 in December 2011. The stock dropped to $10.21 by May 18th, but has been on the ascendant since. At time of writing the stock is at $11.57, a 10.2x multiple of 2013 consensus earnings, and 1% off its 52 week high. The yield is 8.3%. Certainly the stock is not cheap at these levels. We are neutral on the stock, but we do tend to be reluctant to jump on stock band wagons (HTGC is up 13% in six weeks) , and have missed perfectly good rallies in the past.
Debt : For cautious investors, the Hercules Senior Secured Notes might be worth a look. To explain why that might be the case we have to go the long way around because we have generally been very cautious about the numerous BDC unsecured Note issues which have come to market in recent months (and which show no signs of abating). Besides being unsecured, these Notes typically has very few covenant protections. To be brutally honest, there are no meaningful covenant protections.
Structural Subordination: The worst of it, though, is that the so-called Senior Notes are structurally subordinated to all the secured debt the borrower enjoys with it’s bank lenders, and any subsidiary entities which have borrowing facilities. This does not make much of a difference at the current time when BDCs are doing well, bad debts are low and cash flow is sufficient to pay interest on the Revolver, the Notes and a handsome dividend to shareholders. However, these Notes are usually 5-7 years in length, virtually guaranteeing that the borrowers will face at least one more recession during their term. The Great Recession showed that BDCs can go from having no bad debts during good times to seeing 20-40% of their investments getting into trouble.
Do We Have A Problem Here ?: OK, you might say, but BDCs, thanks to their peculiar structure, are not highly leveraged, even when secured and unsecured debt is added together. Investment Assets at their lowest permitted level are a minimum 200% of debt. Or, in other words, a BDC would have to write-off 50% of its assets before debt holders would be in the firing line for losses. On paper, that’s true, but that is not the risk we are most concerned about. Let’s assume a Recession occurs (like death and taxes), chances are the senior secured Revolving loans will go into default. Unlike the Notes, the banks which provide senior secured debt have covenants in their loan agreements. Many covenants. Even if a BDC manages to avoid defaulting under the standard 200% asset coverage test, there are fixed charge covenants, maximum write-off covenants, diversification covenants etc. If a default occurs, and in the general atmosphere of fear and concern about the future that any recession brings on, the banks will require the BDC borrowers to repay any outstandings either on very short notice (under the age old lending theory that things are only going to get worse and that the banks are not being paid to take those kind of risks-which is essentially true), or to amortize down the loan over a longer period. In the latter case, all loan repayments received by the BDC from its portfolio companies (including interest in some cases) is applied to the repayment of the senior secured lender.
For a “Senior Note” holder, that’s when being “structurally subordinated” starts to mean something. Now the bank lenders are calling the tune, and they may or may not allow the BDC to distribute sufficient cash flow to pay the operating expenses of the BDC, the dividends owed to shareholders and the interest owed to the Note Holders. Usually in the past the bank lenders have realized that operating expenses have to be paid to keep a BDC functioning, while they are getting out. As to dividends, the historic experience has been more mixed. What we don’t know, but we can be pretty sure of, is that the senior secured lenders will want to ensure the Note Holders don’t receive any interest payments until the default on their debt is cured.
Waiting… And Waiting : The more a BDC has borrowed from its secured lenders, the longer the Note Holders may have to wait to receive their interest. How long ? Of course it will be a company by company scenario, and will depend on many factors. Judging,though, by the experience of companies such as American Capital (ACAS), Kohlberg Capital (KCAP), Saratoga Investment (SAR), Gladstone Capital (GLAD), Gladstone Investment (GAIN), TICC Capital (TICC) and Hercules itself, a default or just the prospect thereof can take many months or even years to play out. American Capital took two years to renegotiate its admittedly complex debt arrangements, and more than three years since defaults hit the fan the company still has not returned to “normal”.
In a scenario where Notes would be in suspended animation, awaiting a resolution between the BDC and its secured lenders, we can reasonably expect that Note values would drop sharply, and presumably new issues suspended. This is mostly new territory so it’s hard to quantify. We would point out,though, that Allied Capital-the BDC swallowed up by Ares Capital as a result of the Great Recession and a parade of bad debts-had an Unsecured Note outstanding through the 2008-2009. The issue trades under the ticker AFC, and is now an obligation of Ares Capital (ARCC). However, before the buy-out, AFC -which came to market at $25 a share- traded as low as $5 during the darkest days. The issue has now recovered in price , but did trade at a 20% discount for twenty four months. Owners of the unsecured Notes will have to take the long term view if what happened to AFC should re-occur with the more recent Note issues.
Why We Like HTGZ: As we warned that’s a very long explanation of why we’re wary about most BDC unsecured Notes (besides the obvious interest rate risks and the right most of the issuers have kept to recall the Notes at their convenience in a few years). However, investing is about not painting with too broad a brush. In the case of Hercules, there are two factors which mitigate our concerns. First, the Company has proven through the last recession (unlike a number of BDCs which have joined the party only since 2009) that, notwithstanding their exposure to a volatile industry such as technology, their credit underwriting has kept bad debt levels at modest levels. It’s nothing to sneeze at, and does go some way to validate the technology lending model, which Horizon Technology Finance (HRZN) and,most recently, Ares Capital have jumped into.
Secondly, Hercules, despite having two senior secured Revolvers with two different banks, does not appear to be relying on this source of funding as permanent capital. Instead, HTGC, perhaps because of its experience with quick-to-bolt-bankers, seems to regard the Revolvers as short term liquidity vehicles which get refinanced in short order by long term unsecured debt, whether the Notes we are discussing or SBIC borrowings, or by new equity raises. Thus, the risk of Hercules being caught in the next recession with heavy exposure to an unhappy secured lender is lower than in some other situations, and gives us comfort that they will be able to avoid the drama that such exposure might entail. Of course, HTGC is not committed to keeping its Revolvers as essentially back-up or warehousing facilities, so nothing is assured.
BDC Reporter’s Unsolicited Opinion About Unsecured Notes: We have said previously that we would be much more excited about BDC unsecured Notes generally if they were accompanied by some limitation on what the borrower could pledge to secured lenders, which would ensure assets would be available to the Note Holders, and would ensure continuing income. (Kohlberg Capital (KCAP) had a structure like this in the Great Recession. Despite being in a very sharp dispute with its Revolver lenders, Kohlberg had other, unencumbered investment assets which generated a current return, and allowed expenses and dividends to be paid). We’d also prefer that the BDCs keep debt to equity levels leverage at the 0.5 to 1.0 levels they were almost unanimously aiming at a few quarters ago. The availability of the new Notes, and plentiful SBIC funding, has begun to encourage BDCs to increase the use of debt by 25%-100%. However, the investment banks are able to get this debt placed without any such requirements, to both the delight of the management (cheap capital which when deployed pays management fees), the secured lenders (who have a pool of assets two to three times their loan commitments as collateral), the investment banks (fees and a new product) and shareholders (who will see higher earnings despite the higher cost of this new debt as BDCs are able to leverage themselves more). Down the road,though, both the Note Holders and the shareholders (who will see higher credit losses from the higher leverage when the next recession comes along) may regret their enthusiasm.
Doom And Gloom Warning: Shareholders, especially, should have a hard look at the economics. With Notes typically being issued at or around 7% (versus 2.5%-3.5% for Revolver debt), and when management fees, incentive fees and incremental costs of the new business are considered, the cost of this unsecured debt capital reaches double digits. For sake of this discussion, let’s say 10%. That means a BDC, lending out monies at a yield of 12.0% is only earning a net interest margin of 2%, where shareholders are concerned. Under a traditional Revolver, the net yield would be closer to 6.0-7.0%. When the recession comes along, and 5%-10% of all loans go on non-accrual every year for a couple of years, the permanent impairment to shareholder value will be significantly higher than a few quarters of additional 2% interest. Of course, BDCs are in the business of making loans, but we question whether the risk-adjusted return is worthwhile with such a thin incremental gain. The other result is that BDC stocks, which are already as volatile as an unexploded bomb on a desert highway, will only become more when investors start to anticipate the next recession.