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Oil & Gas Sector: Bad, and Worse To Come.

The BDC Credit Reporter is still a work-in-progress, but we are getting to a few milestones. This week, we loaded up all the non-technology Watch List companies (two venture lending BDCs to go) in our BDC universe. Now we have to fill in all the various fields for each and every name before turning to the even larger group of Performing companies. At the same time, we are also developing our search strategies to ensure as comprehensive a catchment of under-performing companies as possible. One approach we are taking is to identify sectors within the dozens of segments within the U.S. economy which are undergoing exceptional stress and which might confound all the credit underwriting that BDC lenders might have undertaken. In other words, there are sectors whose troubles are much worse than might have been expected and which will cause an above average number of companies to fail.

The BDC Credit Reporter looks both at industrial sectors and sub-sectors, but also at geographic regions when appropriate. Sticking with the former for the moment, we’ve identified 6 troubled sectors. We pay special attention to any company in these sectors-even those currently performing well-because the heightened stresses they face could cause unexpected troubles.  We call this our Sector Watch.

Readers will not be surprised by most of the segments we’ve placed on our list. Today we’ll have a look at the most infamous troubled sector of all : Energy-Oil & Gas.

NOT LOST OUR CAPACITY TO BE SURPRISED

Unless you’ve been asleep in a cave for the past two years, the inclusion of Oil And Gas companies on our Sector Watch List should come as no surprise. However, we remain shocked by what a broad swathe of oil and gas drillers, producers and service companies many BDCs added to their books, and most within very recent memory. We’ve identified 70 different under-performing “energy” companies so far that have received BDC monies in one form or another. That’s 20% of all the Watch List names on our Master List. From our experience over the past 10 years, we cannot remember a sector riddled with so many with under-performing and bankrupt companies as we count in the Oil & Gas segment today.

Some are famous names like Sandridge Energy or Venoco. Others are small, privately held companies which no one would have heard of before the oil crash. We still have much work to do here as elsewhere, but we do have a few observations to make from the data gathered so far.

AVOIDABLE ?

First, this was an entirely avoidable misstep by the BDC community. As we learn more about these troubled companies, it is clear that most every one was a “pure play” on the price of oil. We don’t just mean the  E&P companies (Energy and Exploration) players-of which there are plenty on the Watch List-but even the “Service” companies. The latter’s fortunes are directly associated with their E&P clients, and thus indirectly to the oil price. Many of the companies were small in size, had very short operating histories,  little in way of underpinning equity capital and outsized ongoing capital needs (drill or die!).

STAY AWAY

In days of yore these type of companies were usually avoided by bank lenders, or exposure limited to specialist energy groups. However, many BDCs, spreading out from their original focus on industrial and service companies by that rush of new capital that flowed into their coffers after the Great Recession, could not resist venturing into this highly specialized sector. In most cases, the underwriting and due diligence was undertaken by the very same BDC personnel who make all the other loans on their books. As often happens with a new entrant to a capital hungry industry, BDC lenders who jumped in with both feet have been left carrying the bag (2 analogies back to back!) when market conditions turned.

FOLLOW OUR LEADER

There are two other phenomena going on which relate to larger trends underway in the sector that we’ve discussed previously.  Many BDCs are owned or spawned from Private Equity groups. Many PE groups have sought new frontiers to conquer in recent years in non-traditional sectors and turned their attention to the U.S. energy sector, with its huge need for capital. As CNBC breathlessly reported back in November 2014, before the downturn in Energy became palpable:

That opportunity [to invest in Energy] has the private equity industry salivating. PE funds have raised $157 billion since 2009 to invest in energy, according to data from intelligence firm Preqin.

With the willingness of the High Yield market to fund essentially speculative oil and gas plays, the PE community had both the incentive and resources to focus on oil prospecting, production and services. Even though BDCs are generally not permitted (thank goodness) to lend to their related PE groups equity investments, the door was opened. We were not surprised to see how many energy loans Apollo Investment (AINV) had on its books after hearing years ago that parent Apollo Global Management was joining the oil rush as a sponsor. Historically there’s been a pattern of BDCs associated with PE groups imitating their strategic initiatives.

STUFFEES

The other phenomenon is what we’ve clumsily called the “asset management-ization” of lending in recent years. Again, many BDCs  are related to huge credit management organizations with multiple funds, and who underwrite very large loans to energy borrowers. (BDC investors should thank their lucky stars that the High Yield Bond sector was willing to do much of the heavy lifting or we would probably see even greater BDC exposure to the sector). Thanks to inexplicable waivers by the SEC of rules that forbid related funds sharing similar loan assets, the asset management parents have filled many BDC portfolios with portions of bigger loans that they’ve underwritten and placed in different pockets under their control. With the benefit of hindsight we can see that these actions allowed the parent to step up to much bigger underwriting than would been possible otherwise, but leads to BDCs having energy over-weighted portfolios.

Have a look at FS Investment’s (FSIC) energy filled portfolio due to its sourcing relationship with GSO Blackstone, which has been very active in the space. We doubt any malicious intent when the loans were first made by GSO or FSIC, but there is a natural, and hard to resist, temptation for a BDC effectively run by a much larger asset management organization to book deals that serve the interests and focus of the parent organization rather than shareholders. Or put another way, if GSO Blackstone had not been so involved in energy lending at the parent level , we suspect FSIC’s portfolio would  have far fewer oil and gas borrowers in its midst.

ANYONE OUT THERE ?

This is where the Board of a BDC and/or the SEC regulators are supposed to raise their hands and say no to the over weighting of BDC portfolios with by-definition riskier energy exposure.  After all, it should be no surprise to anyone that the oil and gas sector is subject to boom and bust cycles. (We haven’t checked Google but “boom and bust” essentially sums up the entire 120 year history  of the industry).

According to the 1980 Act, BDC managers are supposed to maintain highly diversified portfolios, and there are various rules to that effect if a BDC wants to maintain its special status. Unfortunately the rules are broad enough that a BDC can remain within the letter of the rules, while being way beyond its spirit. Some BDCs have managed to accumulate energy investments well in excess of 10% of their total assets.  Given that BDCs use leverage, energy exposure as a percentage of equity has reached as high as 30%,  or more.

Unfortunately-but no surprise to anyone who has read our BDC Activist postings-the Boards of BDCs (stuffed with the very officers of the External Manager who are putting forward the energy loans to be booked) do not provide much in the way of a “check and balance”. We are not aware of any BDC Board placing a limit on energy exposure by its External Manager, or pushing back as energy exposure at many BDCs increased to double digit percentages.

BUST

Just as remarkable is how quickly the energy sector went from hero to zero. We don’t remember much of any energy exposure on most BDCs books back at the turn of the decade. Now there are literally hundreds of loans and equity investments, spread out over at least 100 energy companies. In fact, many of the Watch List loans were added by overly sanguine BDC lenders in late 2014 and early 2015, months after the oil price began its historic descent. Most every

NOT OVER YET

Another observation: We are still in the early innings of distress in many Energy credits. Yes, there have some high profile bankruptcies and the news flow is filled with a litany of restructurings, distressed sale of assets, debt waivers and the like. Nonetheless, the whole Greek drama of lower oil prices, lower production and unsustainable business models is far from over. The experts are saying 2017 might bring a crescendo of bankruptcies. The distressed investors (many of the same asset management groups with failing assets in existing credit portfolios) are still waiting by the door for the buying opportunities to come. From a BDC perspective, at the end of 2015, many energy Watch List names had only been written down marginally, and could yet drop much further. After all, BDC managers and Boards are required only to mark assets to their “current fair market value”, not estimate what the likely outcome might be (as banks used to do with troubled assets when deciding on loss reserves).  If the poor conditions in the sector continues (and a slightly higher price for oil will not save most of these companies given the damage incurred to date and the very high leveraged involved), BDC investors could yet face “death by a thousand cuts” for years to come. Today’s energy asset written down-say- 25% from Cost investment could still be tomorrow’s full write-off.

STRANGE AND MYSTERIOUS WAYS

For BDCs with substantial energy exposure (we’re still counting but at least a quarter of the universe) this drawn out process will bedevil results for a long time and in many ways. Of course, investors will constantly have to estimate which energy investment will survive and which will not in a BDC’s portfolio, and what the recovery rate will be on the losers. More subtly, earnings might give a false positive reading to investors. Often as energy credits get into trouble the BDC lenders negotiate waivers and amendments while trying to keep their investments afloat. The result can be unusual fee income. At the same time, interest rates on loans to these troubled companies are often raised to compensate lenders for the higher risk. Unfortunately, these higher rates are often in the form of Pay-In-Kind income, which is just increasing the loan balance owed. For awhile a BDC might even show a boost in earnings as fees and yields rise, even if much that additional income is in phantom form.  That will boost Taxable Income and distributions but could be a kind of Fool’s Gold. As an energy company’s credit deterioration goes, that high yield income debt might be converted to equity or Preferred (sometimes with more fees being charged along the way). If the economics of the business still do not work (and a number of oil and gas companies have already gone through these stages), the remaining investment gets permanently written off.  Or the debt that has  become equity in these troubled companies sits on BDC balance sheets for awhile, requiring management fees to be paid to the External Manager until the business closes down months or years later. Unfortunately External Managers have every incentive to stretch out this process as long as possible, both for the hope that the economics of the industry will change back to their favor and to maximize fee income.  No BDC repays management fees previously paid out when a quarter or ten later the underlying business is finally recognized to be insolvent.

VIGILANCE

We suggest investors should keep an eye on how any BDC they own with oil & gas exposure treats income from under-performing entities.  Is PIK income on what might be essentially insolvent companies being recognized and added to loan principal, resulting in higher loan balance and so higher management fees ? Do high yields from highly stressed investments boost Net Investment Income and cause an increase in Incentive Fees for awhile before write-offs occur ?   How much of a BDC’s Net Investment Income is received in cash form and how much in PIK income that might never be collected as the decline in oil and gas borrowers fortunes continue  ?  Most of the External Managers will be taking their fees in cash every quarter, and shareholders will be paying taxes on income as if all income accrued is the same, but the actual cash income available to pay distributions might be significantly lower.  BDCs will have to sell assets or leverage up already fully extended balance sheets to meet their obligations to lenders, managers and shareholders.

HIGH YIELD

Finally, those BDCs that have made those big bets on energy lending-even when all those loans work their way out of the system-will have to adapt to a world of substantially lower income. We don’t mean just the impact of the write-offs that come with the territory, but the fact that oil & gas loans have been made at materially higher yield levels than to non-energy companies. The average yields of many BDCs will drop as capital is re-deployed at rates 2-3% lower than what the capital-hungry energy companies were willing and able to pay. For the BDCs that have bet heavily on the energy sector-even if they miraculously avoided any bad debt (and we don’t know one who has)-will still have to deal with the hangover of reduced portfolio income.

WRAPPING UP

The BDC Sector foray into the oil & gas sector has been bedeviling many of the industry’s players for nearly two years now.  Unfortunately, due to macro factors underway in the asset management industry and because of the one-sided governance of BDC companies (insert fox and hen house analogy here ), the drop in the fortunes of oil and gas companies has wreaked havoc with the earnings and Net Asset Value of many BDC companies. This did not have to happen but has. More importantly for those of us looking forward, the impact of the oil bust will continue to impact many BDCs for years to come, heightening uncertainty about the real value of investment portfolios, and warping earnings, taxable income and distributions.

The BDC Credit Reporter has no idea if the fortunes of the existing oil and gas credits will improve or deteriorate in the months ahead. However, we will be watching and bringing the results to any readers interested. Our first few “deep dives” into some of the names on our Watch List have not been encouraging, but that’s anecdotal. What we can say is that even if there is a sustained bounce back in the price of oil over the next few quarters, there is little prospect that there will be a widespread recovery in the credit prospects of the type of energy borrowers that BDCs have been involved with. The entire economics of the industry, and the approach of the capital markets towards risk therein has changed and is unlikely to revert to the the pre-2014 situation for a generation. As a result, the binary outcome for the BDC Sector where energy investments are concerned is either  “bad” or “disastrous”. Nobody who’s been involved in BDC-land is getting out unscathed.

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